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Form 10-Q CAROLINA FINANCIAL CORP For: Mar 31

May 10, 2018 3:04 PM EDT

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended March 31, 2018


OR

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

For the Transition Period from                      to

 

Commission file number 001-10897

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

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

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x No o

 

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

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

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 21,059,534 shares of common stock, par value $0.01 per share, were issued and outstanding as of May 8, 2018.

 
 

TABLE OF CONTENTS

 

    Page
PART 1 – FINANCIAL INFORMATION  
     
Item 1. Financial Statements 3
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 47
     
Item 3. Quantitative and Qualitative Disclosure about Market Risk 71
     
Item 4. Controls and Procedures 72
     
PART II – OTHER INFORMATION 72
     
Item 1. Legal Proceedings 72
     
Item 1A. Risk Factors 72
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 72
     
Item 3. Defaults Upon Senior Securities 72
     
Item 4. Mine Safety Disclosures 72
     
Item 5. Other Information 72
     
Item 6. Exhibits 72
2
 
PART 1 - FINANCIAL INFORMATION        
Item 1 - Financial Statements        
         
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
 
   March 31, 2018   December 31, 2017 
   (Unaudited)   (Audited) 
   (In thousands, except share data) 
ASSETS          
Cash and due from banks  $25,761    25,254 
Interest-bearing cash   35,603    55,998 
 Cash and cash equivalents   61,364    81,252 
Securities available-for-sale (cost of $755,086 at March 31, 2018 and $736,975 at December 31, 2017)   753,363    743,239 
Federal Home Loan Bank stock, at cost   17,913    19,065 
Other investments   3,432    3,446 
Derivative assets   4,913    2,803 
Loans held for sale   24,618    35,292 
Loans receivable, net of allowance for loan losses of $12,708 at March 31, 2018 and $11,478 at December 31, 2017   2,367,310    2,308,050 
Premises and equipment, net   62,593    61,407 
Accrued interest receivable   11,502    11,992 
Real estate acquired through foreclosure, net   1,963    3,106 
Deferred tax assets, net   4,952    2,436 
Mortgage servicing rights   21,719    21,003 
Cash value life insurance   57,604    57,195 
Core deposit intangible   18,795    19,601 
Goodwill   127,592    127,592 
Other assets   13,443    21,538 
Total assets  $3,553,076    3,519,017 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
Liabilities:          
Noninterest-bearing deposits  $547,744    525,615 
Interest-bearing deposits   2,129,225    2,079,314 
 Total deposits   2,676,969    2,604,929 
Short-term borrowed funds   308,500    340,500 
Long-term debt   67,303    72,259 
Derivative liabilities   164    156 
Drafts outstanding   10,133    7,324 
Advances from borrowers for insurance and taxes   3,302    3,005 
Accrued interest payable   1,288    1,126 
Reserve for mortgage repurchase losses   1,742    1,892 
Dividends payable to stockholders   1,053    1,051 
Accrued expenses and other liabilities   7,576    11,394 
 Total liabilities   3,078,030    3,043,636 
Commitments and contingencies          
Stockholders’ equity:          
Preferred stock, par value $.01; 1,000,000 shares authorized at March 31, 2018 and December 31, 2017; no shares issued or outstanding        
Common stock, par value $.01; 25,000,000 shares authorized at March 31, 2018 and December 31, 2017; 21,057,539 and 21,022,202 issued and outstanding at March 31, 2018 and December 31, 2017, respectively   211    210 
Additional paid-in capital   348,621    348,037 
Retained earnings   126,262    123,537 
Accumulated other comprehensive income (loss), net of tax   (48)   3,597 
 Total stockholders’ equity   475,046    475,381 
Total liabilities and stockholders’ equity  $3,553,076    3,519,017 
           
See accompanying notes to consolidated financial statements.          
3
 
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
         
   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands, except share data) 
Interest income          
Loans  $31,663    14,968 
Investment securities   5,707    2,553 
Dividends from Federal Home Loan Bank stock   175    101 
Other interest income   131    48 
 Total interest income   37,676    17,670 
Interest expense          
Deposits   3,642    1,692 
Short-term borrowed funds   1,253    355 
Long-term debt   650    353 
 Total interest expense   5,545    2,400 
Net interest income   32,131    15,270 
Provision for loan losses        
Net interest income after provision for loan losses   32,131    15,270 
Noninterest income          
Mortgage banking income   3,801    3,608 
Deposit service charges   2,024    858 
Net (loss) gain on sale of securities   (697)   185 
Fair value adjustments on interest rate swaps   803    (58)
Net increase in cash value life insurance   390    211 
Mortgage loan servicing income   2,025    1,566 
Other   1,702    861 
 Total noninterest income   10,048    7,231 
Noninterest expense          
Salaries and employee benefits   13,668    8,609 
Occupancy and equipment   3,652    2,182 
Marketing and public relations   376    381 
FDIC insurance   255    100 
Recovery of mortgage loan repurchase losses   (150)   (225)
Legal expense   76    65 
Other real estate (income) expense, net   (94)   20 
Mortgage subservicing expense   565    486 
Amortization of mortgage servicing rights   979    669 
Merger related expenses   14,710    1,319 
Other   3,561    1,980 
 Total noninterest expense   37,598    15,586 
Income before income taxes   4,581    6,915 
Income tax expense   525    2,011 
Net income  $4,056    4,904 
Earnings per common share:          
Basic  $0.19    0.35 
Diluted  $0.19    0.35 
Dividends per common share  $0.05    0.04 
Weighted average common shares outstanding:          
Basic   20,908,225    13,919,711 
Diluted   21,119,316    14,139,241 
           
See accompanying notes to consolidated financial statements.          
4
 
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
   For the Three Months 
   March 31 
   2018   2017 
   (In thousands) 
         
Net income  $4,056    4,904 
           
Other comprehensive income (loss), net of tax:          
Unrealized gains (losses) on securities   (6,564)   3,474 
Tax effect   1,641    (1,251)
           
Reclassification adjustment for losses (gains) included in earnings   697    (185)
Tax effect   (174)   67 
           
Unrealized gain on interest rate swaps designated as cash flow hedges   1,007    138 
Tax effect   (252)   (50)
Other comprehensive (loss) income, net of tax   (3,645)   2,193 
           
Comprehensive income  $411    7,097 
           
See accompanying notes to consolidated financial statements.          
5
 
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017
(Unaudited)
 
                   Accumulated     
           Additional       Other     
  

Common Stock

   Paid-in   Retained   Comprehensive     
   Shares   Amount   Capital   Earnings   Income (Loss)   Total 
   (In thousands, except share data) 
                         
Balance, December 31, 2016   12,548,328   $125    66,156    98,451    (1,542)   163,190 
Issuance of common stock, net of offering expenses   1,807,143    18    47,653            47,671 
Stock issued - Greer Bancshares Incorporated acquisition   1,784,831    18    54,063            54,081 
Stock awards   60,031    1    108            109 
Vested stock awards surrendered in cashless exercise   (14,925)       (186)   (251)       (437)
Stock-based compensation expense, net           319            319 
Net income               4,904        4,904 
Dividends declared to stockholders               (576)       (576)
Other comprehensive income, net of tax                   2,193    2,193 
Balance, March 31, 2017   16,185,408   $162    168,113    102,528    651    271,454 
                               
Balance, December 31, 2017   21,022,202   $210    348,037    123,537    3,597    475,381 
Stock awards-net of forfeitures   42,807    1    105            106 
Vested stock awards surrendered in cashless exercise   (12,534)       (210)   (279)       (489)
Stock options exercised   5,064        56            56 
Stock-based compensation expense, net           633            633 
Net income               4,056        4,056 
Dividends declared to stockholders               (1,052)       (1,052)
Other comprehensive income, net of tax                   (3,645)   (3,645)
Balance, March 31, 2018   21,057,539   $211    348,621    126,262    (48)   475,046 
                               
See accompanying notes to consolidated financial statements. 
6
 
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Cash flows from operating activities:          
Net income  $4,056    4,904 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses        
Amortization of unearned discount/premiums on investments, net   1,289    834 
Accretion of deferred loan fees   (788)   (251)
Accretion of acquired loans   (2,898)   (372)
Amortization of core deposit intangibles   806    133 
Loss (gain) on sale of available-for-sale securities, net   697    (185)
Mortgage banking income   (3,801)   (3,608)
Originations of loans held for sale   (211,921)   (195,583)
Proceeds from sale of loans held for sale   226,396    209,466 
Amortization of fair value adjustments on subordinated debentures   44     
Recovery of mortgage loan repurchase losses   (150)   (225)
Mortgage repurchase loan losses paid, net of recoveries       (72)
Fair value adjustments on interest rate swaps   (803)   58 
Stock-based compensation   633    319 
Increase in cash surrender value of bank owned life insurance   (390)   (211)
Depreciation   964    568 
Loss on disposals of premises and equipment       3 
Gain on sale of real estate acquired through foreclosure   (92)   (6)
Originations of mortgage servicing rights   (1,695)   (1,429)
Amortization of mortgage servicing rights   979    669 
(Increase) decrease in:          
Accrued interest receivable   490    (170)
Other assets   8,810    (5,156)
Increase (decrease) in:          
Accrued interest payable   162    105 
Dividends payable to stockholders   2    74 
Accrued expenses and other liabilities   (3,747)   (1,031)
Cash flows provided by operating activities   19,043    8,834 
           
         Continued 
7
 
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
         
   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Cash flows from investing activities:          
Activity in available-for-sale securities:          
 Purchases  $(93,296)   (85,787)
 Maturities, payments and calls   21,324    11,877 
 Proceeds from sales   51,178    37,697 
Increase in other investments       (7)
Decrease in Federal Home Loan Bank stock   1,152    189 
Increase in loans receivable, net   (55,591)   (43,725)
Purchase of premises and equipment   (2,150)   (1,931)
Proceeds from sale of real estate acquired through foreclosure   1,252    29 
Net cash received for acquisitions       37,622 
Cash flows used in investing activities   (76,131)   (44,036)
           
Cash flows from financing activities:          
Net increase in deposit accounts   72,040    38,394 
Net decrease in Federal Home Loan Bank advances   (37,000)   (8,000)
Net increase in drafts outstanding   2,809    906 
Net increase in advances from borrowers for insurance and taxes   297    979 
Cash dividends paid on common stock   (1,052)   (502)
Proceeds from issuance of common stock   106    47,671 
Cash flows provided by financing activities   37,200    79,448 
Net increase (decrease) in cash and cash equivalents   (19,888)   44,246 
Cash and cash equivalents, beginning of period   81,252    24,352 
Cash and cash equivalents, end of period  $61,364    68,598 
           
Supplemental disclosure:          
Cash paid for:          
 Interest on deposits and borrowed funds  $5,383    2,037 
 Income taxes paid, net of refunds   24    19 
Noncash investing activities:          
 Transfer of loans receivable to real estate acquired through foreclosure  $17    281 
 Acquisitions:          
 Fair value of tangible assets acquired  $    380,011 
 Other intangible assets acquired       4,480 
 Liabilities assumed       358,866 
 Net identifiable assets acquired over liabilities assumed       25,625 
 Common stock issued in acquisition       54,223 
 Goodwill       33,020 
           
See accompanying notes to consolidated financial statements.          
8
 

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization

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

At March 31, 2018, statutory business trusts (“Trusts”) created or acquired by the Company had outstanding trust preferred securities with an aggregate par value of $36.0 million. The principal assets of the Trusts are $37.1 million of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $1,116,000 of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 as filed with the Securities and Exchange Commission (the “SEC”) on March 16, 2018. There have been no significant changes to the accounting policies as disclosed in the Company’s Form 10-K.

Management’s Estimates

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

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

9
 

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

Earnings Per Share

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

Subsequent Events

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

On April 25, 2018, the Company declared a $0.06 dividend per common share, payable on July 6, 2018, to stockholders of record on June 15, 2018.

On May 2, 2018, the Company’s stockholders approved an amendment to its Certificate of Incorporation that increases the number of authorized common shares from 25,000,000 to 50,000,000.

Reclassification

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

Recently Adopted Accounting Pronouncements

During the first quarter of 2018, the Company adopted Accounting Standards Update (“ASU”) No. 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which are applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. Refer to Note 8 - Estimated Fair Value of Financial Instruments for more information.

10
 

In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”). ASU 2016-08 updates the new revenue standard by clarifying the principal versus agent implementation guidance, but does not change the core principle of the new standard. The updates to the principal versus agent guidance: (i) require an entity to determine whether it is a principal or an agent for each distinct good or service (or a distinct bundle of goods or services) to be provided to the customer; (ii) illustrate how an entity that is a principal might apply the control principle to goods, services, or rights to services, when another party is involved in providing goods or services to a customer and (iii) clarify that the purpose of certain specific control indicators is to support or assist in the assessment of whether an entity controls a good or service before it is transferred to the customer, provide more specific guidance on how the indicators should be considered, and clarify that their relevance will vary depending on the facts and circumstances. For business entities, the effective date and transition requirements for these amendments are the same as the effective date and transition requirements of ASU 2014-09 which is effective for interim and annual periods beginning after December 15, 2017. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this new guidance recognized at the date of initial application. The Company’s revenue is primarily comprised of net interest income on financial assets and financial liabilities, which is explicitly excluded from the scope of ASU 2014-09, and non-interest income. The Company has evaluated ASU 2016-08 and 2014-09 and determined that this guidance did not have a material impact on the way the Company currently recognizes revenue or the way it recognizes expenses related to those revenue streams. The Company adopted ASU No. 2014-09 and its related amendments on its required effective date of January 1, 2018 utilizing the modified retrospective approach. Since there was no net income impact upon adoption of the new guidance, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Consistent with the modified retrospective approach, the Company did not adjust prior period amounts.

 

In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718) (“ASU 2017-09”). ASU 2017-09 provides clarity when applying guidance to a change to the terms or conditions of a share-based payment award. The amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. The Company adopted ASU No. 2017-09 and its related amendments on its required effective date of January 1, 2018. The amendments will be applied prospectively to an award modified on or after the adoption date. The Company has determined that this guidance did not have a material impact on the Company’s consolidated financial statements.

 

Recently Issued Accounting Pronouncements

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 amends the requirements of the Derivatives and Hedging Topic of the Accounting Standards Codification (“ASC”) to improve the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. The amendments will be effective for the Company for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

11
 

In March 2017, the FASB issued ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Cost (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities (“ASU 2017-08”). ASU 2017-08 shortens the amortization period of the premium for certain callable debt securities, from the contractual maturity date to the earliest call date. The amendments do not require an accounting change for securities held at a discount; an entity will continue to amortize to the contractual maturity date the discount related to callable debt securities. The amendments apply to the amortization of premiums on callable debt securities with explicit, non-contingent call features that are callable at fixed prices on preset dates. For public business entities, ASU 2017-08 is effective in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted for all entities, including in an interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the amendments are adopted. The Company has determined that this guidance will not have a material impact on the Company’s consolidated financial statements.

 

In January 2017, the FASB issued ASU No. 2017-04, Intangible-Goodwill and other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in today’s two-step impairment test under Accounting Standards Codification ASC 350 and eliminating Step 2 from the goodwill impairment test. As amended, the goodwill impairment test will consist of one step comparing the fair value of a reporting unit with its carrying amount. An entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The guidance is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those years. The amendments should be adopted prospectively and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company has determined that this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In June 2016, the FASB ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 requires an entity to utilize a new impairment model known as the current expected credit loss (“CECL”) model to estimate its lifetime “expected credit loss” and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The CECL model is expected to result in earlier recognition of credit losses. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is continuing to assess the impact that this new guidance will have on its consolidated financial statements through its implementation team. The team has assigned roles and responsibilities, key tasks to complete, and a general timeline to be followed. The implementation team meets periodically to discuss the latest developments and ensure progress is being made. The team also keeps current on evolving interpretations and industry practices related to ASU 2016-13 via webcasts, publications, and conferences. The Company has engaged an outside consultant to assist with the methodology review and validation, as well as other key aspects of implementing the standard. The Company’s preliminary evaluation indicates the provisions of ASU No. 2016-13 are expected to impact the Company’s consolidated financial statements, in particular the level of the reserve for credit losses. However, the Company continues to evaluate the extent of the potential impact.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 applies a right-of-use (“ROU”) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset and a liability to make lease payments. For leases with a term of 12 months or less, a practical expedient is available whereby a lessee may elect, by class of underlying asset, not to recognize an ROU asset or lease liability. At inception, lessees must classify all leases as either finance or operating based on five criteria. Balance sheet recognition of finance and operating leases is similar, but the pattern of expense recognition in the income statement, as well as the effect on the statement of cash flows, differs depending on the lease classification. For public business entities, the amendments in ASU 2016-02 are effective for interim and annual periods beginning after December 15, 2018. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach which includes a number of optional practical expedients that entities may elect to apply. The Company is currently evaluating the provisions of ASU 2016-02 in relation to its outstanding leases to determine the potential impact the new standard will have to the Company’s financial statements. The Company expects the new guidance will require these lease arrangements to be recognized on the consolidated statements of condition as a right-of-use asset and a corresponding lease liability. Therefore, the Company’s preliminary evaluation indicates the provisions of ASU No. 2016-02 are expected to impact the Company’s consolidated statements of condition, as well as our regulatory capital ratios. However, the Company continues to evaluate the extent of potential impact the new guidance will have on the Company’s consolidated financial statements. The Company is nearing completion of identifying a complete inventory of arrangements containing a lease and accumulating the lease data necessary to apply the amended guidance. In addition, the Company has obtained new software to aid in the transition to the new leasing guidance.

12
 

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

 

NOTE 2 – BUSINESS COMBINATIONS

On November 1, 2017, the Company acquired all of the common stock of First South Bancorp, Inc., the holding company for First South Bank (“First South”). Under the terms of the merger agreement, each share of First South common stock was converted into the right to receive 0.5064 shares of the Company’s common stock.

The following table presents a summary of total consideration paid by the Company at the acquisition date (dollars in thousand).

 

Common stock issued (4,822,540 shares at $36.85 per share)  $177,711 
Cash in lieu of fractional shares and fair value of stock options   983 
Total consideration paid  $178,694 

 

The assets acquired and liabilities assumed from First South were recorded at their fair value as of the closing date of the merger. Fair values were preliminary and subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values became available. Goodwill of $90.3 million was recorded at the time of the acquisition. The following table summarizes the consideration paid by the Company in the merger with First South and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date.

13
 

November 1, 2017  As Reported by
First South
   Fair Value
Adjustments
   As Recorded by
the Company
 
Assets  (In thousands) 
Cash and cash equivalents  $66,109        66,109 
Securities available-for-sale   186,038        186,038 
Federal Home Loan Bank stock   1,593        1,593 
Loans held for sale   1,282        1,282 
Loans receivable   783,779    (24,620)(a)    759,159 
Allowance for loan losses   (9,495)   9,495(b)    
Premises and equipment   10,761    1,500(c)   12,261 
Foreclosed assets   1,922    (556)(d)   1,366 
Core deposit intangible   1,410    11,090(e)   12,500 
Deferred tax asset, net   3,961    238(f)   4,199 
Other assets   33,552    (3,417)(g)   30,135 
 Total assets acquired  $1,080,912    (6,270)   1,074,642 
                
Liabilities               
Deposits  $952,573    78(h)   952,651 
Borrowings   26,810    (1,439)(i)   25,371 
Other liabilities   8,515    (284)(j)   8,231 
Total liabilities assumed  $987,898    (1,645)   986,253 
Net identifiable assets acquired over liabilities assumed             88,389 
Total consideration paid             178,694 
Goodwill            $90,305 

 

Explanation of fair value adjustments:  

(a) Represents the amount necessary to adjust loans to their fair value due to interest rate and credit factors.
(b) Reflects the elimination of First South's historical allowance for loan losses.
(c) Reflects fair value adjustments on acquired branch and administrative offices based on the Company's assessment.
(d) Reflects the impact of acquisition accounting fair value adjustments.
(e) Reflects the fair value adjustment to record the estimated core deposit intangible based on the Company's assessment.
(f) Reflects the tax impact of acquisition accounting fair value adjustments.
(g) Reflects the fair value adjustment based on the Company's evaluation of acquired other assets.
(h) Represents the fair value adjustment due to interest rate factors.
(i) Represents the fair value adjustment due to interest rate factors.
(j) Reflects the fair value adjustment based on the Company's evaluation of acquired other liabilities.

 

Acquisition of Greer Bancshares Incorporated

On March 18, 2017, the Company completed its acquisition of Greer Bancshares Incorporated (“Greer”), the holding company for Greer State Bank. Under the terms of the merger agreement, each share of Greer common stock was converted into the right to receive $18.00 in cash or 0.782 shares of the Company’s common stock, or a combination thereof, subject to certain limitations.

The following table presents a summary of total consideration paid by the Company at the acquisition date (dollars in thousand).

Common stock issued (1,789,523 shares at $30.30 per share)  $54,223 
Cash payments to common stockholders   4,422 
Total consideration paid  $58,645 
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The assets acquired and liabilities assumed from Greer were recorded at their fair value as of the closing date of the merger. Fair values were preliminary and subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values became available. Goodwill of $33.0 million was recorded at the time of the acquisition. The following table summarizes the consideration paid by the Company in the merger with Greer and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date.

   As Reported   Fair Value   As Recorded by 
March 18, 2017  by Greer   Adjustments   the Company 
Assets   (In thousands) 
Cash and cash equivalents  $42,187        42,187 
Securities available for sale   121,374        121,374 
Loans held for sale   105        105 
Loans receivable   205,209    (10,559)(a)   194,650 
Allowance for loan losses   (3,198)   3,198(b)    
Premises and equipment   3,928    4,202(c)   8,130 
Foreclosed assets   42        42 
Core deposit intangible       4,480(d)   4,480 
Deferred tax asset, net   3,831    (1,434) (e)   2,397 
Other assets   11,367    (241) (f)   11,126 
Total assets acquired  $384,845    (354)   384,491 
                
Liabilities               
Deposits  $310,866    200(g)   311,066 
Borrowings   43,712    (3,510) (h)   40,202 
Other liabilities   7,086    512(i)   7,598 
Total liabilities assumed  $361,664    (2,798)   358,866 
Net identifiable assets acquired over liabilities assumed             25,625 
Total consideration paid             58,645 
Goodwill            $33,020 
   
Explanation of fair value adjustments:
(a) Adjustment represents the amount necessary to adjust loans to their fair value due to interest rate and credit factors.
(b) Adjustment reflects the elimination of Greer's historical allowance for loan losses.
(c) Adjustment reflects fair value adjustments on acquired branch and administrative offices based on third party appraisals.
(d) Adjustment reflects the fair value adjustment to record the estimated core deposit intangible based on the Company's third
  party valuation report.
(e) Adjustment reflects the tax impact of acquisition accounting fair value adjustments.
(f) Adjustment reflects the fair value adjustment based on the Company's evaluation of acquired other assets.
(g) Adjustment represents the fair value adjustment due to interest rate factors.
(h) Adjustment represents the fair value adjustment due to interest rate factors.
(i) Adjustment reflects the fair value adjustment based on the Company's evaluation of acquired other liabilities.

 

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NOTE 3 – SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of securities available-for-sale at March 31, 2018 and December 31, 2017 follows:

 

   March 31, 2018   December 31, 2017 
       Gross   Gross           Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value   Cost   Gains   Losses   Value 
Securities available-for-sale:  (In thousands) 
Municipal securities  $207,088    2,632    (1,562)   208,158    240,904    6,790    (344)   247,350 
US government agencies   16,111        (45)   16,066    11,983    34    (9)   12,008 
Collateralized loan obligations   134,590    596    (2)   135,184    128,080    581    (18)   128,643 
Corporate securities   6,896    85        6,981    6,891    115        7,006 
Mortgage-backed securities:                                        
Agency   234,171    431    (2,989)   231,613    243,075    1,234    (714)   243,595 
Non-agency   145,018    551    (1,079)   144,490    94,834    551    (260)   95,125 
Total mortgage-backed securities   379,189    982    (4,068)   376,103    337,909    1,785    (974)   338,720 
Trust preferred securities   11,212    1,763    (2,104)   10,871    11,208    1,132    (2,828)   9,512 
Total  $755,086    6,058    (7,781)   753,363    736,975    10,437    (4,173)   743,239 

 

The Company had no held-to-maturity securities as of March 31, 2018 or December 31, 2017.

The amortized cost and fair value of debt securities by contractual maturity at March 31, 2018 follows:

 

   At March 31, 2018 
   Amortized   Fair 
   Cost   Value 
   (In thousands) 
Securities available-for-sale:         
Less than one year  $2,309    2,307 
One to five years   14,730    14,660 
Six to ten years   127,688    127,518 
After ten years   610,359    608,878 
Total  $755,086    753,363 

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

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

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   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
         
Proceeds  $51,178    37,697 
           
Realized gains  $14    373 
Realized losses   (711)   (188)
Total investment securities (losses) gains, net  $(697)   185 

 

At March 31, 2018, the Company had no securities pledged for Federal Home Loan Bank (“FHLB”) advances.

At March 31, 2018, the Company has pledged $184.6 million of securities to secure public agency funds.

At March 31, 2018, the Company had $208.4 million of securities pledged for FRB advances.

The following tables summarize gross unrealized losses on investment securities and the fair market value of the related securities at March 31, 2018 and December 31, 2017, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

 

   At March 31, 2018 
   Less than 12 Months   12 Months or Greater   Total 
   Amortized   Fair   Unrealized   Amortized   Fair   Unrealized   Amortized   Fair   Unrealized 
   Cost   Value   Losses   Cost   Value   Losses   Cost   Value   Losses 
   (In thousands) 
Available-for-sale:                                             
Municipal securities  $86,402    85,077    (1,325)   3,589    3,352    (237)   89,991    88,429    (1,562)
US government agencies  $16,111    16,066    (45)               16,111    16,066    (45)
Collateralized loan obligations   5,000    4,998    (2)               5,000    4,998    (2)
Mortgage-backed securities:                                             
Agency   181,577    178,988    (2,589)   16,616    16,216    (400)   198,193    195,204    (2,989)
Non-agency   89,740    88,782    (958)   9,177    9,056    (121)   98,917    97,838    (1,079)
Total mortgage-backed securities   271,317    267,770    (3,547)   25,793    25,272    (521)   297,110    293,042    (4,068)
Trust preferred securities               8,483    6,379    (2,104)   8,483    6,379    (2,104)
Total  $378,830    373,911    (4,919)   37,865    35,003    (2,862)   416,695    408,914    (7,781)
17
 
   At December 31, 2017 
   Less than 12 Months   12 Months or Greater   Total 
   Amortized   Fair   Unrealized   Amortized   Fair   Unrealized   Amortized   Fair   Unrealized 
   Cost   Value   Losses   Cost   Value   Losses   Cost   Value   Losses 
   (In thousands) 
Available-for-sale:                                             
Municipal securities  $23,849    23,631    (218)   3,606    3,480    (126)   27,455    27,111    (344)
US government agencies   1,681    1,672    (9)               1,681    1,672    (9)
Collateralized loan obligations   23,000    22,982    (18)               23,000    22,982    (18)
Mortgage-backed securities:                                             
Agency   107,501    107,011    (490)   17,484    17,260    (224)   124,985    124,271    (714)
Non-agency   21,874    21,704    (170)   9,889    9,799    (90)   31,763    31,503    (260)
Total mortgage-backed securities   129,375    128,715    (660)   27,373    27,059    (314)   156,748    155,774    (974)
Trust preferred securities               8,516    5,688    (2,828)   8,516    5,688    (2,828)
Total  $177,905    177,000    (905)   39,495    36,227    (3,268)   217,400    213,227    (4,173)
                                              

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

 

At March 31, 2018 and December 31, 2017, the Company had 218 and 135, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in US government-sponsored agencies, municipal securities, mortgage-backed securities (agency and non-agency), and trust preferred securities summarized above were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows testing as needed, and determined that no OTTI expense was necessary during 2018 or 2017.

NOTE 4 – DERIVATIVES

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

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The derivative positions of the Company at March 31, 2018 and December 31, 2017 are as follows:

   At March 31,   At December 31, 
   2018   2017 
   Fair   Notional   Fair   Notional 
   Value   Value   Value   Value 
   (In thousands) 
Derivative assets:                    
Cash flow hedges:                    
Interest rate swaps  $1,651    55,000    644    45,000 
Non-hedging derivatives:                    
Interest rate swaps   1,673    45,000    964    50,000 
Mortgage loan interest rate lock commitments   1,380    121,760    890    98,584 
Mortgage loan forward sales commitments   209    13,227    305    23,401 
Total derivative assets  $4,913    234,987    2,803    216,985 
                     
Derivative liabilities:                    
Interest rate swaps  $32    15,000    95    5,000 
Mortgage-backed securities forward sales commitments   132    87,330    61    75,000 
Total derivative liabilities  $164    102,330    156    80,000 

Non-Designated Hedges

 

Derivative Loan Commitments and Forward Sales Commitments

 

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

 

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

 

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

 

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

 

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

19
 

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

 

Interest Rate Swaps

 

The Company enters into interest rate swaps that do not meet the hedge accounting requirements and are recorded at fair value as a derivative asset or liability. Interest rate swaps that are not designated as hedges are primarily used to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches. Fair value changes are recognized in noninterest income as “fair value adjustments on interest rate swaps.”

 

Cash Flow Hedges of Interest Rate Risk

 

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

 

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

 

Risk Management Objective of Using Derivatives

 

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

 

NOTE 5 - LOANS RECEIVABLE, NET

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

 

Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer lending limits, with approval processes for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds the maximum senior officer’s lending authority, the loan request will be considered by the management loan committee, or MLC, which is comprised of four members, all of whom are part of the senior management team of the Bank. The MLC meets weekly to approve loans with total loan commitment relationships generally exceeding $2.0 million. The loan authority of the MLC is equal to two-thirds of the legal lending limit of the Bank which is equivalent to the in-house loan limit. Total credit exposure above the in-house limit requires approval by the majority of the board of directors. We do not make any loans to any director, executive officer of the Bank, or the related interests of each, unless the loan is approved by the full Board of Directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.

20
 

The following is a description of the risk characteristics of the material loan portfolio segments:

 

Residential Mortgage Loans and Home Equity Loans. We generally originate and hold short-term and long-term first mortgages and traditional second mortgage residential real estate loans. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%. Loans over 80% LTV generally require private mortgage insurance. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We also offer a variety of lot loan options to consumers to purchase the lot on which they intend to build their home. The options available depend on whether the borrower intends to begin building within 12 months of the lot purchase or at an undetermined future date. We also offer traditional home equity loans and lines of credit. Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity loans typically have terms of 10 years or less.

 

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

 

Real Estate Construction and Development Loans. We offer fixed and adjustable rate residential and commercial construction loan financing to builders and developers and to consumers who wish to build their own home. The term of construction and development loans generally is limited to 18 months, although payments may be structured on a longer amortization basis. Most loans will mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the subsequent sale of the property. We attempt to reduce risk associated with construction and development loans by obtaining personal guarantees and by keeping the maximum loan-to-value ratio at or below 65%-80% of the lesser of cost or appraised value, depending on the project type. Generally, we do not have interest reserves built into loan commitments but require periodic cash payments for interest from the borrower’s cash flow.

 

Commercial Loans. We make loans for commercial purposes in various lines of businesses, including the manufacturing industry, service industry, and professional service areas. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate. Equipment loans typically will be made for a term of 10 years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 75% of cost. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.

 

The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company purchases nationally syndicated commercial and industrial loans. These loans typically have terms of seven years and are generally tied to a floating rate index such as LIBOR or prime. To effectively manage this line of business, the Company has an experienced senior lending executive with relevant experience to manage this area of this segment of the loan portfolio. In addition, the Company engaged a consulting firm that specializes in syndicated loans to assist in monitoring performance analytics. As of March 31, 2018 and December 31, 2017, there were approximately $86.7 million and $75.0 million in broadly syndicated loans outstanding. Syndicated loans are grouped within commercial business loans below.

21
 

The Bank began originating leases, primarily on equipment utilized for business purposes, as a result of the First South acquisition. Lease terms generally range from 12 to 60 months and include options to purchase the leased equipment at the end of the lease. Most leases provide 100% of the cost of the equipment and are secured by the leased equipment. The Company requires the leased equipment to be insured and that we be listed as a loss payee and named as an additional insured on the insurance policy. We manage credit risk associated with our lease financing loan class based upon the dollar amount of the lease and the level of credit risk. We follow a formal review process that entails analysis of the following factors: equipment value/residual value, exposure levels, jurisdiction risk, industry risk, guarantor requirements, and regulatory compliance. As of March 31, 2018 and December 31, 2017, there were approximately $20.3 million and $24.0 million in lease receivables outstanding. Lease receivables are grouped within commercial business loans below.

 

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

 

Loans receivable, net at March 31, 2018 and December 31, 2017 are summarized by category as follows:

 

   At March 31,   At December 31, 
   2018   2017 
       % of Total       % of Total 
All Loans:  Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                    
 One-to-four family  $689,249    28.96%   665,774    28.70
 Home equity   89,492    3.76%   90,141    3.89%
 Commercial real estate   941,796    39.57%   933,820    40.26%
 Construction and development   311,044    13.07%   294,793    12.71%
Consumer loans   17,752    0.75%   19,990    0.86%
Commercial business loans   330,685    13.89%   315,010    13.58%
 Total gross loans receivable   2,380,018    100.00%   2,319,528    100.00%
Less:                    
 Allowance for loan losses   12,708         11,478      
 Total loans receivable, net  $2,367,310         2,308,050      

 

Loans receivable, net at March 31, 2018 and December 31, 2017 for purchased non-credit impaired loans and nonacquired loans are summarized by category as follows:

22
 

   At March 31,   At December 31, 
   2018   2017 
Purchased Non-Credit Impaired Loans      % of Total       % of Total 
(ASC 310-20) and Nonpurchased Loans:  Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                    
 One-to-four family  $678,191    29.37%   654,597    29.21
 Home equity   89,319    3.87%   89,961    4.01%
 Commercial real estate   900,181    38.98%   891,469    39.77%
 Construction and development   303,873    13.16%   287,437    12.83%
Consumer loans   17,665    0.77%   19,895    0.89%
Commercial business loans   319,759    13.85%   297,754    13.29%
 Total gross loans receivable   2,308,988    100.00%   2,241,113    100.00%
Less:                    
 Allowance for loan losses   12,708         11,478      
 Total loans receivable, net  $2,296,280         2,229,635      

 

Loans receivable, net at March 31, 2018 and December 31, 2017 for purchased credit impaired loans are summarized by category below.

 

   At March 31,   At December 31, 
   2018   2017 
Purchased Credit Impaired      % of Total       % of Total 
Loans (ASC 310-30):  Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                    
 One-to-four family  $11,058    15.57%   11,177    14.25%
 Home equity   173    0.24%   180    0.23%
 Commercial real estate   41,615    58.59%   42,351    54.01%
 Construction and development   7,171    10.10%   7,356    9.38%
Consumer loans   87    0.12%   95    0.12%
Commercial business loans   10,926    15.38%   17,256    22.01%
 Total gross loans receivable   71,030    100.00%   78,415    100.00
Less:                    
 Allowance for loan losses                  
 Total loans receivable, net  $71,030         78,415      

 

Included in the loan totals, net of purchase discount, were $877.0 million and $962.3 million in loans acquired through acquisitions at March 31, 2018 and December 31, 2017, respectively. At March 31, 2018 and December 31, 2017, the purchase discount on acquired non-credit impaired loans was $15.3 million and $17.7 million, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

 

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

23
 

PCI loans are aggregated into pools of loans based on common risk characteristics such as the type of loan, payment status, or collateral type. The Company estimates the amount and timing of expected cash flows for each purchased loan pool and the expected cash flows in excess of the amount paid are recorded as interest income over the remaining life of the pool (accretable yield). The excess of the pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

Over the life of the loan pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

At March 31, 2018, the outstanding balance and recorded investment of PCI loans was $86.1 million and $71.0 million, respectively. At December 31, 2017, the outstanding balance and recorded investment of PCI loans was $93.8 million and $78.4 million, respectively.

The following table presents changes in the value of PCI loans receivable for the three months ended March 31, 2018:

     
   For the Three Months 
   Ended March 31, 2018 
   (In thousands) 
      
Balance at beginning of period  $78,415 
Net reductions for payments, foreclosures, and accretion   (7,385)
Balance at end of period  $71,030 

 

The following table presents changes in the value of the accretable yield for PCI loans for the three months ended March 31, 2018 (in thousands):

   For the Three Months 
   Ended March 31, 2018 
   (In thousands) 
     
Accretable yield, beginning of period  $12,536 
Additions    
Accretion   (1,332)
Reclassification from nonaccretable balance, net   3,196 
Other changes, net   1,345 
Accretable yield, end of period  $15,745 
24
 

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

   At March 31,   At December 31, 
   2018   2017 
   (Dollars in thousands) 
                 
Variable rate loans  $735,602    30.91%   807,748    34.82
Fixed rate loans   1,644,416    69.09%   1,511,780    65.18%
Total loans outstanding  $2,380,018    100.00%   2,319,528    100.00%

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

Allowance for loan losses:  For the Three Months Ended March 31, 2018 
   Loans Secured by Real Estate                 
   One-to-       Commercial   Construction                 
   four   Home   real   and       Commercial         
   family   equity   estate   development   Consumer   business   Unallocated   Total 
   (In thousands) 
Balance, beginning of period  $2,719    168    3,986    1,201    79    2,840    485    11,478 
Provision for loan losses   286    50    187    (204)   (35)   (147)   (137)    
Charge-offs           (34)   (1)   (9)   (89)       (133)
Recoveries   5    8    5    1,036    40    269        1,363 
Balance, end of period  $3,010    226    4,144    2,032    75    2,873    348    12,708 
                                         

   For the Three Months Ended March 31, 2017 
   Loans Secured by Real Estate                 
   One-to-       Commercial   Construction                 
   four   Home   real   and       Commercial         
   family   equity   estate   development   Consumer   business   Unallocated   Total 
   (In thousands) 
Balance, beginning of period  $2,636    197    3,344    1,132    80    2,805    494    10,688 
Provision for loan losses   (114)   39    244    (190)   35    (329)   315     
Charge-offs   (17)               (9)           (26)
Recoveries   1        25    1    4    22        53 
Balance, end of period  $2,506    236    3,613    943    110    2,498    809    10,715 

25
 

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

 

   Loans Secured by Real Estate                 
   One-to-       Commercial   Construction                 
   four   Home   real   and       Commercial         
   family   equity   estate   development   Consumer   business   Unallocated   Total 
   (In thousands) 
At March 31, 2018:    
Allowance for loan losses ending balances:                                
Individually evaluated for impairment  $189    29    51    534        12        815 
Collectively evaluated for impairment   2,821    197    4,093    1,498    75    2,861    348    11,893 
   $3,010    226    4,144    2,032    75    2,873    348    12,708 
                                         
Loans receivable ending balances:                                        
Individually evaluated for impairment  $5,968    179    5,294    2,312    41    409        14,203 
Collectively evaluated for impairment   672,223    89,140    894,887    301,561    17,624    319,350        2,294,785 
Purchased Credit-Impaired Loans   11,058    173    41,615    7,171    87    10,926        71,030 
Total loans receivable  $689,249    89,492    941,796    311,044    17,752    330,685        2,380,018 
                                         
                                         
At December 31, 2017:                                        
Allowance for loan losses ending balances:                                        
Individually evaluated for impairment  $64    29                16        109 
Collectively evaluated for impairment   2,655    139    3,986    1,201    79    2,824    485    11,369 
   $2,719    168    3,986    1,201    79    2,840    485    11,478 
                                         
Loans receivable ending balances:                                        
Individually evaluated for impairment  $3,435    108    4,811    318    26    285        8,983 
Collectively evaluated for impairment   651,162    89,853    886,658    287,119    19,869    297,469        2,232,130 
Purchased Credit-Impaired Loans   11,177    180    42,351    7,356    95    17,256        78,415 
Total loans receivable  $665,774    90,141    933,820    294,793    19,990    315,010        2,319,528 

 

26
 

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of March 31, 2018 and December 31, 2017. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

 

   At March 31, 2018   At December 31, 2017 
       Unpaid           Unpaid     
   Recorded   Principal   Related   Recorded   Principal   Related 
   Investment   Balance   Allowance   Investment   Balance   Allowance 
   (In thousands) 
With no related allowance recorded:                              
Loans secured by real estate:                              
 One-to-four family  $4,600    4,721        2,725    2,846     
 Home equity   81    81                 
 Commercial real estate   3,585    3,589        3,370    3,370     
 Construction and development   724    724        318    318     
Consumer loans   41    41        26    26     
Commercial business loans   245    246        113    114     
    9,276    9,402        6,552    6,674     
                               
With an allowance recorded:                              
Loans secured by real estate:                              
 One-to-four family   1,368    1,368    189    710    710    64 
 Home equity   98    98    29    108    108    29 
 Commercial real estate   1,709    1,709    51    1,441    1,441     
 Construction and development   1,588    1,588    534             
Consumer loans                        
Commercial business loans   164    164    12    172    172    16 
    4,927    4,927    815    2,431    2,431    109 
                               
Total:                              
 Loans secured by real estate:                              
 One-to-four family   5,968    6,089    189    3,435    3,556    64 
 Home equity   179    179    29    108    108    29 
 Commercial real estate   5,294    5,298    51    4,811    4,811     
 Construction and development   2,312    2,312    534    318    318     
 Consumer loans   41    41        26    26     
 Commercial business loans   409    410    12    285    286    16 
   $14,203    14,329    815    8,983    9,105    109 

 

 27 

 

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three months ended March 31, 2018 and 2017.

 

   For the Three Months Ended March 31, 
   2018   2017 
   Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
   (In thousands) 
With no related allowance recorded:                    
 Loans secured by real estate:                    
 One-to-four family  $2,739    16    3,827    36 
 Home equity   20    1    541    3 
 Commercial real estate   3,483    81    4,070    136 
 Construction and development   408    3    491     
 Consumer loans   28    1    20    1 
 Commercial business loans   168    5    38    17 
    6,846    107    8,987    193 
                     
With an allowance recorded:                    
 Loans secured by real estate:                    
 One-to-four family   1,372    11    597    3 
 Home equity   103    3    192    1 
 Commercial real estate   1,647    21    1,019    66 
 Construction and development   396    (4)        
 Consumer loans                
 Commercial business loans   168    2    217    6 
    3,686    33    2,025    76 
                     
Total:                    
 Loans secured by real estate:                    
 One-to-four family   4,111    27    4,424    39 
 Home equity   123    4    733    4 
 Commercial real estate   5,130    102    5,089    202 
 Construction and development   804    (1)   491     
 Consumer loans   28    1    20    1 
 Commercial business loans   336    7    255    23 
   $10,532    140    11,012    269 

28
 

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of March 31, 2018 and December 31, 2017.

 

   At March 31, 2018 
   Real Estate Loans             
   One-to-       Commercial   Construction             
   four   Home   real   and       Commercial     
   family   equity   estate   development   Consumer   business   Total 
All Loans:  (In thousands) 
                             
30-59 days past due  $11,934    643    1,194    91    225    3,390    17,477 
60-89 days past due   1,836    108        20    1    23    1,988 
90 days or more past due   3,241    171    982    1,585    27    278    6,284 
Total past due   17,011    922    2,176    1,696    253    3,691    25,749 
Current   672,238    88,570    939,620    309,348    17,499    326,994    2,354,269 
Total loans receivable  $689,249    89,492    941,796    311,044    17,752    330,685    2,380,018 

   At March 31, 2018 
Purchased Non-Credit  Real Estate Loans             
Impaired Loans  One-to-       Commercial   Construction             
(ASC 310-20) and  four   Home   real   and       Commercial     
Nonpurchased Loans:  family   equity   estate   development   Consumer   business   Total 
  (In thousands) 
30-59 days past due  $10,978    607    926    (326)   225    165    12,575 
60-89 days past due   1,796    108        8    1    23    1,936 
90 days or more past due   2,516    162    982    457    27    278    4,422 
Total past due   15,290    877    1,908    139    253    466    18,933 
Current   662,901    88,442    898,273    303,734    17,412    319,293    2,290,055 
Total loans receivable  $678,191    89,319    900,181    303,873    17,665    319,759    2,308,988 

   At March 31, 2018 
   Real Estate Loans             
   One-to-       Commercial   Construction             
Purchased Credit Impaired  four   Home   real   and       Commercial     
Loans (ASC 310-30):  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
30-59 days past due  $956   $36   $268   $417   $   $3,225    4,902 
60-89 days past due   40            12            52 
90 days or more past due   725    9        1,128            1,862 
Total past due   1,721    45    268    1,557        3,225    6,816 
Current   9,337    128    41,347    5,614    87    7,701    64,214 
Total loans receivable  $11,058    173    41,615    7,171    87    10,926    71,030 
29
 
   At December 31, 2017 
   Real Estate Loans             
   One-to-       Commercial   Construction             
   four   Home   real   and       Commercial     
   family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
30-59 days past due  $8,139    1,350    1,358    2,328    108    366    13,649 
60-89 days past due   1,025    109    421        129    185    1,869 
90 days or more past due   2,580    117    689    2,482    21    59    5,948 
Total past due   11,744    1,576    2,468    4,810    258    610    21,466 
Current   654,030    88,565    931,352    289,983    19,732    314,400    2,298,062 
Total loans receivable  $665,774    90,141    933,820    294,793    19,990    315,010    2,319,528 

 

   At December 31, 2017 
Purchased Non-Credit  Real Estate Loans             
Impaired Loans  One-to-       Commercial   Construction             
(ASC 310-20) and  four   Home   real   and       Commercial     
Nonpurchased Loans:  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
30-59 days past due  $7,874    1,319    1,112    2,315    108    366    13,094 
60-89 days past due   1,000    109    421        129    185    1,844 
90 days or more past due   1,894    108    689    1,297    21    59    4,068 
Total past due   10,768    1,536    2,222    3,612    258    610    19,006 
Current   643,829    88,425    889,247    283,825    19,637    297,144    2,222,107 
Total loans receivable  $654,597    89,961    891,469    287,437    19,895    297,754    2,241,113 

 

   At December 31, 2017 
   Real Estate Loans             
   One-to-       Commercial   Construction             
Purchased Credit Impaired  four   Home   real   and       Commercial     
Loans (ASC 310-30):  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
30-59 days past due  $265    31    246    13            555 
60-89 days past due   25                        25 
90 days or more past due   686    9        1,185            1,880 
Total past due   976    40    246    1,198            2,460 
Current   10,201    140    42,105    6,158    95    17,256    75,955 
Total loans receivable  $11,177    180    42,351    7,356    95    17,256    78,415 

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

30
 

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at March 31, 2018 and December 31, 2017.

   At March 31,   At December 31, 
   2018   2017 
Loans secured by real estate:  (In thousands) 
 One-to-four family  $3,814    1,927 
 Home equity   192    108 
 Commercial real estate   2,154    1,540 
 Construction and development   2,045    51 
 Consumer loans   131    22 
 Commercial business loans   313    313 
   $8,649    3,961 

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

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

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

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

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

 

The Company uses the following definitions in the tables below:

 

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

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

31
 

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of March 31, 2018 and December 31, 2017.

   At March 31, 2018 
   Real Estate Loans             
   One-to-       Commercial   Construction             
   four   Home   real   and       Commercial     
Total Loans:  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $681,727    89,192    908,739    302,873    17,456    324,515    2,324,502 
Special Mention   2,031    29    25,714    3,277    133    5,061    36,245 
Substandard   5,491    271    7,343    4,894    163    1,109    19,271 
Total loans receivable  $689,249    89,492    941,796    311,044    17,752    330,685    2,380,018 
                                    
Performing  $684,710    89,291    939,642    307,871    17,621    330,372    2,369,507 
Nonperforming:                                   
90 days past due still accruing   725    9        1,128            1,862 
Nonaccrual   3,814    192    2,154    2,045    131    313    8,649 
Total nonperforming   4,539    201    2,154    3,173    131    313    10,511 
Total loans receivable  $689,249    89,492    941,796    311,044    17,752    330,685    2,380,018 

   At March 31, 2018 
Purchased Non-Credit  Real Estate Loans             
Impaired Loans  One-to-       Commercial   Construction             
(ASC 310-20) and  four   Home   real   and       Commercial     
Nonpurchased Loans:  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $674,209    89,127    896,462    301,573    17,429    318,496    2,297,296 
Special Mention   25        1,428    75    100    950    2,578 
Substandard   3,957    192    2,291    2,225    136    313    9,114 
Total loans receivable  $678,191    89,319    900,181    303,873    17,665    319,759    2,308,988 
                                    
Performing  $674,377    89,127    898,027    301,828    17,534    319,446    2,300,339 
Nonperforming:                                   
90 days past due still accruing                            
Nonaccrual   3,814    192    2,154    2,045    131    313    8,649 
Total nonperforming   3,814    192    2,154    2,045    131    313    8,649 
Total loans receivable  $678,191    89,319    900,181    303,873    17,665    319,759    2,308,988 
32
 
   At March 31, 2018 
   Real Estate Loans             
   One-to-       Commercial   Construction             
Purchased Credit Impaired  four   Home   real   and       Commercial     
Loans (ASC 310-30):  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $7,518    65    12,277    1,300    27    6,019    27,206 
Special Mention   2,006    29    24,286    3,202    33    4,111    33,667 
Substandard   1,534    79    5,052    2,669    27    796    10,157 
Total loans receivable  $11,058    173    41,615    7,171    87    10,926    71,030 
                                    
Performing  $10,333    164    41,615    6,043    87    10,926    69,168 
Nonperforming:                                   
90 days past due still accruing   725    9        1,128            1,862 
Nonaccrual                            
Total nonperforming   725    9        1,128            1,862 
Total loans receivable  $11,058    173    41,615    7,171    87    10,926    71,030 

   At December 31, 2017 
   Real Estate Loans             
   One-to-       Commercial   Construction             
   four   Home   real   and       Commercial     
Total Loans:  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $658,031    89,919    898,328    287,491    19,817    296,038    2,249,624 
Special Mention   4,086    30    28,670    4,201    35    12,339    49,361 
Substandard   3,657    192    6,822    3,101    138    6,633    20,543 
Total loans receivable  $665,774    90,141    933,820    294,793    19,990    315,010    2,319,528 
                                    
Performing  $663,161    90,024    932,280    293,557    19,968    314,697    2,313,687 
Nonperforming:                                   
90 days past due still accruing   686    9        1,185            1,880 
Nonaccrual   1,927    108    1,540    51    22    313    3,961 
Total nonperforming   2,613    117    1,540    1,236    22    313    5,841 
Total loans receivable  $665,774    90,141    933,820    294,793    19,990    315,010    2,319,528 
33
 

 

   At December 31, 2017 
Purchased Non-Credit  Real Estate Loans             
Impaired Loans  One-to-       Commercial   Construction             
(ASC 310-20) and  four   Home   real   and       Commercial     
Nonpurchased Loans:  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $652,508    89,853    887,458    286,857    19,785    295,470    2,231,931 
Special Mention           2,526    79        2,067    4,672 
Substandard   2,089    108    1,485    501    110    217    4,510 
 Total loans receivable  $654,597    89,961    891,469    287,437    19,895    297,754    2,241,113 
                                    
Performing  $652,670    89,853    889,929    287,386    19,873    297,441    2,237,152 
Nonperforming:                                   
 90 days past due still accruing                            
 Nonaccrual   1,927    108    1,540    51    22    313    3,961 
 Total nonperforming   1,927    108    1,540    51    22    313    3,961 
Total loans receivable  $654,597    89,961    891,469    287,437    19,895    297,754    2,241,113 

 

   At December 31, 2017 
   Real Estate Loans             
   One-to-       Commercial   Construction             
Purchased Credit Impaired  four   Home   real   and       Commercial     
Loans (ASC 310-30):  family   equity   estate   development   Consumer   business   Total 
   (In thousands) 
Internal Risk Rating Grades:                                   
Pass  $5,523    66    10,870    634    32    568    17,693 
Special Mention   4,086    30    26,144    4,122    35    10,272    44,689 
Substandard   1,568    84    5,337    2,600    28    6,416    16,033 
 Total loans receivable  $11,177    180    42,351    7,356    95    17,256    78,415 
                                    
Performing  $10,491    171    42,351    6,171    95    17,256    76,535 
Nonperforming:                                   
 90 days past due still accruing   686    9        1,185            1,880 
 Nonaccrual                            
 Total nonperforming   686    9        1,185            1,880 
Total loans receivable  $11,177    180    42,351    7,356    95    17,256    78,415 
                                    

There were no loans 90 days or more past due and still accruing at December 31, 2017.

 

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

Troubled Debt Restructurings

 

At March 31, 2018, there were $6.5 million in loans designated as troubled debt restructurings of which $5.1 million were accruing. At March 31, 2017, there were $6.6 million in loans designated as troubled debt restructurings of which $5.5 million were accruing. At December 31, 2017, there were $6.5 million in loans designated as troubled debt restructurings of which $5.3 million were accruing.

34
 

There was one loan with a premodification and post modification balance of $135,000 identified as a troubled debt restructuring during the three months ended March 31, 2018 due to an interest rate change. There was one loan with a premodification and post modification balance of $342,000 identified as a troubled debt restructuring during the three months ended March 31, 2017 due to a payment structure change.

No loans previously restructured in the twelve months prior to March 31, 2018 and 2017 went into default during the three and three months ended March 31, 2018 and 2017.

 

NOTE 6 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in real estate acquired through foreclosure for the periods ended March 31, 2018 and December 31, 2017:

 

   March 31,   December 31, 
   2018   2017 
   (In thousands) 
Balance at beginning of period  $3,106    1,179 
Additions   17    2,554 
Sales   (1,160)   (627)
Write downs        
Balance at end of period  $1,963    3,106 

 

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

 

   At March 31,   At December 31, 
   2018   2017 
   (In thousands) 
Real estate loans:          
One-to-four family  $487    709 
Construction and development   1,476    2,397 
   $1,963    3,106 

 

NOTE 7 - DEPOSITS

Deposits outstanding by type of account at March 31, 2018 and December 31, 2017 are summarized as follows:

 

   At March 31,   At December 31, 
   2018   2017 
   (In thousands) 
Noninterest-bearing demand accounts  $547,744    525,615 
Interest-bearing demand accounts   558,942    551,308 
Savings accounts   212,249    213,142 
Money market accounts   463,676    452,734 
Certificates of deposit:          
Less than $250,000   791,789    755,887 
$250,000 or more   102,569    106,243 
Total certificates of deposit   894,358    862,130 
 Total deposits  $2,676,969    2,604,929 
35
 

The aggregate amount of brokered certificates of deposit was $114.5 million and $99.2 million at March 31, 2018 and December 31, 2017, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $250,000. The aggregate amount of institutional certificates of deposit was $50.9 million and $39.1 million at March 31, 2018 and December 31, 2017, respectively.

 

NOTE 8 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

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

 

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

 

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

 

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

 

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

 

  Level 2 Observable inputs other than Level 1 quoted prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices in markets that are not active, or model-based valuation techniques for which all significant assumptions are derived principally from or corroborated by observable market data. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined by using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. U.S. Government sponsored agency securities, mortgage-backed securities issued by U.S. Government sponsored enterprises and agencies, obligations of states and municipalities, collateralized mortgage obligations issued by U.S. Government sponsored enterprises, and mortgage loans held-for-sale are generally included in this category. Certain private equity investments that invest in publicly traded companies are also considered Level 2 assets.
36
 
  Level 3 Unobservable inputs that are supported by little, if any, market activity for the asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow models and similar techniques, and may also include the use of market prices of assets or liabilities that are not directly comparable to the subject asset or liability. These methods of valuation may result in a significant portion of the fair value being derived from unobservable assumptions that reflect The Company’s own estimates for assumptions that market participants would use in pricing the asset or liability. This category primarily includes collateral-dependent impaired loans, other real estate, certain equity investments, and certain private equity investments.

 

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

 

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

 

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

 

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

 

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

 

Loans receivable - During the first quarter of 2018, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which are applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. The entry price notion previously applied by the Company used a discounted cash flows technique to calculate the present value of expected future cash flows for a financial instrument. The exit price notion uses the same approach, but also incorporates other factors, such as enhanced credit risk, illiquidity risk and market factors that sometimes exist in exit prices in dislocated markets.

As of March 31, 2018, the technique used by the Company to estimate the exit price of the loan portfolio consists of similar procedures to those used as of December 31, 2017, but with added emphasis on both illiquidity risk and credit risk not captured by the previously applied entry price notion. The fair value of the Company’s loan portfolio has always included a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company’s loan portfolio is initially fair valued using a segmented approach. The Company divides its loan portfolio into the following categories: variable rate loans, impaired loans and all other loans. The results are then adjusted to account for credit risk as described above. However, under the new guidance, the Company believes a further credit risk discount must be applied through the use of a discounted cash flow model to compensate for illiquidity risk, based on certain assumptions included within the discounted cash flow model, primarily the use of discount rates that better capture inherent credit risk over the lifetime of a loan. This consideration of enhanced credit risk provides an estimated exit price for the Company’s loan portfolio.

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral.

37
 

As of December 31, 2017, the fair value of the Company’s loan portfolio includes a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company’s loan portfolio is initially fair valued using a segmented approach. The Company divides its loan portfolio into the following categories: variable rate loans, impaired loans and all other loans. The results are then adjusted to account for credit risk. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral. For other loans, fair values are estimated using discounted cash flow models, using current market interest rates offered for loans with similar terms to borrowers of similar credit quality. The values derived from the discounted cash flow approach for each of the above portfolios are then further discounted to incorporate credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price as of December 31, 2017. Loans receivable are classified within Level 3 of the valuation hierarchy.

 

Accrued interest receivable - The carrying value approximates the fair value.

 

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

 

Deposits - The estimated fair value of demand deposits, savings accounts, and money market accounts is the amount payable on demand at the reporting date. The estimated fair value of fixed maturity certificates of deposits is estimated by discounting the future cash flows using rates currently offered for deposits of similar remaining maturities.

 

Short-term borrowed funds - The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Estimated fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

Long-term debt - The estimated fair values of the Company’s long-term debt are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

Other Investments – The carrying value approximates the fair value.

 

Derivative assets and liabilities – The primary use of derivative instruments are related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, The Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. Management also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate hedge ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

38
 

Derivative instruments not related to mortgage banking activities interest rate swap agreements - Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices are recurring Level 1.

 

Commitments to extend credit – The carrying amounts of these commitments are considered to be a reasonable estimate of fair value because the commitments underlying interest rates are based upon current market rates.

 

Accrued interest payable - The fair value approximates the carrying value.

 

Off-balance sheet financial instruments – Contract values and fair values for off-balance sheet, credit-related financial instruments are based on estimated fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and counterparties’ credit standing.

The carrying amount and estimated fair value of the Company’s financial instruments at March 31, 2018 and December 31, 2017 are as follows:

   At March 31, 2018 
   Carrying   Fair Value 
   Amount   Total   Level 1   Level 2   Level 3 
Financial assets:  (In thousands) 
Cash and due from banks  $25,761    25,761    25,761         
Interest-bearing cash   35,603    35,603    35,603         
Securities available-for-sale   753,363    753,363        742,492    10,871 
Federal Home Loan Bank stock   17,913    17,913            17,913 
Other investments   3,432    3,432            3,432 
Derivative assets   4,913    4,913    3,324    1,589     
Loans held for sale   24,618    24,618        24,618     
Loans receivable, net   2,367,310    2,380,824            2,380,824 
Accrued interest receivable   11,502    11,502        11,502     
Mortgage servicing rights   21,719    28,759            28,759 
                          
Financial liabilities:                         
Deposits   2,676,969    2,681,879        2,681,879     
Short-term borrowed funds   308,500    306,572        306,572     
Long-term debt   67,303    65,700        65,700     
Derivative liabilities   164    164    32    132     
Accrued interest payable   1,288    1,288        1,288     
39
 
   At December 31, 2017 
   Carrying   Fair Value 
   Amount   Total   Level 1   Level 2   Level 3 
Financial assets:  (In thousands) 
Cash and due from banks  $25,254    25,254    25,254         
Interest-bearing cash   55,998    55,998    55,998         
Securities available-for-sale   743,239    743,239        733,727    9,512 
Federal Home Loan Bank stock   19,065    19,065            19,065 
Other investments   3,446    3,446            3,446 
Derivative assets   2,803    2,803    1,608    1,195     
Loans held for sale   35,292    35,292        35,292     
Loans receivable, net   2,308,050    2,311,088            2,311,088 
Accrued interest receivable   11,992    11,992        11,992     
Mortgage servicing rights   21,003    26,255            26,255 
                          
                          
Financial liabilities:                         
Deposits   2,604,929    2,597,526        2,597,526     
Short-term borrowed funds   340,500    339,870        339,870     
Long-term debt   72,259    71,859        71,859     
Derivative liabilities   156    156    95    61     
Accrued interest payable   1,126    1,126        1,126     

 

   At March 31, 2018   At December 31, 2017 
   Notional   Estimated   Notional   Estimated 
   Amount   Fair Value   Amount   Fair Value 
Off-Balance Sheet Financial Instruments:  (In thousands) 
Commitments to extend credit  $439,454        422,065     
Standby letters of credit   3,547        4,449     

 

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

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

Securities Available-for-Sale

 

Measurement is on a recurring basis upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity. At March 31, 2018 and December 31, 2017, the Company’s investment securities available-for-sale are recurring Level 2 except for trust preferred securities which are determined to be Level 3.

 

Mortgage Loans Held for Sale

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

40
 

Derivative Assets and Liabilities

 

The primary use of derivative instruments is related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, the Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. The Company also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate hedge ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

 

Derivative instruments not related to mortgage banking activities include interest rate swap agreements. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices in an active market are recurring Level 1.

 

Impaired Loans

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

Other Real Estate Owned (“OREO”)

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

Mortgage Servicing Rights

 

A mortgage servicing right asset represents the amount by which the present value of the estimated future net cash flows to be received from servicing loans are expected to more than adequately compensate the Company for performing the servicing. The Company initially measures servicing assets and liabilities retained related to the sale of residential loans held for sale (“mortgage servicing rights”) at fair value, if practicable. For subsequent measurement purposes, the Company measures servicing assets and liabilities based on the lower of cost or market on a quarterly basis. The quarterly determination of fair value of servicing rights is provided by a third party and is estimated using a present value cash flow model. The most important assumptions used in the valuation model are the anticipated rate of the loan prepayments and discount rates. Although some assumptions in determining fair value are based on standards used by market participants, some are based on unobservable inputs and therefore are classified in Level 3 of the valuation hierarchy.

41
 

Assets and liabilities measured at fair value on a recurring basis are as follows as of March 31, 2018 and December 31, 2017:

 

   Quoted market   Significant other   Significant other 
   price in active   observable inputs   unobservable inputs 
   markets (Level 1)   (Level 2)   (Level 3) 
   (In thousands) 
March 31, 2018               
Available-for-sale investment securities:               
Municipal securities  $    208,158     
US government agencies       16,066     
Collateralized loan obligations       135,184     
Corporate securities       6,981     
Mortgage-backed securities:               
Agency       231,613     
Non-agency       144,490     
Trust Preferred Securities           10,871 
Loans held for sale       24,618     
Derivative assets:               
Cash flow hedges:               
Interest rate swaps   1,651         
Non-hedging derivatives:               
Interest rate swaps   1,673         
Mortgage loan interest rate lock commitments       1,380     
Mortgage loan forward sales commitments       209     
Derivative liabilities:               
Non-hedging derivatives:               
Interest rate swaps   32         
Mortgage-backed securities forward sales commitments       132     
Total  $3,356    768,831    10,871 
                
December 31, 2017               
Available-for-sale investment securities:               
Municipal securities  $    247,350     
US government agencies       12,008     
Collateralized loan obligations       128,643     
Corporate securities       7,006     
Mortgage-backed securities:               
Agency       243,595     
Non-agency       95,125     
Trust preferred securities           9,512 
Loans held for sale       35,292     
Derivative assets:               
Cash flow hedges:               
Interest rate swaps   644         
Non-hedging derivatives:               
Interest rate swaps   964         
Mortgage loan interest rate lock commitments       890     
Mortgage loan forward sales commitments       305     
Derivative liabilities:               
Non-hedging derivatives:               
Interest rate swaps   95         
Mortgage-backed securities forward sales commitments       61     
Total  $1,703    770,275    9,512 

 

 42 

 

Assets measured at fair value on a nonrecurring basis are as follows as of March 31, 2018 and December 31, 2017:

 

   Quoted market   Significant other   Significant other 
   price in active
markets
   observable inputs   unobservable inputs 
   (Level 1)   (Level 2)   (Level 3) 
   (In thousands) 
March 31, 2018               
Impaired loans:               
Loans secured by real estate:               
One-to-four family  $        5,779 
Home equity           150 
Commercial real estate           5,243 
Construction and development           1,778 
Consumer loans           41 
Commercial business loans           397 
Real estate owned:               
One-to-four family           487 
Construction and development           1,476 
Mortgage servicing rights           28,759 
Total  $        44,110 
                
December 31, 2017               
Impaired loans:               
Loans secured by real estate:               
One-to-four family  $        3,371 
Home equity           79 
Commercial real estate           4,811 
Construction and development           318 
Consumer loans           26 
Commercial business loans           269 
Real estate owned:               
One-to-four family             709 
Construction and development           2,397 
Mortgage servicing rights           26,255 
Total  $        38,235 
43
 

For Level 3 assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2018 and December 31, 2017, the significant unobservable inputs used in the fair value measurements were as follows:

 

    March 31, 2018 and December 31, 2017
        Significant   Significant Unobservable
    Valuation Technique   Observable Inputs   Inputs
Impaired Loans   Appraisal Value   Appraisals and or sales of   Appraisals discounted 10% to 20% for
        comparable properties   sales commissions and other holding costs
             
Real estate owned   Appraisal Value/   Appraisals and or sales of   Appraisals discounted 10% to 20% for
    Comparison Sales   comparable properties   sales commissions and other holding costs
             
             
Mortgage Servicing Rights   Discounted cash flows   Comparable sales   Discount rates averaging 11% - 13%
            in each period presented
            Prepayment rates averaging 6% - 8% in 2018
            Prepayment rates averaging 8% - 10% in 2017

 

NOTE 9 - EARNINGS PER SHARE

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

The following is a summary of the reconciliation of weighted average shares outstanding for the three months ended March 31, 2018 and 2017:

 

   For the Three Months Ended March 31, 
   2018   2017 
   Basic   Diluted   Basic   Diluted 
                 
Weighted average shares outstanding   20,908,225    20,908,225    13,919,711    13,919,711 
Effect of dilutive securities       211,091        219,530 
Weighted average shares outstanding   20,908,225    21,119,316    13,919,711    14,139,241 

 

44
 

The following is a summary of the reconciliation of shares issued and outstanding and unvested restricted stock awards as of March 31, 2018 and 2017 used to calculate book value per share:

 

   As of March 31, 
   2018   2017 
         
Issued and outstanding shares   21,057,539    16,185,408 
Less nonvested restricted stock awards   (136,395)   (227,439)
Period end dilutive shares   20,921,144    15,957,969 

 

NOTE 10 – SUPPLEMENTAL SEGMENT INFORMATION

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

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

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

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

45
 

The following tables present selected financial information for the Company’s reportable business segments for the three months ended March 31, 2018 and 2017:

 

   Community   Mortgage             
For the Three Months Ended March 31, 2018  Banking   Banking   Other   Eliminations   Total 
   (In thousands) 
Interest income  $37,257    431    13    (25)   37,676 
Interest expense   5,084    53    461    (53)   5,545 
Net interest income (expense)   32,173    378    (448)   28    32,131 
Provision for loan losses                    
Noninterest income from external customers   5,059    4,924    65        10,048 
Intersegment noninterest income   242    17        (259)    
Noninterest expense   32,929    4,389    280        37,598 
Intersegment noninterest expense       240    2    (242)    
Income (loss) before income taxes   4,545    690    (665)   11    4,581 
Income tax expense (benefit)   561    128    (168)   4    525 
Net income (loss)  $3,984    562    (497)   7    4,056 

 

   Community   Mortgage             
For the Three Months Ended March 31, 2017  Banking   Banking   Other   Eliminations   Total 
   (In thousands) 
Interest income  $17,257    395    6    12    17,670 
Interest expense   2,218    12    182    (12)   2,400 
Net interest income (expense)   15,039    383    (176)   24    15,270 
Provision for loan losses                    
Noninterest income from external customers   2,419    4,812            7,231 
Intersegment noninterest income   242    34        (276)    
Noninterest expense   11,324    4,053    209        15,586 
Intersegment noninterest expense       240    2    (242)    
Income (loss) before income taxes   6,376    936    (387)   (10)   6,915 
Income tax expense (benefit)   1,867    291    (143)   (4)   2,011 
Net income (loss)  $4,509    645    (244)   (6)   4,904 

 

The following tables present selected financial information for the Company’s reportable business segments for March 31, 2018 and December 31, 2017:

 

   Community   Mortgage             
At March 31, 2018  Banking   Banking   Other   Eliminations   Total 
   (In thousands) 
Assets  $3,551,890    77,105    506,580    (582,499)   3,553,076 
Loans receivable, net   2,347,478    30,321        (10,489)   2,367,310 
Loans held for sale   4,098    20,520            24,618 
Deposits   2,683,154            (6,185)   2,676,969 
Borrowed funds   343,500    10,028    32,303    (10,028)   375,803 

 

   Community   Mortgage             
At December 31, 2017  Banking   Banking   Other   Eliminations   Total 
   (In thousands) 
Assets  $3,516,551    81,681    503,144    (582,359)   3,519,017 
Loans receivable, net   2,295,316    28,206        (15,472)   2,308,050 
Loans held for sale   5,999    29,293            35,292 
Deposits   2,611,106            (6,177)   2,604,929 
Borrowed funds   380,500    15,000    32,259    (15,000)   412,759 
46
 

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

 

The following discussion reviews our results of operations for the three months ended March 31, 2018 as compared to the three months ended March 31, 2017 and assesses our financial condition as of March 31, 2018 as compared to December 31, 2017. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2017 included in our Form 10-K for that period. Results for the three months ended March 31, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018 or any future period.

 

Cautionary Warning Regarding Forward-Looking Statements

 

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

 

  · our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;
  · examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;
  · changes in economic conditions, either nationally or regionally and especially in our primary market areas, resulting in, among other things, a deterioration in credit quality;
  · changes in interest rates, or changes in regulatory environment resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;
  · greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;
  · greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;
  · changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, eastern North Carolina and national real estate markets;
  · the rate of delinquencies and amount of loans charged-off;
  · the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
  · the rate of loan growth in recent or future years;
  · our ability to attract and retain key personnel;
  · our ability to retain our existing customers, including our deposit relationships;
  · significant increases in competitive pressure in the banking and financial services industries;
  · adverse changes in asset quality and resulting credit risk-related losses and expenses;
  · changes in the interest rate environment which could reduce anticipated or actual margins;
  · changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking, mortgage banking, and financial service industries;
  · changes occurring in business conditions and inflation;
  · increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;
  · our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;
47
 
  · changes in deposit flows;
  · changes in technology;
  · changes in monetary and tax policies;
  · changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the FASB;
  · loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;
  · our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;
  · our anticipated capital expenditures and our estimates regarding our capital requirements;
  · our liquidity and working capital requirements;
  · competitive pressures among depository and other financial institutions;
  · the growth rates of the markets in which we compete;
  · our anticipated strategies for growth and sources of new operating revenues;
  · our current and future products, services, applications and functionality and plans to promote them;
  · anticipated trends and challenges in our business and in the markets in which we operate;
  · the evolution of technology affecting our products, services and markets;
  · our ability to retain and hire necessary employees and to staff our operations appropriately;
  · management compensation and the methodology for its determination;
  · our ability to compete in our industry and innovation by our competitors;
  · increased cybersecurity risk, including potential business disruptions or financial losses;
  · acquisition integration risks, including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related matters, and the inability to identify and successfully negotiate and complete additional combinations with potential merger or acquisition partners or to successfully integrate such businesses into the Company, including the ability to realize the benefits and cost savings from, and limit any unexpected liabilities associated with, any such business combinations;
  · our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business; and
  · estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices and stock-based compensation.

 

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements prove to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2017. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q and our other reports filed pursuant to the Securities Exchange Act of 1934. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

 

Company Overview

 

 Carolina Financial Corporation is a Delaware corporation that was organized in February 1997 to serve as a bank holding company. In 2017, it applied for, and received, financial holding company status from the Federal Reserve. The Company operates principally through its wholly-owned subsidiary, CresCom Bank, a South Carolina state-chartered bank. CresCom Bank operates Crescent Mortgage Company, Carolina Service Corporation of Charleston, CresCom Insurance, LLC, CresCom Leasing, LLC, and DTFS Inc., as wholly-owned subsidiaries of CresCom Bank. Except where the context otherwise requires, the “Company”, “we”, “us” and “our” refer to Carolina Financial Corporation and its consolidated subsidiaries and the “Bank” refers to CresCom Bank.

CresCom Bank provides a full range of commercial and retail banking financial services designed to meet the financial needs of our customers through its branch network in South Carolina and North Carolina. Crescent Mortgage Company, headquartered in Atlanta, Georgia, is a wholesale mortgage company licensed to provide mortgage banking services in 48 states and the District of Columbia and partners with community banks, credit unions and mortgage brokers. 

48
 

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

 

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

 

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

 

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

 

Recent Events

 

Executive Summary of Operating Results

The following is a summary of the Company’s financial highlights and significant events in the first quarter of 2018:

 

·Net income for the first quarter 2018 decreased 17.29% to $4.1 million, or $0.19 per diluted share, from $4.9 million, or $0.35 per diluted share for the first quarter of 2017. Included in net income are pretax merger related expenses of $14.7 million for the first quarter of 2018 compared to $1.3 million for the first quarter of 2017.

 

·Operating earnings for the first quarter of 2018, which excludes certain non-operating income and expenses, increased 160.0% to $14.9 million, or $0.71 per diluted share, from $5.8 million, or $0.41 per diluted share, from the first quarter of 2017.

 

·Performance ratios first quarter of 2018 compared to first quarter of 2017:
oReturn on average assets was 0.46% compared to 1.11%.
oOperating return on average assets was 1.70% compared to 1.30%.
oReturn on average tangible equity was 4.90% compared to 9.98%.
oOperating return on average tangible equity was 18.06% compared to 11.70%.
oAverage stockholders’ equity to average assets increased to 12.85% compared to 11.88%.

 

·Loans receivable, grew at an annualized rate of 10.4% or $60.5 million, since December 31, 2017.
·Nonperforming assets to total assets were 0.30% at March 31, 2018 compared to 0.20% at December 31, 2017.
·Total deposits, increased $72.0 million since December 31, 2017. Core deposits increased $39.8 million since December 31, 2017.

Non-GAAP Financial Measures

 

Statements included in this management’s discussion and analysis include non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The Company’s management uses these non-GAAP financial measures, including: (i) operating earnings; (ii) operating earnings per common share (iii) operating return on average assets, (iv) operating return on average tangible equity, (v) core deposits, (vi) tangible book value and (vii) allowance for loan losses to non-acquired loans.

 

Management believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company without regard to transactional activities. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under GAAP, and investors should consider the Company’s performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the Company’s results or financial condition as reported under GAAP.

49
 

The following is a summary of the Company’s performance measures:

 

   At or for the Three Months Ended 
Selected Financial Data:  March 31,
2018
   December
31, 2017
   September
30, 2017
   June 30,
2017
   March 31,
2017
 
                          
Selected Average Balances:                         
Total assets  $3,522,407    3,048,214    2,230,586    2,166,803    1,768,323 
Investment securities and FHLB stock   770,161    647,276    521,569    510,706    373,551 
Loans receivable, net   2,322,203    2,003,429    1,463,771    1,412,940    1,214,777 
Loans held for sale   21,645    25,001    27,282    22,412    17,827 
Deposits   2,616,640    2,352,303    1,710,263    1,633,285    1,330,805 
Stockholders’ equity   477,830    380,529    286,524    277,708    210,071 
                          
Performance Ratios (annualized):                         
Return on average stockholders’ equity   3.40%   6.65%   11.16%   13.45%   9.34%
Return on average tangible equity (Non-GAAP)   4.90%   8.78%   13.24%   16.02%   9.98%
Return on average assets   0.46%   0.83%   1.43%   1.72%   1.11%
Operating return on average stockholders’ equity (Non-GAAP)   12.51%   11.69%   11.02%   13.15%   10.95%
Operating return on average tangible equity (Non-GAAP)   18.06%   15.44%   13.08%   15.65%   11.70%
Operating return on average assets (Non-GAAP)   1.70%   1.46%   1.42%   1.69%   1.30%
Average earning assets to average total assets   89.28%   89.25%   91.09%   90.68%   91.99%
Average loans receivable to average deposits   88.75%   85.17%   85.59%   86.51%   91.28%
Average stockholders’ equity to average assets   13.57%   12.48%   12.85%   12.82%   11.88%
Net interest margin-tax equivalent (1)   4.20%   4.19%   3.94%   4.03%   3.93%
Net charge-offs (recoveries) to average loans receivable   (0.21)%   0.02%   0.02%   (0.01)%   (0.01)%
Nonperforming assets to period end loans receivable   0.45%   0.30%   0.44%   0.48%   0.52%
Nonperforming assets to total assets   0.30%   0.20%   0.29%   0.31%   0.34%
Nonperforming loans to total loans   0.36%   0.17%   0.33%   0.38%   0.42%
Allowance for loan losses as a percentage of gross loans receivable (end of period) (2)   0.53%   0.49%   0.72%   0.75%   0.76%
Allowance for loan losses as a percentage of non-acquired loans receivable (Non-GAAP)   0.85%   0.85%   0.87%   0.93%   0.96%
Allowance for loan losses as a percentage of nonperforming loans (2)   146.93%   291.81%   216.53%   196.85%   180.66%

 

(1) Net interest margin-tax equivalent reflects tax-exempt income on a tax-equivalent basis.  

(2) Acquired loans represent 36.8%, 41.5%, 17.3%, 19.4%, and 21.4% of gross loans receivable at March 31, 2018, December 31, 2017, September 30, 2017, June 30, 2017, March 31, 2017, respectively.  

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The following table presents a reconciliation of Non-GAAP performance measures for consolidated operating earnings and corresponding ratios:

 

   For the Three Months Ended 
   March 31,
 2018
   December 31,
 2017
   September 30,
 2017
   June 30,
 2017
   March 31,
 2017
 
As Reported:                         
Income before income taxes  $4,581    10,630    11,968    12,013    6,915 
Tax expense   525    4,302    3,975    2,673    2,011 
Net Income  $4,056    6,328    7,993    9,340    4,904 
                          
Average equity  $477,830    380,529    286,524    277,708    210,071 
Average tangible equity (Non-GAAP)  $331,047    288,156    241,489    233,256    196,561 
Average assets  $3,522,407    3,048,214    2,230,586    2,166,803    1,768,323 
                          
Return on average assets   0.46%   0.83%   1.43%   1.72%   1.11%
Return on average equity   3.40%   6.65%   11.16%   13.45%   9.34%
Return on average tangible equity (Non-GAAP)   4.90%   8.78%   13.24%   16.02%   9.98%
                          
Weighted average common shares outstanding:                         
Basic   20,908,225    19,207,307    16,029,332    16,029,332    13,919,711 
Diluted   21,119,316    19,443,353    16,187,869    16,180,171    14,139,241 
Earnings per common share:                         
Basic  $0.19    0.33    0.50    0.58    0.35 
Diluted  $0.19    0.33    0.49    0.58    0.35 
                          
                          
Operating Earnings and Performance Ratios:                         
Income before income taxes  $4,581    10,630    11,968    12,013    6,915 
Net gain/(loss) on sale of securities   697    242    (368)   (621)   (185)
Fair value adjustments on interest rate swaps   (803)   (419)   (90)   69    58 
Merger related expenses   14,710    6,391    311    279    1,319 
Operating earnings before income taxes   19,185    16,844    11,821    11,740    8,107 
Tax expense (1)   4,242    5,721    3,926    2,612    2,358 
Operating earnings (Non-GAAP)  $14,943    11,123    7,895    9,128    5,749 
                          
Average equity  $477,830    380,529    286,524    277,708    210,071 
Less average intangible assets   (146,783)   (92,373)   (45,035)   (44,452)   (13,510)
Average tangible common equity (Non-GAAP)  $331,047    288,156    241,489    233,256    196,561 
                          
Average assets  $3,522,407    3,048,214    2,230,586    2,166,803    1,768,323 
Less average intangible assets   (146,783)   (92,373)   (45,035)   (44,452)   (13,510)
Average tangible assets (Non-GAAP)  $3,375,624    2,955,841    2,185,551    2,122,351    1,754,813 
                          
Operating return on average assets (Non-GAAP)   1.70%   1.46%   1.42%   1.69%   1.30%
Operating return on average equity (Non-GAAP)   12.51%   11.69%   11.02%   13.15%   10.95%
Operating return on average tangible assets (Non-GAAP)   1.77%   1.51%   1.44%   1.72%   1.31%
Operating return on average tangible equity (Non-GAAP)   18.06%   15.44%   13.08%   15.65%   11.70%
                          
Weighted average common shares outstanding:                         
Basic   20,908,225    19,207,307    16,029,332    16,029,332    13,919,711 
Diluted   21,119,316    19,443,353    16,187,869    16,180,171    14,139,241 
Operating earnings per common share:                         
Basic (Non-GAAP)  $0.71    0.58    0.49    0.57    0.41 
Diluted (Non-GAAP)  $0.71    0.57    0.49    0.56    0.41 

 

 (1) Tax expense is determined using the effective tax rate adjusted to eliminate the impact of the non-operating items.

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Carolina Financial Corporation

Reconciliation of Non-GAAP Financial Measures - Consolidated

(Unaudited)

 

(In thousands, except share data)                    
   At the Month Ended 
   March 31,
   December 31,
   September 30,
   June 30,   March 31, 
   2018   2017   2017   2017   2017 
                     
Core deposits:                         
Noninterest-bearing demand accounts  $547,744    525,615    333,267    330,641    298,365 
Interest-bearing demand accounts   558,942    551,308    309,241    298,123    309,961 
Savings accounts   212,249    213,142    69,552    70,336    66,506 
Money market accounts   463,676    452,734    377,754    380,108    363,600 
Total core deposits (Non-GAAP)   1,782,611    1,742,799    1,089,814    1,079,208    1,038,432 
                          
Certificates of deposit:                         
Less than $250,000   791,789    755,887    567,483    539,177    524,836 
$250,000 or more   102,569    106,243    50,357    45,344    44,452 
Total certificates of deposit   894,358    862,130    617,840    584,521    569,288 
Total deposits  $2,676,969    2,604,929    1,707,654    1,663,729    1,607,720 
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   At the Month Ended 
   March 31,   December 31,   September 30,   June 30,   March 31, 
   2018   2017   2017   2017   2017 
Tangible book value per share:                         
Total stockholders’ equity  $475,046    475,381    290,224    281,818    271,454 
Less intangible assets   (146,387)   (147,193)   (44,953)   (45,123)   (45,292)
Tangible common equity (Non-GAAP)  $328,659    328,188    245,271    236,695    226,162 
                          
Issued and outstanding shares   21,057,539    21,022,202    16,159,309    16,156,943    16,185,408 
Less nonvested restricted stock awards   (136,395)   (134,302)   (99,639)   (101,489)   (227,439)
Period end dilutive shares   20,921,144    20,887,900    16,059,670    16,055,454    15,957,969 
                          
Total stockholders’ equity  $475,046    475,381    290,224    281,818    271,454 
Divided by period end dilutive shares   20,921,144    20,887,900    16,059,670    16,055,454    15,957,969 
Common book value per share  $22.71    22.76    18.07    17.55    17.01 
                          
Tangible common equity (Non-GAAP)  $328,659    328,188    245,271    236,695    226,162 
Divided by period end dilutive shares   20,921,144    20,887,900    16,059,670    16,055,454    15,957,969 
Tangible common book value per share (Non-GAAP)  $15.71    15.71    15.27    14.74    14.17 

 

   At the Month Ended 
   March 31,   December 31,   September 30,   June 30,   March 31, 
   2018   2017   2017   2017   2017 
Acquired and non-acquired loans:                         
Acquired loans receivable  $877,012    962,300    257,461    278,275    303,244 
Non-acquired loans receivable   1,503,006    1,357,228    1,227,000    1,157,145    1,113,766 
Total loans receivable  $2,380,018    2,319,528    1,484,461    1,435,420    1,417,010 
% Acquired   36.85%   41.49%   17.34%   19.39%   21.40%
                          
Non-acquired loans  $1,503,006    1,357,228    1,227,000    1,157,145    1,113,766 
Allowance for loan losses   12,708    11,478    10,662    10,750    10,715 
Allowance for loan losses to non-acquired loans (Non-GAAP)   0.85%   0.85%   0.87%   0.93%   0.96%
                          
Total loans receivable  $2,380,018    2,319,528    1,484,461    1,435,420    1,417,010 
Allowance for loan losses   12,708    11,478    10,662    10,750    10,715 
Allowance for loan losses to total loans receivable   0.53%   0.49%   0.72%   0.75%   0.76%

 

Critical Accounting Policies

 

There have been no significant changes to our critical accounting policies from those disclosed in our 2017 Annual Report on Form 10-K, except as reflected below. Refer to the notes to our consolidated financial statements in our 2017 Annual Report on Form 10-K for a full disclosure of all critical accounting policies.

 

Results of Operations

Summary

The Company reported a decrease in net income for the three months ended March 31, 2018 to $4.1 million, or $0.19 per diluted share, as compared to $4.9 million, or $0.35 per diluted share, for the three months ended March 31, 2017. Included in net income for the three months ended March 31, 2018 and 2017 were pretax merger related expenses of $14.7 million and $1.3 million, respectively.

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Net Interest Income and Margin

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

Net interest income increased to $32.1 million for the three months ended March 31, 2018 from $15.3 million for the three months ended March 31, 2017. The increase in net interest income is a result of the increase in average interest-earning assets balances, as well as an increase in the net interest margin on a tax equivalent yield basis of 27 basis points over the comparable prior year quarter. The increase in average earnings assets for the three months ended March 31, 2018 is primarily the result of increased balances of securities available for sale and loans receivable.

The growth in loan balances was primarily the result of strong organic growth in both commercial and residential lending as well as two acquisitions. On March 18, 2017, the Company acquired approximately $194.7 million of loans, net of purchase accounting adjustments, as part of the acquisition of Greer. In addition, on November 1, 2017, the Company acquired approximately $759.2 million of loans, net of purchase accounting adjustments, as part of the acquisition of First South.

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

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   For The Three Months Ended March 31, 
   2018   2017 
       Interest   Average       Interest   Average 
   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Rate   Balance   Paid   Rate 
                         
Interest-earning assets:                              
Loans held for sale  $21,645    204    3.82%   17,827    168    3.83%
Loans receivable, net (1)   2,322,203    31,458    5.49%   1,214,777    14,798    4.95%
Interest-bearing cash   26,788    104    1.58%   16,384    32    0.79%
Securities available for sale   751,541    5,708    3.04%   363,505    2,551    2.81%
Dividends from non-equitable securities   18,620    175    3.81%   10,046    101    4.09%
Other investments   4,113    27    2.66%   4,124    20    1.94%
Total interest-earning assets   3,144,910    37,676    4.86%   1,626,663    17,670    4.42%
Non-earning assets   377,497              141,660           
Total assets  $3,522,407              1,768,323           
                               
Interest-bearing liabilities:                              
Demand accounts   525,927    342    0.26%   187,178    115    0.25%
Money market accounts   464,505    630    0.55%   305,275    288    0.38%
Savings accounts   213,068    110    0.21%   84,973    21    0.10%
Certificates of deposit   874,654    2,560    1.19%   478,310    1,268    1.08%
Short-term borrowed funds   330,494    1,253    1.54%   176,525    355    0.82%
Long-term debt   71,864    650    3.67%   30,538    353    4.70%
Total interest-bearing liabilities   2,480,512    5,545    0.91%   1,262,799    2,400    0.77%
Noninterest-bearing deposits   538,486              275,069           
Other liabilities   25,579              20,384           
Stockholders’ equity   477,830              210,071           
                               
Total liabilities and                              
Stockholders’ equity  $3,522,407              1,768,323           
                               
Net interest spread             3.95%             3.65%
Net interest margin   4.14%             3.82%          
                               
Net interest margin (tax-equivalent) (2)   4.20%             3.93%          
Net interest income       $32,131              15,270      

 

(1) Average balances of loans include nonaccrual loans.

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

                 

Our net interest margin was 4.14%, or 4.20% on a tax-equivalent basis, for the three months ended March 31, 2018 compared to 3.82%, or 3.93% on a tax equivalent basis, for the three months ended March 31, 2017. The increase in margin from period to period is the result of an increase in yield on securities available for sale and loans receivable. The yield on loans receivable during the quarter ended March 31, 2018 and 2017 reflects accretion income of $2.9 million and $372,000 respectively.

Our net interest spread, which is not on a tax-equivalent basis, was 3.95% for the three months ended March 31, 2018 as compared to 3.65% for the same period in 2017. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 30 basis point increase in net interest spread is a result of the 44 basis point increase in yield on interest-earning assets net of a 14 basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing because of the increases in the prime rate and the impact of accretion income from acquired loans.

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Provision for Loan Losses

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

Following is a summary of the activity in the allowance for loan losses during the periods ended March 31, 2018 and 2017.

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Balance, beginning of period  $11,478    10,688 
Provision for loan losses        
Loan charge-offs   (133)   (26)
Loan recoveries   1,363    53 
Balance, end of period  $12,708    10,715 

 

The Company experienced net recoveries of $1.2 million for the three months ended March 31, 2018 and net recoveries of $27,000 for the three months ended March 31, 2017. Asset quality has remained relatively consistent since December 31, 2017, with nonperforming assets to total assets increasing to 0.30% as of March 31, 2018 as compared to 0.20% as of December 31, 2017. No provision expense for loan losses was recorded during the first three months of 2018 or 2017 primarily due to the net recoveries experienced and asset quality. However, based on historical loan growth, management believes that it will record a provision for loan losses during 2018.

 

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

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Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three months ended March 31, 2018 and 2017 are presented below:

 

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Noninterest income:          
Mortgage banking income  $3,801    3,608 
Deposit service charges   2,024    858 
Net (loss) gain on sale of securities   (697)   185 
Fair value adjustments on interest rate swaps   803    (58)
Net increase in cash value life insurance   390    211 
Mortgage loan servicing income   2,025    1,566 
Other   1,702    861 
Total noninterest income  $10,048    7,231 

Noninterest income increased $2.8 million to $10.0 million for the three months ended March 31, 2018 from $7.2 million for the three months ended March 31, 2017. The increase in noninterest income for the three months ended March 31, 2018 primarily relates to an increase in deposit service charges and mortgage loan servicing. These increases were the result of acquisitions and organic growth.

The following table provides a break out of mortgage banking income from our Bank’s retail mortgage team “Community banking” and Crescent Mortgage Company “Wholesale mortgage banking”.

   For the Three Months Ended March 31, 
   Loan Originations   Mortgage Banking Income   Margin 
   2018   2017   2018   2017   2018   2017 
Additional segment information:                              
Community banking  $31,427    14,753    653    358    2.08%   2.43%
Wholesale mortgage banking   180,494    180,830    3,148    3,250    1.74%   1.80%
Total  $211,921    195,583    3,801    3,608    1.79%   1.84%

The Bank’s retail mortgage originations of $31.4 million in the first quarter of 2018 are $16.7 million higher than the corresponding quarter in 2017. This is the result of the Company’s continued focus on growing its retail mortgage operations both organically and through acquisition. Margins realized on this production have seen competitive pressures.

 

The wholesale mortgage banking originations in the first quarter of 2018 are essentially flat with the corresponding quarter in 2017. Margins have decreased 6bps during this period.

 

The Company recognized a net loss on sale of available-for-sale securities of $697,000 in the first quarter of 2018 and recognized a net gain on sale of $185,000 in the first quarter of 2017.

 

The fair value adjustment on interest rate swaps increased noninterest income by $803,000 for the three months ended March 31, 2018 compared to a decrease in noninterest income of $58,000 for three months ended March 31, 2017. The change in fair value adjustment on interest rate swaps relates to the change in interest rates from period to period. The Company uses standalone interest rate swaps to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches.

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

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Noninterest expense:          
Salaries and employee benefits  $13,668    8,609 
Occupancy and equipment   3,652    2,182 
Marketing and public relations   376    381 
FDIC insurance   255    100 
Recovery of mortgage loan repurchase losses   (150)   (225)
Legal expense   76    65 
Other real estate expense, net   (94)   20 
Mortgage subservicing expense   565    486 
Amortization of mortgage servicing rights   979    669 
Merger related expenses   14,710    1,319 
Other   3,561    1,980 
Total noninterest expense  $37,598    15,586 

 

Noninterest expense represents the largest expense category for the Company. Noninterest expense increased to $37.6 million for the three months ended March 31, 2018 from $15.6 million for the three months ended March 31, 2017. The increase in noninterest expense results from an increase in salaries and employee benefits and occupancy and equipment associated with the acquisitions of Greer during the first quarter of 2017 and First South in the fourth quarter of 2017. Merger related expenses totaled $14.7 million for the three months ended March 31, 2018 as compared to $1.3 million for the three months ended March 31, 2017.

During the first quarter of 2018, certain employees from the First South merger agreed to remain with the Company through its systems conversion. As a result of the conversion completion during the first quarter of 2018, the costs associated with these employees ceased. Also, the Company expects that it will incur additional expense during fiscal 2018 to add the next level of leadership to support its stated growth objectives. Overall, the net incremental costs are not expected to be material during fiscal 2018.

Income Tax Expense

Our effective tax rate was 11.5% for three month period ended March 31, 2018, compared to 29.1% for the three month period ended March 31, 2017. The decrease in the effective tax rate from period to period reflects a reduction in the federal income tax rate from 35% to 21% as enacted in the 2017 Tax Cuts Jobs Act on December 22, 2017. In addition to the lower federal tax rate, the Company incurred $14.7 million of merger related expenses in the first quarter of 2018 compared to $1.3 million in the first quarter of 2017. The Company’s tax rates also reflected tax benefits related to excess stock-based compensation.

Balance Sheet Review

 

Securities

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

At March 31, 2018, our securities portfolio, excluding FHLB stock and other investments, was $753.4 million or approximately 21.2% of our assets. Our available-for-sale securities portfolio included US agency securities, municipal securities, collateralized loan obligations, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $753.4 million and an amortized cost of $755.1 million resulting in a net unrealized loss of $1.7 million.

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

The increase in securities from period to period is attributable to the securities acquired with the acquisition of Greer on March 18, 2017 and First South on November 1, 2018. For additional information, see note 2 “Business Combinations” in the accompanying financial statements.

 

Loans by Type

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Gross loans receivable at March 31, 2018 and December 2017 were $2.4 billion and $2.3 billion, respectively.

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of March 31, 2018, our loan portfolio included $2.0 billion, or 85.4%, of gross loans secured by real estate. As of December 31, 2017, our loan portfolio included $2.0 billion, or 85.6%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, gross loans receivable increased $60.5 million since December 31, 2017. The increase in loans receivable relates to the Bank’s focus on growing residential mortgage and commercial lending. For additional information, see the net interest margin discussion above as well as Note 2 “Business Combinations” in the accompanying financial statements. For additional information regarding loans, see Note 5, “Loans Receivable, Net”.

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

   At March 31,   At December 31, 
   2018   2017 
       % of Total       % of Total 
All Loans:  Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                    
One-to-four family  $689,249    28.96%   665,774    28.70%
Home equity   89,492    3.76%   90,141    3.89%
Commercial real estate   941,796    39.57%   933,820    40.26%
Construction and development   311,044    13.07%   294,793    12.71%
Consumer loans   17,752    0.75%   19,990    0.86%
Commercial business loans   330,685    13.89%   315,010    13.58%
Total gross loans receivable   2,380,018    100.00%   2,319,528    100.00%
Less:                    
Allowance for loan losses   12,708         11,478      
Total loans receivable, net  $2,367,310         2,308,050      

Maturities and Sensitivity of Loans to Changes in Interest Rates

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

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

   At March 31, 2018 
       After one         
   One Year   but within   After five     
   or Less   five years   years   Total 
   (In thousands) 
Loans secured by real estate:                    
One-to-four family  $27,642    156,868    504,739    689,249 
Home equity   7,931    21,497    60,064    89,492 
Commercial real estate   98,601    578,609    264,586    941,796 
Construction and development   103,119    174,222    33,703    311,044 
Consumer loans   1,903    12,838    3,011    17,752 
Commercial business loans   64,592    153,319    112,774    330,685 
Total gross loans receivable  $303,788    1,097,353    978,877    2,380,018 
                     
Loans maturing - after one year:                    
Variable rate loans                 $599,742 
Fixed rate loans                  1,476,488 
                 $2,076,230 

 

Nonperforming and Problem Assets

 

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of nine consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of March 31, 2018, the Company had $1.7 million of PCI loans that were 90 days past due and accruing. At December 31, 2017, we had $1.9 million of credit-impaired loans under ASC 310-30 that were 90 days past due and still accruing.

Troubled Debt Restructurings (“TDRs”)

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

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

 

   At March 31,   At December 31, 
   2018   2017 
   (In thousands) 
Loans receivable:          
Nonaccrual loans-renegotiated loans  $2,302    1,140 
Nonaccrual loans-other   6,347    2,793 
Real estate acquired through foreclosure, net   1,963    3,106 
Total Non-Performing Assets  $10,612    7,039 
           
Problem Assets not included in Non-Performing Assets-Accruing renegotiated loans outstanding  $4,231    5,324 

At March 31, 2018, nonperforming assets were $10.6 million, or 0.30% of total assets. Comparatively, nonperforming assets were $7.0 million, or 0.20% of total assets, at December 31, 2017. Nonperforming loans were 0.36% and 0.17% of gross loans receivable at March 31, 2018 and December 31, 2017, respectively.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $4.2 million at March 31, 2018, compared to $5.3 million at December 31, 2017. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at March 31, 2018 and December 31, 2017 are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on loans greater than $100,000 on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.

Credit quality indicators continue to show favorable metrics. The Company can make no assurances that nonperforming assets will continue to remain low in future periods. The Company continues to monitor the loan portfolio and foreclosed assets carefully and is continually working to reduce its problem assets.

Allowance for Loan Losses

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

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

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

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

The allowance for loan losses was $12.7 million, or 0.85% of non-acquired loans, at March 31, 2018, compared to $11.5 million, or 0.84% of total non-acquired loans, at December 31, 2017. Loans acquired in business combinations were $877.0 million and $962.3 million at March 31, 2018 and December 31, 2017, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. At March 31, 2018 and December 31, 2017, acquired non-credit impaired loans had a purchase discount remaining of $15.3 million and $17.7 million, respectively.

The table below shows a reconciliation of acquired and non-acquired loans and allowance for loan losses to non-acquired loans:

   At the Month Ended 
   March 31,   December 31,   September 30,   June 30,   March 31, 
   2018   2017   2017   2017   2017 
Acquired and non-acquired loans:                         
Acquired loans receivable  $877,012    952,220    257,461    278,275    303,244 
Non-acquired loans receivable   1,503,006    1,367,308    1,227,000    1,157,145    1,113,766 
Total loans receivable  $2,380,018    2,319,528    1,484,461    1,435,420    1,417,010 
% Acquired   36.85%   41.05%   17.34%   19.39%   21.40%
                          
Non-acquired loans  $1,503,006    1,367,308    1,227,000    1,157,145    1,113,766 
Allowance for loan losses   12,708    11,478    10,662    10,750    10,715 
Allowance for loan losses to non-acquired loans (Non-GAAP)   0.85%   0.84%   0.87%   0.93%   0.96%
                          
Total loans receivable  $2,380,018    2,319,528    1,484,461    1,435,420    1,417,010 
Allowance for loan losses   12,708    11,478    10,662    10,750    10,715 
Allowance for loan losses to total loans receivable   0.53%   0.49%   0.72%   0.75%   0.76%

The Company experienced net recoveries of $1.2 million for the three months ended March 31, 2018 and net recoveries of $27,000 for the three months ended March 31, 2017. Asset quality has remained relatively consistent since year end, with nonperforming assets to total assets slightly increasing to 0.30% as of March 31, 2018 as compared to 0.20% as of December 31, 2017.

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The following table summarizes the activity related to our allowance for loan losses for the three months ended March 31, 2018 and 2017.

 

   For the Three Months 
   Ended March 31 
   2018   2017 
   (Dollars in thousands) 
Balance, beginning of period  $11,478    10,688 
Provision for loan losses        
Loan charge-offs:          
Loans secured by real estate:          
One-to-four family       (17)
Home equity        
Commercial real estate   (34)    
Construction and development   (1)    
Consumer loans   (9)   (9)
Commercial business loans   (89)    
Total loan charge-offs   (133)   (26)
Loan recoveries:          
Loans secured by real estate:          
One-to-four family   5    1 
Home equity   8     
Commercial real estate   5    25 
Construction and development   1,036    1 
Consumer loans   40    4 
Commercial business loans   269    22 
Total loan recoveries   1,363    53 
Net loan recoveries   1,230    27 
Balance, end of period  $12,708    10,715 
           
Allowance for loan losses as a percentage of loans receivable (end of period)   0.53%   0.76%
Net charge-offs (recoveries) to average loans receivable (annualized)   (0.21)%   (0.01)%

 

Mortgage Operations

Mortgage Activities and Servicing

Our wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans and is included in mortgage banking income in the accompanying consolidated statements of operations. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations is provided in “Results of Operations – Noninterest Income and Expense”. Additional segment information is provided in Note 10 “Supplemental Segment Information” in the accompanying financial statements.

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Loan Servicing

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

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

The Company was servicing $3.0 billion loans for others at March 31, 2018 and $2.9 billion at December 31, 2017. Mortgage servicing rights asset had a balance of $21.7 million and $21.0 million at March 31, 2018 and December 31, 2017, respectively. The economic estimated fair value of the mortgage servicing rights was $28.8 million and $26.3 million at March 31, 2018 and December 31, 2017, respectively. Amortization expense related to the mortgage servicing rights was $979,000 and $669,000 during the three months ended March 31, 2018 and 2017, respectively.

Below is a roll-forward of activity in the balance of the servicing assets for the three months ended March 31, 2018 and 2017.

 

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
MSR beginning balance  $21,003    15,032 
Amount capitalized   1,695    1,429 
Amount amortized   (979)   (669)
MSR ending balance  $21,719    15,792 
64
 

Reserve For Mortgage Repurchase Losses

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

The following table demonstrates the activity for the reserve for mortgage repurchase losses for the three months ended March 31, 2018 and 2017.

 

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
Beginning Balance  $1,892    2,880 
Losses paid       (72)
Recoveries        
Recovery of mortgage loan repurchase losses   (150)   (225)
Ending balance  $1,742    2,583 

 

For the three months ended March 31, 2018 and 2017, the Company recorded a recovery of mortgage repurchase losses of $150,000 and $225,000, respectively. The reduction in the reserve for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. As a result of the Company’s analysis of its reserve for mortgage loan repurchase losses, the reserve was reduced accordingly.

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At March 31, 2018, deposits totaled $2.7 billion, an increase of $72.0 million from deposits of $2.6 billion at December 31, 2017. The increase in deposits since December 31, 2017 relates to continued efforts to increase our core deposits through business development.

65
 

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

 

   For the Three Months 
   Ended March 31, 
   2018   2017 
   Average   Average   Average   Average 
   Balance   Rate   Balance   Rate 
   (Dollars in thousands) 
                 
Interest-bearing demand accounts  $525,927    0.86%   187,178    0.25%
Money market accounts   464,505    1.37%   305,275    0.38%
Savings accounts   213,068    0.58%   84,973    0.10%
Certificates of deposit less than $100,000   423,321    1.09%   254,778    0.95%
Certificates of deposit of $100,000 or more   451,333    1.28%   223,532    1.19%
Total interest-bearing average deposits   2,078,154         1,055,736      
                     
Noninterest-bearing deposits   538,463         275,069      
Total average deposits  $2,616,617         1,330,805      

 

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

 

   At March 31, 2018 
   (In thousands) 
     
Three months or less  $71,693 
Over three through six months   79,609 
Over six through twelve months   131,392 
Over twelve months   174,399 
Total certificates of deposits  $457,093 

 

Borrowings

 

The followings table outlines our various sources of short-term borrowed funds during the three months ended March 31, 2018 and 2017 and the amounts outstanding at the end of each period, the maximum amount for each component during the periods, the average amounts for each period, and the average interest rate that we paid for each borrowings source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the periods shown.

66
 

           Maximum   Average for the 
       Contractual   Month   Period including 
   Ending   Period End   End   Fair Value Amortization 
   Balance   Rate   Balance   Balance   Rate 
At or for the three months ended March 31, 2018  (Dollars in thousands) 
Short-term borrowed funds                         
Short-term FHLB advances  $308,500    1.05% - 2.16%    379,000    330,494    1.54%
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2018 through 2020   31,000    0.87% - 2.71%    42,500    39,583    1.94%
Subordinated debentures, due 2032 through 2037   32,303    3.50% - 5.00%    32,303    32,281    5.79%

 

           Maximum   Average for the 
       Contractual   Month   Period including 
   Ending   Period End   End   Fair Value Amortization 
   Balance   Rate   Balance   Balance   Rate 
At or for the three months ended March 31, 2017  (Dollars in thousands) 
Short-term borrowed funds                         
Short-term FHLB advances  $214,500    0.66% - 2.28%    214,500    176,525    0.82%
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2018 through 2020   32,000    0.69% - 2.71%    32,000    13,894    4.94%
Subordinated debentures, due 2032 through 2037   23,304    2.77% - 4.25%    26,806    16,644    4.36%

Liquidity

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

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

Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At March 31, 2018, the Company had FHLB advances of $339.5 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $415.8 million.

Lines of credit with the FRB are based on collateral pledged. At March 31, 2018 the Company had lines available with the FRB for $208.4 million. At March 31, 2018 the Company had no FRB advances outstanding.

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Capital Resources

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

 

Effective January 2, 2015, the Company and Bank became subject to the regulatory risk-based capital rules adopted by the federal banking agencies implementing Basel III. Under the new capital guidelines, applicable regulatory capital components consist of (1) common equity Tier 1 capital (common stock, including related surplus, and retained earnings, plus limited amounts of minority interest in the form of common stock, net of goodwill and other intangibles (other than mortgage servicing assets), deferred tax assets arising from net operating loss and tax credit carry forwards above certain levels, mortgage servicing rights above certain levels, gain on sale of securitization exposures and certain investments in the capital of unconsolidated financial institutions, and adjusted by unrealized gains or losses on cash flow hedges and accumulated other comprehensive income items (subject to the ability of a non-advanced approaches institution to make a one-time irrevocable election to exclude from regulatory capital most components of AOCI), (2) additional Tier 1 capital (qualifying non-cumulative perpetual preferred stock, including related surplus, plus qualifying Tier 1 minority interest and, in the case of holding companies with less than $15 billion in consolidated assets at December 31, 2009, certain grandfathered trust preferred securities and cumulative perpetual preferred stock in limited amounts, net of mortgage servicing rights, deferred tax assets related to temporary timing differences, and certain investments in financial institutions) and (3) Tier 2 capital (the allowance for loan and lease losses in an amount not exceeding 1.25% of standardized risk-weighted assets, plus qualifying preferred stock, qualifying subordinated debt and qualifying total capital minority interest, net of Tier 2 investments in financial institutions). Total Tier 1 capital, plus Tier 2 capital, constitutes total risk-based capital.

 

The required minimum ratios are as follows:

·Common equity Tier 1 capital ratio (common equity Tier 1 capital to total risk-weighted assets) of 4.5%
·Tier 1 Capital Ratio (Tier 1 capital to total risk-weighted assets) of 6%
·Total capital ratio (total capital to total risk-weighted assets) of 8%; and
·Leverage ratio (Tier 1 capital to average total consolidated assets) of 4%

 

The new capital guidelines also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity Tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. The phase-in of the capital conservation buffer requirement began on January 1, 2016.

 

The final regulatory capital rules also incorporate these changes in regulatory capital into the prompt corrective action framework, under which the thresholds for “adequately capitalized” banking organizations are equal to the new minimum capital requirements. Under this framework, in order to be considered “well capitalized”, insured depository institutions are required to maintain a Tier 1 leverage ratio of 5%, a common equity Tier 1 risk-based capital measure of 6.5%, a Tier 1 risked-based capital ratio of 8% and a total risk-based capital ratio of 10%.

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The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at March 31, 2018 and December 31, 2017 are as follows:

     
                   To Be Well 
           Minimum Capital   Minimum Capital   Capitalized Under 
           Required - Basel III   Required - Basel III   Prompt Corrective 
   Actual   Phase-In Schedule   Fully Phased-In   Action Regulations 
     Amount     Ratio     Amount     Ratio     Amount     Ratio     Amount     Ratio 
    (Dollars in thousands) 
                                         
March 31, 2018                                        
Carolina Financial Corporation                                        
CET1 capital (to risk weighted assets)  $328,707    12.15%   83,446    5.125%   113,975    7.000%   N/A    N/A 
Tier 1 capital (to risk weighted assets)   359,894    13.30%   107,869    6.625%   138,398    8.500%   N/A    N/A 
Total capital (to risk weighted assets)   372,602    13.76%   140,433    8.625%   170,962    10.500%   N/A    N/A 
Tier 1 capital (to total average assets)   359,894    10.66%   87,334    4.000%   87,334    4.000%   N/A    N/A 
                                         
CresCom Bank                                        
CET1 capital (to risk weighted assets)   356,465    13.18%   83,445    5.125%   113,974    7.000%   105,833    6.50%
Tier 1 capital (to risk weighted assets)   356,465    13.18%   107,868    6.625%   138,397    8.500%   130,256    8.00%
Total capital (to risk weighted assets)   369,173    13.65%   140,433    8.625%   170,961    10.500%   162,820    10.00%
Tier 1 capital (to total average assets)   356,465    10.56%   87,639    4.000%   87,639    4.000%   109,549    5.00%
                                         
                                         
December 31, 2017                                        
Carolina Financial Corporation                                        
CET1 capital (to risk weighted assets)  $328,511    12.42%   152,145    5.750%   185,220    7.000%   N/A    N/A 
Tier 1 capital (to risk weighted assets)   359,654    13.59%   191,835    7.250%   224,910    8.500%   N/A    N/A 
Total capital (to risk weighted assets)   371,133    14.03%   244,755    9.250%   277,830    10.500%   N/A    N/A 
Tier 1 capital (to total average assets)   359,654    12.38%   116,198    4.000%   116,198    4.000%   N/A    N/A 
                                         
CresCom Bank                                        
CET1 capital (to risk weighted assets)   355,024    13.43%   152,035    5.750%   185,086    7.000%   171,865    6.50%
Tier 1 capital (to risk weighted assets)   355,024    13.43%   191,696    7.250%   224,747    8.500%   211,527    8.00%
Total capital (to risk weighted assets)   366,503    13.86%   244,578    9.250%   277,629    10.500%   264,408    10.00%
Tier 1 capital (to total average assets)   355,024    12.21%   116,312    4.000%   116,312    4.000%   145,390    5.00%

The following table provides the amount of dividends and dividend payout ratios (dividends declared divided by net income) for the three months ended March 31, 2018 and 2017.

 

   For the Three Months 
   Ended March 31, 
   2018   2017 
   (In thousands) 
         
Dividends declared  $1,052    576 
Dividend payout ratios   25.94%   11.75%

 

Off Balance Sheet Arrangements

 

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

69
 

At March 31, 2018, we had issued commitments to extend credit and standby letters of credit of approximately $443.0 million through various types of lending arrangements. There were 56 standby letters of credit included in the commitments for $3.5 million. Total fixed rate commitments were $253.6 million and variable rate commitments were $189.4 million.

 

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

 

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

 

Market Risk Management and Interest Rate Risk

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

 

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

 

As of March 31, 2018, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market condition.

70
 
        Annualized Hypothetical 
Interest Rate Scenario   Percentage Change in 
Change   Prime Rate   Net Interest Income 
          
 (1.00)%   3.75%   (3.60)%
 0.00%   4.75%   0.00%
 1.00%   5.75%   0.4%
 2.00%   6.75%   0.8%
 3.00%   7.75%   0.9%

 

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

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

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

Accounting, Reporting, and Regulatory Matters

Information regarding recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of the financial information by the Company are included in Note 1 “Summary of Significant Accounting Polices” in the accompanying financial statements.

Effect of Inflation and Changing Prices

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

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

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

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

71
 

Item 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

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

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2018, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS.

 

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

 

Item 1A. RISK FACTORS.

 

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for fiscal years ended December 31, 2017, as well as cautionary statements contained in this Form 10-Q, including those under the caption “Cautionary Note Regarding Any Forward-Looking Statements” set forth in Part I, Item 2 of this Form 10-Q, risks and matters described elsewhere in this Form 10-Q and in our other filings with the SEC.

 

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

 

Not applicable

 

Item 3. DEFAULTS UPON SENIOR SECURITIES.

 

Not applicable

 

Item 4. MINE SAFETY DISCLOSURES.

 

Not applicable

 

Item 5. OTHER INFORMATION.

 

Not applicable

 

Item 6. EXHIBITS.

 

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

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SIGNATURES

 

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

 
    CAROLINA FINANCIAL CORPORATION
    Registrant
     
Date: May 10, 2018   /s/ Jerold L. Rexroad  
    Jerold L. Rexroad
    President and Chief Executive Officer
    (Principal Executive Officer)
     
Date: May 10, 2018   /s/ William A. Gehman, III  
    William A. Gehman III
    Executive Vice President and Chief Financial Officer
    (Principal Financial and Accounting Officer)
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INDEX TO EXHIBITS

 

Exhibit
Number  Description
   
2.1 Agreement and Plan of Merger by and between Carolina Financial Corporation, CBAC, Inc., and Congaree Bancshares, Inc. dated January 5, 2016.(1)
   
2.2 Agreement and Plan of Merger by and between Carolina Financial Corporation and Greer Bancshares Incorporated, dated November 7, 2016.(2)
   
2.3 Agreement and Plan of Merger and Reorganization by and between Carolina Financial Corporation and First South Bancorp, Inc. dated June 9, 2017. (3)
   
4.1 Restated Certificate of Incorporation.(4)
   
4.2 Amendment to the Restated Certificate of Incorporation (incorporated by reference to Exhibit A of the Company’s Definitive Proxy Statement on Schedule 14A filed on March 31, 2016).
   
4.3 Amendment to Restated certificate of Incorporation (incorporated by reference to Exhibit A of the Company’s Definitive Proxy Statement on Schedule 14A filed on March 29, 2018).
   
4.4 Amended and Restated Bylaws.(6)
   
4.5 Specimen Common Stock Certificate.(7)
   
4.6 See Exhibits 4.1, 4.2, and 4.3 for provisions of the Restated Certificate of Incorporation and Amended and Restated Bylaws which define the rights of the stockholders.
   
31.1 Rule 13a-14(a) Certification of the Principal Executive Officer.
   
31.2 Rule 13a-14(a) Certification of the Principal Financial Officer.
   
32 Section 1350 Certifications.
   
101 The following materials from the Quarterly Report on Form 10-Q of Carolina Financial Corporation as of and for the quarter ended March 31, 2018, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statement of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.
   
(1) Incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on January 11, 2016.
   
(2) Incorporated by reference to Exhibit 2.2 of the Company’s Registration Statement on Form S-3 filed on December 23, 2016.
 
(3) Incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on June 15, 2017.
   
(4) Incorporated by reference to Exhibit 3.1 of the Company’s Registration Statement on Form S-3 filed on August 31, 2015.
 
(5) Incorporated by reference to Exhibit A of the Company’s Definitive Proxy Statement on Schedule 14A filed on March 31, 2016.
 
(6) Incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on May 5, 2016.
   
(7) Incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form 10 filed on February 26, 2014.
74

Exhibit 31.1

Rule 13a-14(a) Certification of the Principal Executive Officer.

I, Jerold L. Rexroad, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Carolina Financial Corporation;
2.Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

 

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 

a)All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants’ internal control over financial reporting.

 

Date: May 10, 2018 By:  /s/ Jerold L. Rexroad
    Jerold L. Rexroad
    President and Chief Executive Officer
    (Principal Executive Officer)
75

Exhibit 31.2

Rule 13a-14(a) Certification of the Principal Financial Officer.

I, William A. Gehman, III, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Carolina Financial Corporation;
2.Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

 

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5.The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a)All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants’ internal control over financial reporting.

 

Date: May 10, 2018 By:  /s/ William A. Gehman III
    William A. Gehman III
    Executive Vice President and Chief Financial Officer
    (Principal Financial Officer)
76

 

Exhibit 32

 

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

 

The undersigned, the President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of Carolina Financial Corporation (the “Company”), each certify that, to his knowledge on the date of this certification:

 

1.The quarterly report of the Company for the period ended March 31, 2018 as filed with the Securities and Exchange Commission on this date (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
2.The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
/s/ Jerold L. Rexroad
    Jerold L. Rexroad
    President and Chief Executive Officer
    (Principal Executive Officer)
    Date: May 10, 2018

 

/s/ William A. Gehman III
    William A. Gehman III
    Executive Vice President and Chief Financial Officer
    (Principal Financial Officer)
    Date: May 10, 2018
77


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