The following discussion reviews our results of operations for the three and six months ended
June 30, 2014as compared to the three and six months ended June 30, 2013and assesses our financial condition as of June 30, 2014as compared to December 31, 2013. 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, 2013included in our Form 10 for that period. Results for the three and six months ended June 30, 2014are not necessarily indicative of the results for the year ending December 31, 2014or 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,
to increase our allowance for loan losses or write-down assets
otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be
? changes in economic conditions, either nationally or regionally and especially in our primary service areas, resulting in, among other things, a deterioration in credit quality;
? an increase in interest rates, resulting in a decline in our mortgage
production and a decrease in the profitability of our mortgage banking operations;
? credit losses as a result of declining real estate values, increasing
interest rates, increasing unemployment, changes in payment behavior or other factors; ? 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 Carolinaand 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; 39 ? 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 Wall Street Reform and Consumer Protection Act and regulations adopted thereunder, changes in federal or state tax laws or
thereof by taxing authorities and other governmental
affecting the banking and financial service industries; ? 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
to, business and a negative impact on results of operations; ? changes in deposit flows; ? changes in technology; ? changes in monetary and tax policies;
? changes in accounting policies, as may be adopted by the regulatory
agencies, as well as the
Public Company Accounting Oversight Boardand the Financial Accounting Standards Board; ? loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions; ? our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations; ? the general decline in the real estate and lending markets;
? 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; ? 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
? our ability to stay abreast of new or modified laws and regulations
that currently apply or become applicable to our business; ? increased cybersecurity risk, including potential business disruptions or financial losses; and ? estimates and estimate methodologies used in preparing our consolidated financial statements and determining option
exercise prices. If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed, implied or projected by us in 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 the Form 10. 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. 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. 40 Overview
Carolina Financial Corporationis a Delawarecorporation and bank holding company that was incorporated in 1996 and began operations in 1997. It operates principally through CresCom Bank, a South Carolina state-chartered bank. Unless the context indicates otherwise, all references in this report to "we," "us," and "our" refer to Carolina Financial Corporationand our wholly owned subsidiary, CresCom Bank, except that in the discussion of our capital stock and related matters, these terms refer solely to Carolina Financial Corporationand not to the Bank. All references to the "Bank" refer to CresCom Bankonly.
Our subsidiaries provide a full range of financial services designed to meet the financial needs of our customers, including:
? Commercial and retail banking; ? Mortgage banking; and ? Cash management Through the Bank, the Company currently conducts business through 13 bank branches located in the following counties in
South Carolina: Charleston(4), Dorchester(3), Berkeley(1) Georgetown(1), and Horry(4). Effective July 31, 2011, the Company merged its wholly-owned subsidiary bank, Community FirstBank of Charleston, with and into its other wholly-owned subsidiary bank, Crescent Bank. In conjunction with this internal reorganization, Crescent Bank'sname was changed to CresCom Bank, and Crescent Mortgage Company, formerly a wholly-owned subsidiary of Community FirstBank of Charleston, became a wholly-owned subsidiary of CresCom Bank. Crescent Mortgage Companyis located in Atlanta, Georgia, and is qualified to originate loans in 46 states. At June 30, 2014, we had total assets of $988.4 million, an increase of $106.8 million, from total assets of $881.6 millionat December 31, 2013. The largest components of our total assets are loans receivable and securities which were $605.3 millionand $231.6 million, respectively at June 30, 2014. Comparatively, our loans receivable and securities totaled $535.2 millionand $192.1 million, respectively, at December 31, 2013. At June 30, 2014loans held for sale were $47.9 millioncompared to $36.9 millionas of December 31, 2013. Our liabilities and stockholders' equity at June 30, 2014totaled $899.1 millionand $89.3 million, respectively, compared to liabilities of $799.4 millionand stockholders' equity of $82.2 millionat December 31, 2013. The principal components of our liabilities are deposits, which were $779.5 millionand $697.6 millionat June 30, 2014and December 31, 2013, respectively. 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. Of course, 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 substantial portion of our income from Crescent Mortgage Companythrough net gain on sale of loans held for sale 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. We describe the various components of this noninterest income, as well as our noninterest expense, within the "Results of Operations" within the MD&A. 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. 41 Recent Events On January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record as of February 10, 2014, payable on February 28, 2014. All share, earnings per share, and per share data have been retroactively adjusted in the consolidated balance sheets, earnings per share, and stockholders' equity disclosures to reflect the stock split for all periods presented in accordance with GAAP.
August 6, 2014, the Bank entered into a definitive agreement with First Community Bank, Bluefield, Virginiato acquire 13 branches with total deposits of approximately $230 millionand approximately $67 millionin loans. Three of the offices are in South Carolinaand operate under the name " People's Community Bank" and 10 are in southeastern North Carolina. The deposit premium will be approximately 3.11% of deposits acquired. The transaction, which is subject to regulatory approval and other customary conditions, is expected to close in late 2014 or early 2015.
Critical Accounting Policies
We have adopted various accounting policies that govern the application of accounting principles generally accepted in
the United Statesand with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the notes to our consolidated financial statements in this report. Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations. We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management's estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses. The evaluation and recognition of other-than-temporary impairment, or OTTI, on certain investments including our private label mortgage-backed securities and trust preferred securities requires significant judgment and estimates. Some of the more critical judgments supporting the evaluation of OTTI include projected cash flows including prepayment assumptions, default rates and severities of losses on the underlying collateral within the security. Under different conditions or utilizing different assumptions, the actual OTTI realized by us may be different from the actual amounts recognized in our consolidated financial statements. The determination of fair value related to derivatives of the Company requires significant judgment and estimates. The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers ("interest rate lock commitments") and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans ("forward commitments"). The Company's objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in net gain on sale of loans held for sale within the noninterest income section of the consolidated statements of operations. 42
Derivative instruments not related to mortgage banking activities, including interest rate swap agreements, that do not satisfy the hedge accounting requirements, are recorded at fair value and changes in fair value are recognized in noninterest income in the consolidated statements of operations.
The establishment of the mortgage repurchases reserves related to various representations and warranties that reflect management's estimate of losses require significant judgment and estimates. Some of the more critical factors that are incorporated into the estimation of the mortgage repurchase reserve include the defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, changes in regulatory framework regarding representations and warranties and projected loss severity. The Company establishes a reserve at the time loans are sold and continually updates the reserve estimate during the estimated loan life. To the extent that economic conditions and the housing market do not recover or future investor repurchase demand and appeals success rates differ from past experience, the Company could continue to have increased demands and increased loss severities on repurchases, causing future additions to the repurchase reserve. Refer to the "Mortgage Operations" within the MD&A for additional discussion.
Results of Operations
For the three months ended
June 30, 2014, net income available to common stockholders was approximately $2.2 million, or $0.57per diluted share, compared to net income available to common stockolders of $5.5 million, or $1.40per diluted share, for the three months ended June 30, 2013. The $3.3 milliondecrease in net income from quarter to quarter resulted primarily from a $3.2 milliondecrease in income derived from our wholesale mortgage banking subsidiary. For the six months ended June 30, 2014, net income available to common stockholders was approximately $4.2 million, or $1.07per share diluted, compared to net income available to common stockholders of $10.0 million, or $2.53per share diluted, for the six months ended June 30, 2013. The $5.8 milliondecrease in net income from period to period resulted primarily from a $6.8 milliondecrease in income derived from our wholesale mortgage banking subsidiary. During the third quarter of 2013, mortgage interest rates began to rise and, as a result, mortgage loan production began to slow down. Rising interest rates significantly slowed the mortgage refinance activity in 2013 and has continued into 2014. As the overall mortgage originations volumes declined, there was a corresponding reduction in margins earned due to competitive pressures. For additional information regarding the effects of the wholesale mortgage banking subsidiary on net income, refer to Note 9 under Item 1 "Financial Statements".
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
$7.3 millionfor the three months ended June 30, 2014from $6.8 millionfor the three months ended June 30, 2013. During the six months ended June 30, 2014, net interest income increased to $14.4 millioncompared to $13.5 millionfor the six months ended June 30, 2013. The increase in net interest income for the three and six months ended June 30, 2014as compared to the three and six months ended June 30, 2013is a result of the increase in average earning assets as well as a decrease in rates paid on interest-bearing liabilities and a shift to lower cost funding sources. 43 The Company is focused on continuing to improve the utilization of its capital. To accomplish this, the Bank has incorporated various strategies to increase high quality loan portfolios. Accordingly, the increase in average earnings assets for the three and six months ended June 30, 2014is primarily the result of increased balances of loans receivable. The growth in average loan balances were primarily the result of the following:
? Residential mortgage - during the third quarter of 2013 continuing into 2014,
the Company has hired several retail residential mortgage loan officers in its
portion of its production, the Company has retained a portion of the mortgage
production. Due to the emphasis, gross loans receivable within the one-to-four
family portfolio have increased
? Commercial lending - during 2014, the Company expanded its commercial lending
team by hiring additional loan officers in its
commercial real estate and construction and development portfolios have grown
? Syndicated loans - the
have provided limited opportunities for the Bank to develop a Commercial and
Industrial ("C&I") loan portfolio. The Company's primary markets are generally
concentrated in real estate lending. However, in order to diversify our lending
portfolio, the Company began a syndicated loan program in 2014 to purchase C&I
loans to retain in the loan portfolio. These loans typically have terms of
seven years and are tied to a floating rate index such as libor or prime. To
effectively manage this new line of lending, the Company hired an experienced
senior lending executive with relevant experience to lead and manage this area
of the loan portfolio and engaged a consulting firm that specializes in
syndicated loans. The Company expects to continue to grow this portion of the
loan portfolio throughout 2014. As of
syndicated loan portfolio was Ba3, with no credit rated less than B2.
? Acquisition of
related to this first quarter branch acquisition. Approximately
of these loans were one-to-four family secured loans with the remaining loans
consisting of consumer and commercial real estate loans.
Partially offsetting the increase in average earning assets is the decrease in average balance of loans held for sale as the Company experienced a significant decrease in the level of mortgage originations during the latter half of 2013 continuing into 2014. For the six months ended
June 30, 2014, mortgage originations were $449.8 million, a decrease of 54.8%, as compared to originations of $995.8 millionfor the six months ended June 30, 2013. The decrease in rates paid on interest-bearing liabilities is based on the continued historically low interest rates that have positively impacted our ability to reduce funding cost while the shift to lower cost funding sources relates to the sustained efforts of the Company to grow checking, savings, and money market accounts. During the first half of 2014, the Company experienced significant growth in checking, savings, and money market accounts which typically yield less than other forms of interest-bearing liabilities. Specifically, checking, savings and money market balances increased $26.6 millionduring the second quarter of 2014 and $23.3 millionduring the first quarter of 2014 for year to date growth of $49.9 million. This growth includes $11.3 millionof deposits acquired in the St. Georgebranch acquisition during the first quarter of 2014. In addition to the aforementioned growth, the Company established a deposit relationship with its mortgage subservicing provider during the third quarter of 2013 whereby the subservicer deposited impound escrow funds with the Company. The impound escrow funds had average balances of $41.8 millionand $38.6 millionfor the three and six months ended June 30, 2014, respectively, and are included in interest-bearing demand accounts within the yield rate tables below. As this relationship was established during the third quarter of 2013, there were no funds outstanding for the three or six months ended June 30, 2013. 44 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 of capitalized loan costs and fees, which are considered immaterial, are amortized into interest income on loans. For The Three Months Ended June 30, 2014 2013 Interest Average Interest Average Average Paid/ Yield/ Average Paid/ Yield/ Balance Earned Rate Balance Earned Rate
Loans held for sale
$ 28,466251 3.45 % 89,042 754 3.31 % Loans receivable, net (1) 581,267 6,906 4.71 % 499,181 6,251 4.97 % Interest-bearing cash 24,063 14 0.23 % 44,289 29 0.26 % Securities available for sale 199,634 1,352 2.69 % 166,587 1,122 2.67 % Securities held to maturity 24,238 174 2.85 % 9,169 83 3.59 % Federal Home Loan Bank stock 3,625 35 3.86 % 4,106 31 3.02 % Other investments 1,925 11 2.27 % 1,731 11 2.52 % Total interest-earning assets 863,218 8,743 4.02 % 814,105 8,281 4.04 % Non-earning assets 84,949 73,932 Total assets $ 948,167888,037 Interest-bearing liabilities: Demand accounts 104,140 46 0.18 % 44,525 22 0.20 % Money market accounts 213,576 132 0.25 % 210,519 231 0.44 % Savings accounts 24,812 11 0.18 % 13,206 12 0.36 % Certificates of deposit 312,809 709 0.90 % 315,046 577 0.73 % Short-term borrowed funds 11,523 11 0.38 % 20,812 80 1.53 % Long-term debt 69,571 512 2.92 % 79,762 546 2.72 % Total interest-bearing liabilities 736,431 1,421 0.77 % 683,870 1,468 0.85 %
Noninterest-bearing deposits 112,021 107,475 Other liabilities 12,587 21,781 Stockholders' equity 87,128 74,911 Total liabilities and Stockholders' equity
$ 948,167888,037 Net interest spread 3.25 % 3.19 % Net interest margin 3.37 % 3.32 % Net interest margin (tax equivalent) (2) 3.45 % 3.37 % Net interest income 7,322 6,813
(1) Average balances of loans include nonaccrual loans.
(2) The tax equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.
Our net interest margin was 3.37%, or 3.45% on a tax equivalent basis, for the three month period ended
June 30, 2014compared to 3.32%, or 3.37% on a tax equivalent basis, for the three month period ended June 30, 2013. The increase in our net margin primarily resulted from a decrease in the rate paid on interest-bearing liabilities, an increase in average non-interest bearing depoists, as well as the shift to lower cost deposits. Our net interest spread was 3.25% for the three months ended June 30, 2014as compared to 3.19% for the same period in 2013. 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 six basis point increase in net interest spread is a result of the 8 basis point reduction in rate paid on our interest-bearing liabilities offset by a two basis point reduction in yield on interest-earning assets. 45 For The Six Months Ended June, 2014 2013 Interest Average Interest Average Average Paid/ Yield/ Average Paid/ Yield/ Balance Earned Rate Balance Earned Rate
Loans held for sale
$ 27,062517 3.80 % 97,985 1,672 3.39 % Loans receivable, net (1) 567,379 13,473 4.79 % 500,940 12,412 5.00 %
cash 22,536 28 0.25 % 28,775 47 0.33 %
available for sale 190,852 2,705 2.86 % 163,592 2,183 2.69 % Securities held to maturity 24,282 342 2.84 % 9,120 125 2.76 % Federal Home Loan Bank stock 3,699 69 7.46 % 4,786 60 5.01 % Other investments 1,911 21 2.22 % 1,730 11 1.28 % Total interest-earning assets 837,721 17,155 4.13 % 806,928 16,510 4.13 % Non-earning assets 83,729 73,997 Total assets
$ 921,450880,925 Interest-bearing liabilities: Demand accounts 94,131 86 0.18 % 44,137 49 0.22 % Money market accounts 215,722 268 0.25 % 209,842 500 0.48 % Savings accounts 22,784 21 0.19 % 12,299 23 0.38 % Certificates of deposit 302,585 1,338 0.89 % 306,681 1,136 0.75 % Short-term borrowed funds 8,086 16 0.40 % 26,519 194 1.48 % Long-term debt 71,436 1,023 2.89 % 87,505 1,068 2.46 % Total
liabilities 714,744 2,752 0.78 % 686,983 2,970 0.87 %
deposits 107,814 99,687 Other liabilities 13,563 20,676 Stockholders' equity 85,329 73,579 Total liabilities and Stockholders' equity
$ 921,450880,925 Net interest spread 3.35 % 3.26 % Net interest margin 3.47 % 3.38 % Net interest margin (tax equivalent) (2) 3.56 % 3.42 % Net interest income 14,403 13,540
(1) Average balances of loans include nonaccrual loans.
(2) The tax equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.
Our net interest margin was 3.47%, or 3.56% on a tax equivalent basis, for the six months ended
June 30, 2014compared to 3.38%, or 3.42% on a tax equivalent basis, for the six months ended June 30, 2013. The increase in our net margin primarily resulted from a decrease in the rate paid on interest-bearing liabilities, an increase in average non-interest bearing depoists, as well as the shift to lower cost deposits. Our net interest spread was 3.35% for the six months ended June 30, 2014as compared to 3.26% for the same period in 2013. 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 nine basis point increase in net interest spread is a result of the nine basis point reduction in rate paid on our interest-bearing liabilities. 46 Provision for Loan Loss We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of operations. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under "Allowance for Loan Losses" for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.
Following is a summary of the activity in the allowance for loan losses during the periods ended
For the Three Months For the Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 (Dollars in thousands) Balance, beginning of period
$ 8,4019,638 8,091 9,520 Provision for loan losses - (700 ) - (700 ) Loan charge-offs (36 ) (771 ) (284 ) (899 ) Loan recoveries 297 236 855 482 Balance, end of period $ 8,6628,403 8,662 8,403
During the three and six months ended
June 30, 2014, there was no provision for loan loss recorded. During the three months and six months ended June 30, 2013, a negative provision of $700,000was recorded. The negative provision was recorded during 2013 was primarily related to the removal of a specific reserve on an impaired loan relationship. The specific reserve was removed during the quarterly impairment analysis performed where it was determined that the net realizable value of the collateral was greater than the amortized cost of the loan; therefore, no specific reserve was warranted. Provision expense is recorded based on our assessment of general loan loss risk as well as asset quality and is driven by the determination of the 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. For further discussion regarding the calculation of the allowance, see the "Allowance for Loan Losses" discussion below.
Noninterest Income and Expense
Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three and six months ended
June 30, 2014and 2013 are presented below: For the Three Months For the Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 (In thousands) Noninterest income: Net gain on sale of loans held for sale $ 3,42610,199 5,880 21,549 Deposit service charges 517 371 948 689 Net loss on extinguishment of debt (31 ) (19 ) (31 ) (19 ) Net gain (loss) on sale of securities 164 (62 ) 480 (46 ) Fair value adjustments on interest rate swaps (263 ) 263 (518 ) 263 Net gain on sale of servicing assets - - 775 - Net increase in cash value life insurance 187 - 373 1 Mortgage loan servicing income 1,254 1,836
2,531 3,328 Other 195 217 380 423 Total noninterest income
$ 5,44912,805 10,818 26,188 47 Noninterest income decreased $7.4 millionto $5.4 millionfor the three months ended June 30, 2014from $12.8 millionfor the three months ended June 30, 2013. For the six months ended June 30, 2014, noninterest income decreased $15.4 millionto $10.8 millionfrom $26.2 millionfor the six months ended June 30, 2013. The decrease in noninterest income for the three and six months ended June 30, 2014as compared to the three and six months ended June 30, 2013primarily relates to the decrease in the gain on sale of loans sold from our mortgage banking subsidiary. During the third quarter of 2013, mortgage interest rates began to rise and, as a result, mortgage loan production began to slow down. Rising interest rates significantly slowed the mortgage refinancing activity, and, as the overall mortgage originations volumes declined, there was a corresponding reduction in margins earned due to competitive pressures. Mortgage loan originations decreased 54.8% to $449.8 millionfor the six months ended June 30, 2014compared to originations of $995.8 millionfor the six months ended June 30, 2013. Partially offsetting the overall decrease in noninterest income was an increase in the net gain on sale of servicing asset. During the first quarter of 2014, the Company sold $147.7 millionin unpaid principal balance of mortgage servicing rights for a net gain of $776,000. There were no servicing rights sold during three or six months ended June 30, 2013. The sale of mortgage servicing rights during the first quarter of 2014 as well as a sale of servicing rights during the second half of 2013 of $972.9 millionof unpaid principal balance of mortgage servicing rights resulted in a corresponding decrease of mortgage loan servicing income for the three and six months ended June 30, 2014as compared to the prior periods. During the three and six months ended June 30, 2014, the Company recognized net gains on sale of available-for-sale securities of $164,000and $480,000, respectively, compared to losses on sale of securities during the three and six months ended June 30, 2013of $62,000and $46,000, respectively. The fair value adjustment on interest rate swaps was a reduction of noninterest income of $263,000and $518,000for the three and six months ended, June 30, 2014, respectively, compared to an increase of noninterest income of $263,000for the three and six months ended June 30, 2013. The change in fair value adjustment on interest rate swaps relate to the change in interest rates from period to period. Net increase in cash value of life insurance was $187,000and $0for the three months ended June 30, 2014and 2013, respectively. Net increase in the cash value of life insurance was $373,000and $1,000for the six months ended June 30, 2014and 2013, respectively. The increase in cash surrender value relates to the increase of $20.1 millionin cash value life insurance that was purchased at the end of the first quarter in 2013 and was outstanding for all of the three and six month periods ended June 30, 2014. During 2013, the Company purchased and invested in bank owned life insurance policies on certain employees with an initial cash surrender value of $20.0 millionthrough two insurance carriers. As of June 30, 2014, cash value of life insurance was $21.2 millioncompared to $20.9 millionat December 31, 2013. The following table sets forth for the periods indicated the primary components of noninterest expense: For the Three Months For the Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 (In thousands) Noninterest expense:
Salaries and employee benefits
$ 5,5156,248 10,859 12,708 Occupancy and equipment 1,051 847 2,035 1,661 Marketing and public relations 297 263
571 498 FDIC insurance 136 157 263 413 Legal expense 191 290 361 440
Other real estate expense, net 60 335 307 411 Mortgage subservicing expense 326 469 689 935 Amortization of mortgage servicing rights 441 738 913 1,331 Settlement of employment agreements - 119
- 1,902 Other 1,474 2,139 3,100 4,329 Total noninterest expense
$ 9,49111,605 19,098 24,628 Noninterest expense represents the largest expense category for the Company. Noninterest expense decreased $2.1 millionto $9.5for the three months ended June 30, 2014from $11.6 millionfor the three months ended June 30, 2013. For the six months ended June 30, 2014, noninterest expense decreased $5.5 millionto $19.1 millionfrom $24.6 millionfor the six months ended June 30, 2013. The decrease in noninterest expense for the three and six months ended June 30, 2014compared to the prior periods are primarily a result of the decrease in salaries and employee benefits, a reduction in mortgage subservicing and amortization expense, the reduction in settlement of employment agreements and other. 48
The decrease in salaries and benefits and noninterest expense - other is a result of the reduced mortgage loan originations during the three and six months ended
June 30, 2014as compared to the prior periods, and the related compensation paid on and expenses releated to those originations. As previously discussed, mortgage loan originations decreased 54.8% to $449.8 millionfor the six months ended June 30, 2014compared to originations of $995.8 millionfor the six months ended June 30, 2013. Mortgage subservicing expense and amortization of mortgage subservicing rights decreased during the three and six months ended June 30, 2014as compared to the three and six months ended June 30, 2013due to the sale of $147.7 millionin unpaid principal balance of mortgage servicing rights during the first quarter of 2014 and the sale of $972.9 millionin unpaid principal balance of mortgage servicing rights during the second half of 2013. The decrease in expense in settlement of employment agreements related to the Company settling employment agreements with two former retired executive officers during 2013. All amounts related to the settlement of these agreements were expensed during 2013. As such, there were no additional expenses related to these contracts during the three or six months ended June 30, 2014.
Income Tax Expense
Our effective tax rate decreased to 31.4% for three month period ended
June 30, 2014, compared to 36.5% for the three month period ended June 30, 2013. For the six months ended June 30, 2014, our effective tax rate decreased to 31.5% compared to 37.0% for the six months ended June 30, 2013. The lower effective tax rate in 2014 is primarily attributable to the increase in balances of tax-exempt municipal securities as well as the increase in average balances of bank-owned life insurance during the second half of 2013 and into 2014. 49 Balance Sheet Review Investment Securities
Our primary objective in managing the investment portfolio is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns. We are required under federal regulations to maintain adequate liquidity to ensure safe and sound operations. We maintain investment balances based on a continuing assessment of cash flows, the level of current and expected loan production, current interest rate risk strategies and the assessment of the potential future direction of market interest rate changes. Investment securities differ in terms of default, interest rate, liquidity and expected rate of return risk. At
June 30, 2014, the $231.5 millionin our investment securities portfolio, excluding FHLB stock and other investments, represented approximately 23.4% of our assets. Our available-for-sale investment portfolio included US agency securities, municipal securities, collateralized loan obligations and mortgage-backed securities (agency and non-agency) with a fair value of $207.3 millionand an amortized cost of $202.6 millionfor a net unrealized gain of $4.7 million. Our held-to-maturity portfolio included municipal securities and asset-backed securities, made up of pooled trust preferred securities, with a fair value of $25.9 millionand a cost of $24.3 millionfor a net unrealized gain of $1.6 million. As securities are purchased, they are designated as held-to-maturity or available-for-sale based upon our intent, which incorporates liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements. We do not currently hold, nor have we ever held, any securities that are designated as trading securities. The following table summarizes issuer concentrations of agency mortgage-backed securities for which aggregate fair values exceed 10% of stockholders' equity at June 30, 2014: Aggregate Aggregate Fair Value Amortized Fair as a % of Issuer Cost Value Stockholders' Equity (Dollars in thousands) GNMA $ 30,41031,337 35.10 % FNMA 45,599 46,841 52.47 % FHLMC 25,071 25,964 29.08 % $ 101,080104,142 116.65 %
See Note 2 "Securities" in the "Notes to Consolidated Financial Statements" herein for additional disclosures related to the Company's evaluation of securities for OTTI.
Loans by Type
Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Before allowance for loan losses, loans outstanding at
Our loan portfolio consists primarily of loans secured by real estate mortgages. As of
June 30, 2014, our loan portfolio included $554.1 million, or 90.2%, of loans secured by real estate before allowance for loan losses. As of December 31, 2013, our loan portfolio included $515.1 million, or 94.8%, of loans secured by real estate before allowance for loan losses. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. The Bank's primary markets are generally concentrated in real estate lending. In order to diversify our lending portfolio, the Bank began a syndicated loan program during 2014 with balances of $29.1 millionas of June 30, 2014and are grouped within commercial business loans in the table below. As of June 30, 2014, the Moody's weighted average credit facility rating of the syndicated loan portfolio was Ba3, with no credit rated less than B2. 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. 50 As shown in the table below, loans prior to the allowance for loan losses increased $70.7 millionto $614.0 millionat June 30, 2014from $543.3 millionat December 31, 2013. The increase in loans receivable primarily relates to the Bank's focus on growing residential mortgage, commercial lending, and syndicated loans, as well as $11.2 millionof loans acquired related to the acquisition of the St. Georgebranch. See additional discussion in "Results of Operations - Net Interest Income and Margin". The following table summarizes loans by type and percent of total at the end of the periods indicated: At June 30, At December 31, 2014 2013 % of Total % of Total Amount Loans Amount Loans (Dollars in thousands) Loans secured by real estate: One-to-four family $ 209,87832.62 % 184,210 32.60 % Home equity 23,529 3.66 % 23,661 4.19 % Commercial real estate 264,911 41.18 % 253,035 44.79 % Construction and development 77,629 12.07 % 67,056 11.87 % Consumer loans 3,132 0.49 % 3,060 0.54 % Commercial business loans 64,187 9.98 % 33,938 6.01 % Total gross loans receivable 643,266 100.00 % 564,960 100.00 % Less: Undisbursed loans in process 29,053 21,550 Allowance for loan losses 8,662 8,091 Deferred fees, net 256 98 Total loans receivable, net $ 605,295535,221
Maturities and Sensitivity of Loans to Changes in Interest Rates
The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.
The following table summarizes the loan maturity distribution by type and related interest rate characteristics.
At June 30, 2014 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
$ 41,22362,698 105,957 209,878 Home equity 6,347 1,222 15,960 23,529 Commercial real estate 32,764 97,537 134,610 264,911 Construction and development 10,795 21,852 44,982 77,629 Consumer loans 549 1,226 1,357 3,132 Commercial business loans 2,779 18,217 43,191 64,187 Total gross loans receivable 94,457 202,752 346,057 643,266 Less: Undisbursed loans in process 2,210 13,791 13,052 29,053 Deferred fees, net 33 74 149 256 Total loans receivable $ 92,214188,887 332,856 613,957 Loans maturing - after one year Variable rate loans $ 310,505Fixed rate loans 211,238 $ 521,74351
Nonperforming and Problem Assets
Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower's loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of six consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of
June 30, 2014and December 312013, we had no loans 90 days past due and still accruing.
Troubled Debt Restructurings ("TDRs")
The Company designates loan modifications as TDRs when, for economic or legal reasons related to the borrower's financial difficulties, it grants a concession to the borrower that it would not otherwise consider. Loans on nonaccrual status at the date of modification are initially classified as nonaccrual TDRs. Loans on accruing status at the date of modification are initially classified as accruing TDRs at the date of modification, if the note is reasonably assured of repayment and performance is in accordance with its modified terms. Such loans may be designated as nonaccrual loans subsequent to the modification date if reasonable doubt exists as to the collection of interest or principal under the restructuring agreement. Nonaccrual TDRs are returned to accrual status when there is economic substance to the restructuring, there is well documented credit evaluation of the borrower's financial condition, the remaining balance is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated repayment performance in accordance with the modified terms for a reasonable period of time, generally a minimum of six months. The following table summarizes nonperforming and problem assets at the end of the periods indicated. At June 30, At December 31, 2014 2013 (In thousands) Loans receivable: Nonaccrual loans-renegotiated loans
$ 6,5377,641 Nonaccrual loans-other 2,856 3,438 Accruing loans 90 days or more delinquent - - Real estate acquired through foreclosure, net 5,655 6,273 Total Non-Performing Assets $ 15,04817,352
Problem Assets not included in Non-Performing Assets- Accruing renegotiated loans outstanding
$ 15,48816,367 At June 30, 2014, nonperforming assets were $15.0 million, or 1.52% of total assets. Comparatively, nonperforming assets were $17.4 million, or 2.0% of total assets, at December 31, 2013. Nonperforming loans were 1.53% and 2.0% of loans outstanding at June 30, 2014and December 31, 2013, respectively. Nonaccrual loans decreased $1.7 millionto $9.4 millionat June 30, 2014from $11.1 millionat December 31, 2013. Potential problem loans, which are not included in nonperforming loans, amounted to approximately $15.5 million, or 2.5% of loans outstanding prior to the allowance for loan losses, at June 30, 2014, compared to $16.4 million, or 3.0% of loans outstanding prior to the allowance for loan losses, at December 31, 2013. 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 June 30, 2014and December 31, 2013are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.
52 Although nonperforming assets remain at a historically elevated level, credit quality indicators generally showed improvement during 2013 and continuing into 2014 as the Company experienced reduced loan migrations to nonaccrual status, lower loss severity on individual problem assets and a reduction in nonperforming assets. The Company believes this general trend in reduced loans migrating into nonaccrual status is an indication of improving credit quality in the Company's overall loan portfolio and a leading indicator of reduced credit losses going forward. Nevertheless, the Company can make no assurances that nonperforming assets will continue to improve in future periods. The Company continues to monitor the loan portfolio and foreclosed assets and is continually working to reduce its problem assets.
Allowance for Loan Losses
The allowance for loan losses is management's estimate of probable credit losses inherent in the loan portfolio at the balance sheet date. Management determines the allowance based on an ongoing evaluation. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The allowance consists of specific and general components. The general component covers nonimpaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by major loan category and is based on the actual loss history trends for the previous 12 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 12 quarter historical loss rate to recognize the most recent loss results and changes in the economic conditions to ensure the estimated losses in the portfolio are recognized in the period incurred and that the allowance at each balance sheet date is adequate and appropriate in accordance with GAAP. Qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent twelve quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. Impaired loans are evaluated for impairment using the discounted cash flow methodology or based on the net realizable value of the underlying collateral. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. See additional discussion in section "Nonperforming and Problem Assets" of the MD&A. 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. At
June 30, 2014and December 31, 2013, the allowance for loan losses was $8.7 millionand $8.1 million, respectively, or 1.41% and 1.49% of outstanding loans, respectively. There was no provision recorded for the three or six months ended June 30, 2014. During the three and six months ended June 30, 2013, the Company recorded a negative provision of $700,000primarily due to the removal of a specific reserve on an impaired loan relationship. The specific reserve was removed during the quarterly impairment analysis performed where it was determined that the net realizable value of the collateral was greater than the amortized cost of the loan; therefore, management determined the reserve previously placed against this loan relationship should be reversed through
a negative provision. 53
The following table summarizes the activity related to our allowance for loan losses for the three and six months ended
For the Three Months For the Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 (Dollars in thousands) Balance, beginning of period
$ 8,4019,638 8,091 9,520 Provision for loan losses - (700 ) - (700 ) Loan charge-offs: Loans secured by real estate: One-to-four family (36 ) (48 ) (73 ) (81 ) Home equity - (28 ) - (28 ) Commercial real estate - (110 ) (28 ) (110 ) Construction and development - (248 ) (170 ) (310 ) Consumer loans - (1 ) (13 ) (34 ) Commercial business loans - (336 ) - (336 ) Total loan charge-offs (36 ) (771 ) (284 ) (899 ) Loan recoveries: Loans secured by real estate: One-to-four family 52 18 71 133 Home equity - - - - Commercial real estate - 21 - 73 Construction and development 2 72 329 79 Consumer loans 10 8 50 32 Commercial business loans 233 117 405 165 Total loan recoveries 297 236 855 482
Net loan (charge-offs) recoveries 261 (535 ) 571 (417 ) Balance, end of period
Allowance for loan losses as a percentage of loans receivable, net (end of period) 1.41 % 1.64 % 1.41 % 1.64 % Net charge-offs (recoveries) to average loans receivable (annualized) -0.16 % 0.43 %
-0.20 % 0.17 % 54 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. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company's profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations are provided in "Results of Operations". Additional segment information is provided in Note 9 "Supplemental Segment Information" to the consolidated financial statements.
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. At
June 30, 2014, the Company was servicing $1.8 billionof loans for others, a decrease of $200 millionfrom $2.0 billionat December 31, 2013. The decrease in loans serviced in the current year primarily relates to principal payments and a loan servicing sale where the Company sold $147.7 millionin unpaid principal balance of mortgage servicing rights for a net gain of $775,000. 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. In the aggregate, the net servicing asset had a balance of $9.8 millionand $10.9 millionat June 30, 2014and December 31, 2013, respectively. The economic estimated fair value of the mortgage servicing rights was $15.2 millionand $17.7 millionat June 30, 2014and December 31, 2013, respectively. The amortization expense related to the mortgage servicing rights were $441,000and $738,000during the three months ended June 30, 2014and 2013, respectively. For the six months ended June 30, 2014and 2013, the amortization expense recorded was $913,000and $1.3 million, respectively. 55
Below is a roll-forward of activity in the balance of the servicing assets for the three and six months ended
For the Three Months For the Six Months Ended June 30, Ended June 30, 2014 2013 2014 2013 (In thousands) MSR beginning balance
$ 10,00314,564 10,908 12,039 Amount capitalized 281 1,662 648 4,780 Amount sold - - (800 ) - Amount amortized (441 ) (738 ) (913 ) (1,331 ) MSR ending balance $ 9,84315,488 9,843 15,488
Losses on Mortgage Loans Previously Sold
Loans held for sale have primarily been fixed-rate single-family residential mortgage loans under contracts to be sold in the secondary market. In most cases, loans in this category are sold within 30 days of closing. Buyers generally have recourse to return a purchased loan to the Company under limited circumstances. Repurchases and losses on mortgage loans previously sold are recorded when the Company indemnifies or repurchases mortgage loans previously sold. The representations and warranties in our loan sale agreements provide that we repurchase or indemnify the investors for losses or costs on loans we sell under certain limited conditions. Some of these conditions include underwriting errors or omissions, fraud or material misstatements by the borrower in the loan application or invalid market value on the collateral property due to deficiencies in the appraisal. In addition to these representations and warranties, our loan sale contracts define a condition in which the borrower defaults during a short period of time, typically 120 days to one year, as an early payment default, or EPD. In the event of an EPD, we are required to return the premium paid by the investor for the loan as well as certain administrative fees, and in some cases repurchase the loan or indemnify the investor. Because the level of mortgage loan repurchase losses depends upon economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment.
The following table demonstrates the activity for the mortgage repurchase reserve for the three and six months ended
For the Three Months For the Six Months Ended June, Ended June, 2014 2013 2014 2013 (In thousands) Beginning Balance
$ 5,8715,443 6,108 4,882 Losses paid (95 ) (210 ) (354 ) (341 ) Recoveries 7 - 29 - Provision for buyback (250 ) 460 (250 ) 1,152 Ending balance $ 5,5335,693 5,533 5,693 For the three and six months ended June 30, 2014, the Company recorded a negative provision for mortgage repurchase reserve of $250,000. This compares to provision expense for mortgage repurchase reserve of $460,000and $1.1 millionfor the three and six months ended June 30, 2013, respectively. The decline in the provision for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities ("GSEs"), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. Prior to 2012, there was no expiration date related to representations and warranties as long as the loan sold to the investor was outstanding. As a result, the Company received loan repurchase requests years after the loan was originated and sold to various third parties. In the latter part of 2012, the regulatory framework for certain GSEs changed where, under certain circumstances, the loan repurchase risk was limited for production beginning in January 2013. In addition, in May 2014, additional regulatory changes further limited loan repurchase risk. As a result, the Company performed an analysis of its reserve for mortgage loan repurchase losses and, based on management's judgment and interpretation of such regulatory changes, reduced the reserve by $250,000. Management will continue to monitor how the GSEs implement the regulatory changes and trends. If such trends continue to be favorable, there is a possibility that additional reductions in this reserve could occur in future periods. 56 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 June 30, 2014deposits totaled $779.5 million, an increase of $82.0 million, or 11.7%, from deposits of $697.6 millionat December 31, 2013. The increase in deposits is primarily related to $24.5 millionof deposits acquired related to the acquisition of the St. Georgebranch during the first quarter of 2014 as well as an increase in the number of deposit accounts and seasonality of our customer balances during the summer months. Our retail deposits represented $649.5 million, or 83.3% of total deposits at June 30, 2014, while our out-of-market, or brokered deposits and institutional deposits, represented $130.0 million, or 16.7% of our total deposits. Our retail deposits represented $595.7 million, or 85.4% of total deposits at December 31, 2013, while our out-of-market, or brokered deposits and institutional deposits, represented $101.9 million, or 14.6% of our total deposits. The following table shows the average balance amounts and the average rates paid on deposits held by us. For the Six Months Ended June, 2014 2013 Average Average Average Yield/ Average Yield/ Balance Rate Balance Rate (In thousands)
Interest-bearing demand accounts
$ 94,1310.18 %
44,137 0.22 % Money market accounts 215,722 0.25 % 209,842 0.48 % Savings accounts 22,784 0.19 % 12,299 0.38 %
Certificates of deposit less than
$100,000207,069 0.92 % 213,279 0.77 % Certificates of deposit of $100,000or more 95,516 0.83 % 93,402 0.70 % Total interest-bearing average deposits 635,222
Noninterest-bearing deposits 107,814
99,687 Total average deposits
$ 743,036672,646 The maturity distribution of our time deposits of $100,000or more is as follows: At June 30, 2014 (In thousands) Three months or less $ 20,862 Over three through six months 18,270 Over six through twelve months 5,925 Over twelve months 58,980 Total certificates of deposits $ 104,03757 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 Atlantaadvance window, 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 Atlantaare 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 June 30, 2014, the Company had FHLB advances of $87.5 millionoutstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $52.0 million.
Lines of credit with the FRB are based on collateral pledged. At
The Company and the Bank are subject to numerous regulatory capital requirements administered by federal banking agencies. If these capital requirements are not met, regulators can initiate certain mandatory - and possibly additional discretionary - actions that, if undertaken, could affect operations. Under capital adequacy guidelines and the regulatory framework for corrective action, the Company and the Bank must meet certain capital guidelines, which involve quantitative measures of the Company's and the Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are subject to qualitative judgments by the regulators about components, risk weightings and certain other factors. Quantitative measures set up by regulation to guarantee capital adequacy require the Company and the Bank to sustain minimum amounts and ratios of Tier 1 capital and total risk-based capital to risk-weighted assets and Tier 1 capital to total average assets. The Company and the Bank are required to maintain minimum Tier 1 capital and total risk-based capital to risk-weighted assets, and Tier 1 capital to total average assets of 4%, 8%, and 4%, respectively. To be considered "well capitalized", the Company and the Bank must maintain at least Tier 1 capital and total risk-based capital to risk-weighted assets, and Tier 1 capital to total average assets of 6%, 10%, and 5%, respectively. As of
June 30, 2014, the Company and the Bank are considered "well capitalized" under regulatory capital adequacy guidelines. 58
The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at
Required to be Categorized Required to be Adequately Categorized Actual Capitalized Well Capitalized Amount Ratio Amount Ratio Amount Ratio (Dollars in thousands) June 30, 2014 Carolina Financial Corporation Tier 1 capital (to risk weighted assets)
$ 103,74414.80 % 28,045 4.00 % N/A N/A Total risk based capital (to risk weighted assets) 113,231 16.15 % 56,089 8.00 % N/A N/A Tier 1 capital (to total average assets) 103,744 10.92 % 37,995 4.00 % N/A N/A CresCom Bank Tier 1 capital (to risk weighted assets) 102,168 14.61 % 27,973 4.00 % 41,960 6.00 % Total risk based capital (to risk weighted assets) 111,655 15.97 % 55,946 8.00 % 69,933 10.00 % Tier 1 capital (to total average assets) 102,168 10.78 % 37,914 4.00 % 47,392 5.00 % December 31, 2013 Carolina Financial Corporation Tier 1 capital (to risk weighted assets) $ 99,60215.42 % 25,834 4.00 % N/A N/A Total risk based capital (to risk weighted assets) 108,650 16.82 % 51,668 8.00 % N/A N/A Tier 1 capital (to total average assets) 99,602 11.15 % 35,732 4.00 % N/A N/A CresCom Bank Tier 1 capital (to risk weighted assets) 98,301 15.26 % 25,763 4.00 % 38,645 6.00 % Total risk based capital (to risk weighted assets) 107,327 16.66 % 51,526 8.00 % 64,408 10.00 % Tier 1 capital (to total average assets) 98,301 11.01 % 35,706 4.00 % 44,632 5.00 % In December 2010, the Basel Committee on Banking Supervision, or BCBS, an international forum for cooperation on banking supervisory matters, announced the "Basel III" capital standards, which substantially revised the existing capital requirements for banking organizations. Modest revisions were made in June 2011. The Basel III standards operate in conjunction with portions of standards previously released by the BCBS and commonly known as "Basel II" and "Basel 2.5." On June 7, 2012, the Federal Reserve, the OCC, and the FDICrequested comment on these proposed rules that, taken together, would implement the Basel regulatory capital reforms through what we refer to herein as the "Basel III capital framework." On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDICadopted the same provisions in the form of an "interim" final rule. The rule will apply to all national and state banks and savings associations and most bank holding companies and savings and loan holding companies, which we collectively refer to herein as "covered" banking organizations. Bank holding companies with less than $500 millionin total consolidated assets are not subject to the final rule, nor are savings and loan holding companies substantially engaged in commercial activities or insurance underwriting. In certain respects, the rule imposes more stringent requirements on "advanced approaches" banking organizations-those organizations with $250 billionor more in total consolidated assets, $10 billionor more in total foreign exposures, or that have opted in to the Basel II capital regime. The requirements in the rule will begin to phase on January 1, 2014, for advanced approaches banking organizations, and on January 1, 2015, for other covered banking organizations. The requirements in the rule will be fully phased in by January 1, 2019. Management expects to comply with the final rules when issued and effective. 59
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
June 30, 2014, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Downward movements do not appear to be applicable due to the low interest rate environment experienced since 2013. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management's assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions. Annualized Hypothetical Interest Rate Scenario Percentage Change in Change PrimeRate Net Interest Income 0.00% 3.25% 0.00% 1.00% 4.25% 2.10% 2.00% 5.25% 4.00% 3.00% 6.25% 4.80% 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. 60 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 of the consolidated financial statements.
Effect of Inflation and Changing Prices
The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with 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.