MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS INTRODUCTION
The following discussion describes our results of operations for the three and six month periods ended
June 30, 2014, as compared to the three and six month periods ended June 30, 2013, and also analyzes our financial condition as of June 30, 2014as compared to December 31, 2013. The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the SEC. OVERVIEW For the six months ended June 30, 2014, the Bank had a net income of $243 thousandcompared to net income of $741 thousandfor the six months ended June 30, 2013. The decrease in net income during the first six months of 2014 was primarily attributable to a provision expense in the amount of $1.5 millionthat was recaptured during the six months ended June 30, 2013while no provision expense was recorded or recaptured for the first six months of 2014. In addition, noninterest expenses decreased $1.2 millionfor the first six months of 2014 as compared to the first six months of 2013. Total assets at June 30, 2014were $452.6 million, an increase of $18.0 millionfrom $434.6 millionat December 31, 2013. Deposit growth of $13.1 millionwas used for purchases of investment securities available-for-sale which increased $25.8 million. Management increased QuickRate deposits by design during the six months ended June 30, 2014to accompany slight growth in non-interest-bearing demand deposits and money market deposits to support the increase in the securities portfolio that was achieved during the period. The deposit growth was a strategic move by management but was not the result of any increase in deposit rates offered during the period. RESULTS OF OPERATIONS
Results of Operations for the Six Months ended
The Company experienced a decrease of
$135 thousandin total interest income for the six months ended June 30, 2014. A decrease in interest, including fees, on our loan portfolio of $690 thousand, or 9.2%, for the six months ended June 30, 2014compared to the six months ended June 30, 2013was partially offset by an increase of $571 thousandin interest income on taxable available-for-sale securities due to the increase in volume of the securities. Declines in rates resulted in a decrease to total interest expense of $199 thousand, or 7.2%, for the six month period in 2014 compared to the six month period in 2013. Net interest income increased $64 thousandfor the six months ended June 30, 2014compared to the six months ended June 30, 2013. The provision for loan losses is charged to earnings based upon management's evaluation of specific loans in its portfolio and general economic conditions and trends in the marketplace. Please refer to the section "Loan Portfolio" for a discussion of management's evaluation of the adequacy of the allowance for loan losses. No provision was considered necessary for the six month period ended June 30, 2014. Provisions were recaptured during the six months ended June 30, 2013in the amount of $1.5 million. Noninterest income decreased $232 thousandto $1.3 millionfor the six months ended June 30, 2014as compared to $1.6 millionfor the six months ended June 30, 2013, primarily due to a reduction in gains on sales of available-for-sale securities of $197 thousand. During the six months ended June 30, 2014, gains on sales of available-for-sale securities totaled $100 thousandcompared to $297 thousandduring the same period in 2013. Noninterest expense decreased from $7.9 millionfor the six months ended June 30, 2013to $6.7 millionfor the six months ended June 30, 2014primarily due to lower costs of operations of other real estate owned. Net cost of operations of other real estate owned decreased from $1.1 millionfor the six months ended June 30, 2013to $161 thousandfor the same period in 2014. -50- HCSB FINANCIAL CORPORATION AND SUBSIDIARY
Results of Operations for the Three Months ended
Net loss for the three months ended
June 30, 2014was $74 thousandcompared to a net income of $77 thousandfor the three months ended June 30, 2013. The decline was primarily the result of provision expense recaptured in the second quarter of 2013 offset by lower noninterest expenses. Interest income decreased $102 thousandfor the quarter ended June 30, 2014when compared the same period in 2013. Lower rates and lower loan volume contributed to the reduction. Interest expense also decreased by $111 thousandfor the quarter ended June 30, 2014when compared to the same period in 2013. Net interest income increased by $9 thousand.
Provisions previously recognized of
Noninterest income for the three months ended
June 30, 2014was $706 thousandcompared to $858 thousandfor the three months ended June 30, 2013. Gains realized on sales of available-for-sale securities were $213 thousandfor the three months ended June 30, 2013compared to gains realized on sales of available-for-sale securities of $49for the three months ended June 30, 2014.
For the three months ended
-51- HCSB FINANCIAL CORPORATION AND SUBSIDIARY FINANCIAL CONDITION Investment Portfolio Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company's ability to hold them until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held-to-maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders' equity on an after-tax basis. As of
June 30, 2014and December 31, 2013, all securities were classified as available-for-sale.
The portfolio of available-for-sale securities increased
The following tables summarize the carrying value of investment securities as of the indicated dates and the weighted-average yields of those securities at
June 30, 2014. June 30, 2014 (in thousands) Amortized Cost Due Due After One After Five Within Through Through After Ten Market One Year Five Years Ten Years Years Total Value Investment securities
Government sponsored enterprises $ - $ -
$ 12,500 $ 38,031 $ 50,531 $ 48,475Mortgage backed securities - 1,491 8,023 60,993 70,507 70,746 State and political subdivisions - - 633
615 1,248 1,199 Total $ -
$ 1,491 $ 21,156 $ 99,639 $ 122,286 $ 120,420Weighted average yields
Government sponsored enterprises - % - % 2.08 % 2.90 % Mortgage backed securities - % 2.00 % 1.43 % 2.20 % State and political subdivisions - % - % 2.54
% 4.07 % Total - % 2.00 % 1.85 % 2.48 % 2.37 % Book Market
December 31, 2013 (in thousands) Value Value Investment securities Government sponsored enterprises
$ 60,628 $ 55,075Mortgage backed securities 37,731 37,034 States and political subdivisions
2,516 2,493 Total
$ 100,875 $ 94,602Loan Portfolio The Company experienced a decline in its loan portfolio of $5.1 millionduring the six months ended June 30, 2014. The following table sets forth the composition of the loan portfolio by category as of June 30, 2014and December 31, 2013. June 30, December 31, 2014 2013 (Dollars in thousands) Real estate:
Commercial construction and land development
$ 36,236 $ 38,899
Other commercial real estate 87,508 91,551 Residential construction 2,256 3,038 Other residential 81,019 81,297 Commercial and industrial 36,796 33,711 Consumer 7,557 7,928
$ 251,372 $ 256,424-52- HCSB FINANCIAL CORPORATION AND SUBSIDIARY Loan Portfolio - continued
The primary component of our loan portfolio is loans collateralized by real estate, which made up approximately 82.4% of our loan portfolio at
Risk Elements The downturn in general economic conditions over the past few years has resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declining real estate market has had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, in our current market the value of the collateral has deteriorated in value during the time the credit is extended. There is a risk that this trend will continue, which could result in additional losses of earnings and increases in our provision for loan losses and loans charged-off. Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees. Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. If the borrower is able to bring the account current, the loan is then placed
back on regular accrual status. For loans to be in excess of 90 days delinquent and still accruing interest, the borrowers must be either remitting payments although not able to get current, liquidation on loans deemed to be well secured must be near completion, or the Company must have a reason to believe that correction of the delinquency status by the borrower is near. The amount of both nonaccrual loans and loans past due 90 days or more were considered in computing the allowance for loan losses
June 30, 2014. Nonperforming loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and any other troubled debt restructurings not included in the previous categories. Nonperforming assets include nonperforming loans plus other real estate that we own as a result of loan foreclosures. Nonperforming loans were $35.6 millionor 13.90% of total loans at the end of 2013 compared to nonperforming loans at June 30, 2014of $34.5 millionor 13.71% of total loans.
June 30, 2014, nonperforming assets were $56.3 millioncompared to $60.6 millionat December 31, 2013. Loans transferred to other real estate owned of $905 thousandwere offset by sales of other real estate owned of $4.0 millionand writedowns of $13 thousandfor the six month period ended June 30, 2014. As a percentage of total assets, nonperforming assets were 12.45% and 13.95% as of June 30, 2014and December 31, 2013, respectively. -53- HCSB FINANCIAL CORPORATION AND SUBSIDIARY Loan Portfolio - continued
The following table summarizes nonperforming assets:
June 30, December 31, Nonperforming Assets 2014 2013 (Dollars in thousands) Nonaccrual loans
$ 9,675 $ 10,631
Performing troubled debt restructurings 24,788 25,010 Loans past due 90 days or more and still accruing interest -
- Total nonperforming loans 34,463 35,641 Other real estate owned 21,880 24,972 Total nonperforming assets
$ 56,343 $ 60,613
Nonperforming assets to total assets 12.45 % 13.95 % Nonperforming loans to total loans 13.71
% 13.90 %
We identify impaired loans through our normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Any resultant shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve. Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At
June 30, 2014, the recorded investment in impaired loans was $44.3 millioncompared to $45.7 millionat December 31, 2013. Troubled debt restructurings are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a troubled debt restructuring is to facilitate ultimate repayment of the loan. At June 30, 2014, the principal balance of troubled debt restructurings totaled $29.5 million. Of these restructured loans, $24.8 millionwere performing as expected under the new terms and $4.7 millionwere considered to be nonperforming and evaluated for reserves on the basis of the fair value of the collateral A troubled debt restructuring can be removed from nonperforming status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months. -54- HCSB FINANCIAL CORPORATION AND SUBSIDIARY
Provision and Allowance for Loan Losses
Management has established an allowance for loan losses through a provision for loan losses charged to expense on our statements of operations. The allowance represents an amount which management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. Management does not allocate specific percentages of our allowance for loan losses to the various categories of loans but evaluates the adequacy on an overall portfolio basis utilizing several factors. The primary factor considered is the credit risk grading system, which is applied to each loan. The amount of both nonaccrual loans and loans past due 90 days or more is also considered. The historical loan loss experience, the size of our lending portfolio, changes in the lending policies and procedures, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons, and current and anticipated economic conditions are also considered in determining the provision for loan losses. The amount of the allowance is adjusted periodically based on changing circumstances. Recognized losses are charged to the allowance for loan losses, while subsequent recoveries are added to the allowance. Management regularly monitors past due and classified loans. However, it should be noted that no assurances can be made that future charges to the allowance for loan losses or provisions for loan losses may not be significant to a particular accounting period. Management's judgment as to the adequacy of the allowance is based upon a number of assumptions about future events which it believes to be reasonable, but which may or may not prove to be accurate. Because of the inherent uncertainty of assumptions made during the evaluation process, there can be no assurance that loan losses in future periods will not exceed the allowance for loan losses or that additional allocations will not be required. Our losses will undoubtedly vary from our estimates, and there is a possibility that charge-offs in future periods will exceed the allowance for loan losses as estimated at any point in time. At
June 30, 2014, the allowance for loan losses was $7.0 millionor 2.77% of total loans compared to $9.4 millionor 3.68% of total loans as of December 31, 2013. Reserves specifically set aside for impaired loans of $1.9 millionand $3.8 millionwere included in the allowance as of June 30, 2014and December 31, 2013, respectively. Management believes the allowance is adequate. The following table summarizes the activity related to our allowance for loan losses.
Summary of Loan Loss Experience
Six months ended Year ended (Dollars in thousands) June 30, December 31, 2014 2013
Total loans outstanding at end of period
Allowance for loan losses, beginning of period
$ 9,443 $ 14,150Charge offs: Real estate (2,853 ) (5,568 ) Commercial (278 ) (1,691 ) Consumer (283 ) (217 ) Total charge-offs (3,414 ) (7,476 )
Recoveries of loans previously charged off 945 4,266 Net charge-offs (2,469 ) (3,210 ) Provision charged to operations - (1,497 ) Allowance for loan losses at end of period
Allowance for loan losses to loans at end of period 2.77 % 3.68 % Net charge-offs to allowance for loan losses 35.40 % 33.99 % Net charge-offs to provisions for loan losses n/a
n/a -55- HCSB FINANCIAL CORPORATION AND SUBSIDIARY
Advances from the
The following table summarizes the Company's FHLB borrowings for the six months ended
Maximum Weighted Outstanding Average Period at any Average Interest End (Dollars in thousands) Month End Balance Rate Balance
Advances from the FHLB are collateralized by one-to-four family residential mortgage loans, certain commercial real estate loans, certain securities in the Bank's investment portfolio and the Company's investment in FHLB stock. Although we expect to continue using FHLB advances as a secondary funding source, core deposits will continue to be our primary funding source. As a result of negative financial performance indicators, there is a risk that the Bank's ability to borrow from the FHLB could be curtailed or eliminated. Although to date the Bank has not been denied advances from the FHLB, the Bank has had its collateral maintenance requirements altered to reflect the increase in our credit risk. Thus, we can make no assurances that this funding source will continue to be available to us. Capital Resources
Shareholders' deficit decreased from a deficit of
$16.4 millionat December 31, 2013to a deficit of $11.8 millionat June 30, 2014. The decrease of $4.7 millionis primarily attributable to a reduction in unrealized losses of $4.4 millionon our available-for-sale securities which are included in accumulated other comprehensive loss in addition to net income of $243 thousandfor the period. The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. -56- HCSB FINANCIAL CORPORATION AND SUBSIDIARY Capital Resources - continued Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Tier 1 capital consists of common shareholders' equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. To be considered "well-capitalized," the Bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. To be considered "adequately capitalized" under these capital guidelines, the Bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, the Bank must maintain a minimum Tier 1 leverage ratio of at least 4%. Further, pursuant to the terms of the Consent Order with the FDICand the State Board, the Bank must achieve and maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. For a more detailed description of the capital amounts required to be obtained in order for the Bank to be considered "well-capitalized," see Note 9 to our Financial Statements. If a bank is not well capitalized, it cannot accept brokered deposits without prior FDICapproval. In addition, a bank that is not well capitalized cannot offer an effective yield in excess of 75 basis points over interest paid on deposits of comparable size and maturity in such institution's normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the Bank's normal market area. Moreover, the FDICgenerally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be categorized as undercapitalized. Undercapitalized institutions are subject to growth limitations (an undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDICdetermines that the proposed action will further the purpose of prompt corrective action) and are required to submit a capital restoration plan. The agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of an amount equal to 5.0% of the depository institution's total assets at the time it became categorized as undercapitalized or the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is categorized as significantly undercapitalized. Significantly undercapitalized categorized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become categorized as adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities. -57- HCSB FINANCIAL CORPORATION AND SUBSIDIARY Capital Resources - continued An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution, that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause a bank to become undercapitalized, it could not pay a management fee or dividend to the bank holding company.
The following table summarizes the capital amounts and ratios of the Company and the Bank at
June 30, December 31, 2014 2013 (Dollars in thousands) The Company Tier 1 capital
$ (9,926 ) $ (10,169 )Tier 2 capital - Total qualifying capital $ (9,926 ) $ (10,169 )Risk-adjusted total assets (including off-balance sheet exposures) $ 311,701 $ 318,900Tier 1 risk-based capital ratio (3.18 )% (3.19 )% Total risk-based capital ratio (3.18 )% (3.19 )% Tier 1 leverage ratio (2.14 )% (2.23 )% The Bank Tier 1 capital $ 10,743 $ 9,789Tier 2 capital 3,931 4,053 Total qualifying capital $ 14,674 $ 13,842Risk-adjustment total assets (including off-balance sheet exposures) $ 311,420 $ 318,813Tier 1 risk-based capital ratio 3.45 % 3.07 % Total risk-based capital ratio 4.71 % 4.34 % Tier 1 leverage ratio 2.35 % 2.17 % At June 30, 2014, the Company was categorized as "critically undercapitalized" and the Bank was categorized as "significantly undercapitalized." Our losses over the past five years have adversely impacted our capital. As a result, we have been pursuing a plan to increase our capital ratios in order to strengthen our balance sheet and satisfy the commitments required under the Consent Order. In addition, the Consent Order required us to achieve and maintain Total Risk Based capital at least equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% of total assets. -58- HCSB FINANCIAL CORPORATION AND SUBSIDIARY
Capital Resources - continued
$10.2 millionin capital would return the Bank to "adequately capitalized" and $25.9 millionin capital would return the Bank to "well capitalized" under regulatory guidelines on a pro forma basis as of June 30, 2014. If we continue to decrease the size of the Bank or return the Bank to profitability, then we could achieve these capital ratios with less additional capital. However, if we suffer additional loan losses or losses in our other real estate owned portfolio, then we would need additional capital to achieve these ratios. There are no assurances that we will be able to raise this capital on a timely basis or at all. If we cannot meet the minimum capital requirements set forth under the Consent Order and return the Bank to a "well capitalized" designation, or if we suffer a continued deterioration in our financial condition, we may be placed into a federal conservatorship or receivership by the FDIC. Our auditors have noted that the uncertainty of our ability to obtain sufficient capital raises substantial doubt about our ability to continue as a going concern. Please refer to Note 2 in the notes to our consolidated financial statements. The Company does not anticipate paying dividends for the foreseeable future, and all future dividends will be dependent on the Company's financial condition, results of operations, and cash flows, as well as capital regulations and dividend restrictions from the Federal Reserve Bank of Richmond, the FDIC,
ACCOUNTING AND FINANCIAL REPORTING ISSUES
We have adopted various accounting policies which govern the application of accounting principles generally accepted in
the United Statesin the preparation of our financial statements. Our significant accounting policies are described in the footnotes to the consolidated financial statements at December 31, 2013, as filed on our Annual Report on Form 10- K. Certainaccounting policies involve significant judgments and assumptions by us which have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgments 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 judgments and assumptions we make, actual results could differ from these judgments and estimates which could have a material impact on our carrying values of assets and liabilities and our results of operations. We believe the allowance for loan losses is a critical accounting policy that requires significant judgment and estimates used in preparation of our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a description of our processes and methodology for determining our allowance for loan losses. The income tax provision is also an accounting policy that requires judgment as the Company seeks strategies to minimize the tax effect of implementing their business strategies. The Company's tax returns are subject to examination by both federal and state authorities. Such examinations may result in assessment of additional taxes, interest and penalties. As a result, the ultimate outcome, and the corresponding financial statement impact, can be difficult to predict with accuracy.
Fair value determination and other-than-temporary impairment is subject to management's evaluation to determine if it is probable that all amounts due according to contractual terms will be collected to determine if any other-than-temporary impairment exists. The process of evaluating other-than-temporary impairment is inherently judgmental, involving the weighing of positive and negative factors and evidence that may be objective or subjective.
-59- HCSB FINANCIAL CORPORATION AND SUBSIDIARY LIQUIDITY Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and federal funds sold are the Company's primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment securities portfolio is the Company's principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits are the Company's primary source of funds for credit activities. Although not historically used as principal sources of liquidity, federal funds purchased from correspondent banks and advances from the FHLB are other options available to management. Management believes that the Company's liquidity sources will enable it to successfully meet its long-term operating needs. As of
June 30, 2014, the Company had no unused lines of credit to purchase federal funds; however, the Bank's greatest source of liquidity resides in its unpledged securities portfolio. Unpledged securities available-for-sale totaled $76.4 millionat June 30, 2014. This source of liquidity may be adversely impacted by changing market conditions, reduced access to borrowing lines, or increased collateral pledge requirements imposed by lenders. The Bank has implemented a plan to address these risks and strengthen its liquidity position. To accomplish the goals of this liquidity plan, the Bank will maintain cash liquidity at a minimum of 4% of total outstanding deposits and borrowings. In addition to cash liquidity, the Bank will also maintain a minimum of 15% off balance sheet liquidity. These objectives have been established by extensive contingency funding stress testing and analytics that indicate these target minimum levels of liquidity to be appropriate and prudent. Comprehensive weekly and quarterly liquidity analyses serve management as vital decision-making tools by providing summaries of anticipated changes in loans, investments, core deposits, and wholesale funds. These internal funding reports provide management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan and securities paydowns and maturities. These liquidity analyses act as a cash forecasting tool and are subject to certain assumptions based on past market and customer trends. Through consideration of the information provided in these reports, management is better able to maximize our earning opportunities by wisely and purposefully choosing our immediate, and more critically, our long-term funding sources. To better manage our liquidity position, management also stress tests our liquidity position on a semi-annual basis under two scenarios: short-term crisis and a longer-term crisis. In the short term crisis, our institution would be cut off from our normal funding along with the market in general. In this scenario, the Bank would replenish our funding through the most likely sources of funding that would exist in the order of price efficiency. In the longer term crisis, the Bank would be cut off from several of our normal sources of funding as our Bank's financial situation deteriorated. In this crisis, we would not be able to utilize our federal funds borrowing lines and brokered CDs and would be allowed to utilize our unpledged securities to raise funds in the reverse repurchase market or borrow from the FHLB. On a quarterly basis, management monitors the market value of our securities portfolio to ensure its ability to be pledged if liquidity needs should arise. We believe our liquidity sources are adequate to meet our needs for at least the next 12 months. However, if we are unable to meet our liquidity needs, the Bank may be placed into a federal conservatorship or receivership by the FDIC, with the FDICappointed conservator or receiver. There are no liquidity sources at the Company level. -60- HCSB FINANCIAL CORPORATION AND SUBSIDIARY
IMPACT OF OFF-BALANCE SHEET INSTRUMENTS
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. Commitments to extend credit are legally binding agreements to lend to a customer at predetermined interest rates as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Company's exposure to credit loss in the event of nonperformance by the other party to the instrument is represented by the contractual notional amount of the instrument. Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued to guarantee a customer's performance to a third party and have essentially the same credit risk as other lending facilities. Standby letters of credit often expire without being used. Management believes that through various sources of liquidity, the Company has the necessary resources to meet obligations arising from these financial instruments. The Company uses the same credit underwriting procedures for commitments to extend credit and standby letters of credit as for on-balance-sheet instruments. The credit worthiness of each borrower is evaluated and the amount of collateral, if deemed necessary, is based on the credit evaluation. Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties, as well as liquid assets such as time deposit accounts, brokerage accounts, and cash value of life insurance.
The Company is not involved in off-balance sheet contractual relationships, other than those disclosed in this report, which it believes could result in liquidity needs or other commitments or that could significantly impact earnings.
-61- HCSB FINANCIAL CORPORATION AND SUBSIDIARY