News Column

SUN BANCORP INC /NJ/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

(All dollar amounts presented in the tables are in thousands)

Overview

The Company is a bank holding company with an executive office in Mt. Laurel, New Jersey. The Bank is the Company's principal subsidiary. Through the Bank, the Company provides commercial and consumer banking services. The Company offers a comprehensive array of lending, depository and financial services to its commercial and consumer customers throughout the marketplace. The Company funds its lending activities primarily through retail and brokered deposits, the scheduled maturities of its investment portfolio and other wholesale funding sources. As a financial institution with a primary focus on traditional banking activities, the Company generates the majority of its revenue through net interest income, which is defined as the difference between interest income earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon the Company's ability to prudently manage the balance sheet for growth, combined with how successfully it maintains or increases net interest margin. The Company has historically generated revenue through fees earned on the various services and products offered to its customers and through sales of loans, primarily residential mortgages. Offsetting these revenue sources are provisions for credit losses on loans, operating expenses and income taxes.



The Company is in the middle of a comprehensive strategic restructuring to refocus on serving commercial borrowers in the communities in which the Bank operates. As a part of this restructuring, the origination and sale of residential mortgages will no longer be a source of revenue for the Bank.

On June 30, 2014, the Board of Directors of the Company and the Bank approved a comprehensive restructuring plan, which includes, among other things, the Bank exiting Sun Home Loans, its retail, consumer mortgage banking origination business and exiting its healthcare and asset-based lending businesses; the sale of seven branch offices in the Cape May County area; significant classified asset and operating expense reductions and declaration of a 1-for-5 reverse stock split. The Company also announced the consolidation of four additional branch offices, which is expected to be completed by the fourth quarter of 2014. On July 2, 2014 the Company entered into a Purchase and Assumption Agreement (the "Purchase Agreement") with Sturdy Savings Bank, pursuant to which the Bank agreed to sell certain assets and assume certain liabilities relating to seven branch offices in and around Cape May County, New Jersey. The Purchase Agreement provides for a purchase price equal to the sum of a deposit premium of 8.765% of the average daily closing balance of deposits for the 31 days prior to the closing date, the Company's carrying amount of loans identified and approved by both parties, the aggregate amount of cash on hand and accrued interest on the loans acquired. The Purchase Agreement contains certain customary representations, warranties, indemnities and covenants of the parties, and is subject to termination in certain circumstances. The transaction is expected to be completed during the first quarter of 2015, subject to regulatory approvals and customary closing conditions. At June 30, 2014, the Company reclassified approximately $28.5 million of loans and $160.8 million of deposits to held-for-sale. Upon settlement after all accounts are identified for sale, the transaction is anticipated to include approximately $65 million of loans and $180 million of deposits. As a result of the restructuring plan, the Company recorded approximately $2.7 million in severance and related benefit expenses in the three and six months ended June 30, 2014. In future reporting periods, the Company expects to report reduced levels of non-interest expense as the restructuring plan is implemented and reduced non-interest income as a result of the exit from Sun Home Loans.



At June 30, 2014, the Company had total assets of $2.89 billion, total liabilities of $2.67 billion and total shareholders' equity of $227.7 million. The Company reported a net loss available to common shareholders of $24.2 million, or a loss of $0.28 per diluted share, for the quarter ended June 30, 2014.

The economic recovery has been slower than anticipated. Although interest rates have begun to rise slightly, they remained near historical lows. The unemployment rate in the U.S. declined to 6.2% in July 2014 from 6.7% in December 2013. Based upon initial estimates, the U.S. gross domestic product for the second quarter of 2014 increased at an annual rate of 4.0% as compared to 2.1% decrease in the 1st quarter of 2014. The growth in the second quarter was mainly driven by exports and real nonresidential fixed investments, which increased 9.5% and 5.5%, respectively, during the quarter. These increases were tempered by modest growth in personal consumption of 2.5% and private inventories of only 1.66%. At the state level, according to the latest South Jersey Business Survey produced by the Federal Reserve Bank, growth in business activity rebounded in the second quarter of 2014 as the region recovered from a sluggish first quarter. Additionally, employment showed signs of improvement in the second quarter of 2014, and optimism remains about increased hiring in the future. In Northern New Jersey, business activity is expected to continue to increase at a modest pace. Overall, New Jersey's unemployment rate remains one of the highest in the U.S. but has declined in the past year and a half to 6.6% as of June 2014 from 9.0% as of December 2012. At its latest meeting in June 2014, the FRB decided to keep the Federal Funds target rate unchanged in a continued effort to help stimulate economic growth. Since December 2008, the FRB has kept the Federal Funds rate, a key indicator of short-term rates such as credit card rates and home equity line of credit rates, at a range of 0.00%-0.25% with the intent of encouraging consumers and businesses to borrow and spend to help jump start the economy. The FRB expects to maintain the current target range through late 2014. However, some FRB officials have discussed the possibility of increasing rates as soon as 2015. While the FRB had previously considered a reduction in unemployment to 6.5% to be a signal to increase rates, that viewpoint has changed because a significant amount of the decrease in unemployment is associated with individuals exiting the workforce. In June 2014, the FRB's tapering of its quantitative easing continued as monthly securities purchases starting in July 2014 were reduced by $10 billion to $35 billion per month. 43



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The continued uncertainty with the economy, together with the challenging regulatory environment, will continue to affect the Company and the markets in which it does business and may adversely impact the Company's results in the future. The following discussion provides further detail on the financial condition and results of operations of the Company at and for the quarter ended June 30, 2014.



Critical Accounting Policies, Judgments and Estimates

The discussion and analysis of the financial condition and results of operations are based on the unaudited condensed consolidated financial statements, which are prepared in conformity with GAAP. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. Management evaluates these estimates and assumptions on an ongoing basis, including those related to the allowance for loan losses, goodwill, intangible assets, income taxes, stock-based compensation and the fair value of financial instruments. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Allowance for Loan Losses. Through the Bank, the Company originates loans that it intends to hold for the foreseeable future or until maturity or repayment. The Company may not be able to collect all principal and interest due on these loans. The allowance for loan losses represents management's estimate of probable credit losses inherent in the loan portfolio as of the balance sheet date. The determination of the allowance for loan losses requires management to make significant estimates with respect to the amounts and timing of losses and market and economic conditions. The allowance for loan losses is maintained at a level that management considers adequate to provide for estimated losses and impairment based upon an evaluation of known and inherent risk in the loan portfolio. Loan impairment is evaluated based on the fair value of collateral or estimated net realizable value. A provision for loan losses is charged to operations based on management's evaluation of the estimated losses that have been incurred in the Company's loan portfolio. It is the policy of management to provide for losses on unidentified loans in its portfolio in addition to classified loans. Management monitors its allowance for loan losses on a monthly basis and makes adjustments to the allowance through the provision for loan losses as economic conditions and other pertinent factors warrant. The quarterly review and adjustment of the qualitative factors employed in the allowance methodology and the updating of historic loss and recovery experience allow for timely reaction to emerging conditions and trends. In this context, a series of qualitative factors are used in a methodology as a measurement of how current circumstances are affecting the loan portfolio. Included in these qualitative factors are: Levels of past due, classified and non-accrual loans, troubled debt restructurings and modifications; Nature and volume of loans; Historical loss trends;



Changes in lending policies and procedures, underwriting standards,

collections, and for commercial loans, the level of loans being approved

with exceptions to policy; Experience, ability and depth of management and staff;



National and local economic and business conditions, including various

market segments;



Quality of the Company's loan review system and degree of Board oversight;

and



Effect of external factors, including the deterioration of collateral

values, on the level of estimated credit losses in the current portfolio.

Additionally, for the commercial loan portfolio, historic loss and recovery experience over a three-year horizon, based on a rolling 12-quarter migration analysis, is taken into account for the quantitative factor component. For the non-commercial loan quantitative component, the average historic loss and recovery experience over a 12-quarter time period is utilized for the allowance calculation. In determining the allowance for loan losses, management has established both specific and general pooled allowances. Values assigned to the qualitative factors and those developed from historic loss and recovery experience provide a dynamic basis for the calculation of reserve factors for both pass-rated loans and those criticized and classified loans through the use of both a general pooled allowance and a specific allowance. In determining the appropriate level of the general pooled allowance, management makes estimates based on internal risk ratings, which take into account such factors as debt service coverage, loan-to-value ratios and external factors. Estimates are periodically measured against actual loss experience. A specific allowance is calculated on individually identified impaired loans. Loans not individually reviewed are evaluated as a group using reserve factor percentages based on historic loss and recovery experience and the qualitative factors described above. As changes in the Company's operating environment occur and as recent loss experience fluctuates, the factors for each category of loan based on type and risk rating will change to reflect current circumstances and the quality of the loan portfolio. Given that the components of the allowance are based partially on historical losses, recoveries and on risk rating changes in response to recent events, required reserves may trail the emergence of any unforeseen deterioration in credit quality. 44



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Although the Company maintains its allowance for loan losses at levels considered adequate to provide for the inherent risk of loss in its loan portfolio, if economic conditions differ substantially from the assumptions used in making the evaluations, there can be no assurance that future losses will not exceed estimated amounts or that additional provisions for loan losses will not be required in future periods. Accordingly, the current state of the national economy and local economies of the areas in which the loans are concentrated and their slow recovery from a severe recession could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, the Company's determination as to the amount of its allowance for loan losses is subject to review by the Bank's primary regulator, the OCC, as part of its examination process, which may result in the establishment of an additional allowance based upon the judgment of the OCC after a review of the information available at the time of the OCC examination. Accounting for Income Taxes. The Company accounts for income taxes in accordance with FASB ASC 740, Income Taxes. ("FASB ASC 740"). FASB ASC 740 requires the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are updated based upon changes in business factors and the tax laws. If actual results differ from the assumptions and other considerations used in estimating the amount and timing of tax recognized, there can be no assurance that additional expenses will not be required in future periods. The Company recognizes, when applicable, interest and penalties related to unrecognized tax benefits in the provision for income taxes in the unaudited condensed consolidated statements of operations. Assessment of uncertain tax positions under FASB ASC 740 requires careful consideration of the technical merits of a position based on management's analysis of tax regulations and interpretations. Significant judgment may be involved in applying the requirements of FASB ASC 740. Management expects that the Company's adherence to FASB ASC 740 may result in increased volatility in quarterly and annual effective income tax rates, as FASB ASC 740 requires that any change in judgment or change in measurement of a tax position taken in a prior period be recognized as a discrete event in the period in which it occurs. Factors that could impact management's judgment include changes in income, tax laws and regulations, and tax planning strategies. Fair Value Measurement. The Company accounts for fair value measurement in accordance with FASB ASC 820, Fair Value Measurements and Disclosures. FASB ASC 820 establishes a framework for measuring fair value. FASB ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, emphasizing that fair value is a market-based measurement and not an entity-specific measurement. FASB ASC 820 clarifies the application of fair value measurement in a market that is not active. FASB ASC 820 also includes additional factors for determining whether there has been a significant decrease in market activity, affirms the objective of fair value when a market is not active, eliminates the presumption that all transactions are not orderly unless proven otherwise, and requires an entity to disclose inputs and valuation techniques, and changes therein, used to measure fair value. FASB ASC 820 addresses the valuation techniques used to measure fair value. These valuation techniques include the market approach, income approach and cost approach. The market approach uses price or relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach involves converting future amounts to a single present value. The measurement is valued based on current market expectations about those future amounts. The cost approach is based on the amount that currently would be required to replace the service capacity of the asset. FASB ASC 820 establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument's fair value measurement. The three levels within the fair value hierarchy are described as follows:



Level 1-Quoted prices in active markets for identical assets or liabilities.

Level 2-Inputs other than quoted prices included within Level 1 that are



observable for the asset or liability, either directly or indirectly.

Level 2 inputs include: quoted prices for similar assets or liabilities in

active markets; quoted prices for identical or similar assets or

liabilities in markets that are not active; inputs other than quoted

prices that are observable for the asset or liability; and inputs that are

derived principally from or corroborated by observable market data by correlation or other means.



Level 3-Unobservable inputs that are supported by little or no market

activity and that are significant to the fair value of the assets or

liabilities. Level 3 assets and liabilities include financial instruments

whose value is determined using pricing models, discounted cash flow

methodologies, or similar techniques, as well as instruments for which the

determination of fair value requires significant management judgment or

estimation. 45



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The Company's policy is to recognize transfers that occur between the fair value hierarchy, Levels 1, 2 and 3, at the beginning of the quarter of when the transfer occurred.

Investment securities available for sale. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated using quoted prices of securities with similar characteristics or discounted cash flows based on observable market inputs and are classified within Level 2 of the fair value hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Level 3 market value measurements include an internally developed discounted cash flow model combined with using market data points of similar securities with comparable credit ratings in addition to market yield curves with similar maturities in determining the discount rate. In addition, significant estimates and unobservable inputs are required in the determination of Level 3 market value measurements. If actual results differ significantly from the estimates and inputs applied, it could have a material effect on the Company's unaudited condensed consolidated financial statements. Derivative financial instruments. The Company's derivative financial instruments are not exchange-traded and therefore are valued utilizing models that use as their basis readily observable market parameters, specifically the LIBOR swap curve, and are classified within Level 2 of the valuation hierarchy. Residential mortgage loans held-for-sale. The Company's residential mortgage loans held-for-sale are recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. The Company adopted the fair value option on these loans which allows the Company to record the mortgage loans held-for-sale portfolio at fair market value as opposed to the lower of cost or market. The Company economically hedges its residential loans held-for-sale portfolio with forward sale agreements which are reported at fair value. A lower of cost or market accounting treatment would not allow the Company to record the excess of the fair market value over book value but would require the Company to record the corresponding reduction in value on the hedges. Both the loans and related hedges are carried at fair value which reduces earnings volatility as the amounts more closely offset, particularly in environments in which interest rates are declining. For loans held-for-sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $278 thousand as of June 30, 2014 and $312 thousand at December 31, 2013. Interest rate lock commitments on residential mortgages. The Company enters into interest rate lock commitments on its residential mortgage loans originated for sale. The determination of the fair value of interest rate lock commitments is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The pull through percentage, which is based upon historical experience, was 75% as of June 30, 2014. In addition, certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The Company measures loans held-for-sale, impaired loans, SBA servicing assets, restricted equity investments and loans or bank properties transferred in other real estate owned at fair value on a non-recurring basis.



Valuation techniques and models utilized for measuring financial assets and liabilities are reviewed and validated by the Company at least quarterly.

Goodwill.Goodwill is the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. FASB ASC 350-20-35, Intangibles - Goodwill and Other - Goodwill, outlines a two-step goodwill impairment test. Significant judgment is applied when goodwill is assessed for impairment. Step one, which is used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. As defined in FASB ASC 280, Segment Reporting, a reporting unit is an operating segment or one level below an operating segment. The Company has one reportable operating segment, "Community Banking", as noted in Note 1 of the notes to the unaudited condensed consolidated financial statements. If the fair value of a reporting unit exceeds its carrying value, goodwill of the reporting unit is considered not impaired and step two is therefore unnecessary. If the carrying amount of the reporting unit exceeds it implied fair value, the second step is performed to measure the amount of the impairment loss, if any. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company typically evaluates its goodwill for impairment annually at December 31, unless circumstances indicate that a test is required at an earlier date. 46



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Recent Accounting Principles.

In June 2014, the FASB issued ASU 2014-11: Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The accounting changes in the amendment affect all entities that enter into repurchase-to-maturity transactions or repurchase financings. The amendments in this update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting and for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty which will result in secured borrowing accounting for the repurchase agreement. All entities are subject to new disclosure requirements for certain transactions that involve a transfer of a financial asset accounted for as a sale. The accounting changes in this Update are effective for public business entities for the first interim or annual period beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements. In May 2014, the FASB issued ASU 2014-09: Revenue from Contracts with Customers (Topic 606): Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40), Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables, Background Information and Basis for Conclusions. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the considerations to which the entity expects to be entitled in exchange for those goods or services. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. For a public entity, the amendments in this Update are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact of the adoption of this accounting standards update of its financial statements. In January 2014, the FASB issued ASU 2014-4, Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either the creditor obtaining legal title to the residential real estate property upon completion of foreclosure or the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both the amount of foreclosed residential real estate property held by the creditor and the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. For public entities, the amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements. In July 2013, the FASB issued Accounting Standards Update ("ASU") 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The amendments in this update seek to eliminate the diversity in practice in the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists by presenting the unrecognized tax benefit, or a portion of the unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset. To the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward are not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. The Company has evaluated the impact of the adoption of this accounting standards update on its financial statements and determined that there currently is no impact to the Company's presentation.



Financial Condition

Total assets were $2.89 billion at June 30, 2014 as compared to $3.09 billion at December 31, 2013. Loans receivable, net of allowance for loan losses, decreased $274.4 million to $1.83 billion at June 30, 2014 as compared to $2.10 billion at December 31, 2013. This was driven by a decrease of $223.6 million in commercial loans due to the sale of $71.1 million of problem commercial loans combined with commercial loan payoffs. Also, there was a decrease of $23.6 million in consumer loans due to $24.4 million of problem consumer loans being moved to held-for-sale at lower of cost 47



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or market and a decrease of $22.8 million home equity loans. Commercial loan production has been slow due to a competitive environment and the Company maintaining a very selective approach to new loan relationships. The Company has positioned itself to take advantage of a rising interest rate environment with an asset sensitive balance sheet. Total liabilities decreased $175.2 million, or 6.2%, to $2.67 billion at June 30, 2014, compared to $2.84 billion at December 31, 2013. The decrease in total liabilities is primarily attributable to a decrease of $188.0 million in total deposits. Shareholders' equity decreased $17.7 million, or 7.2%, to $227.7 million at June 30, 2014, as compared to $245.3 million at December 31, 2013, with the decrease primarily attributable to a net loss for the six months ended June 30, 2014 of $26.2 million and a decrease in additional paid in capital of $5.1 million. These decreases were partially offset by decreases in comprehensive loss of $6.7 million and $6.8 million in treasury stock due to common stock issuances out of treasury. As of June 30, 2014, the Company had $48.7 million outstanding on 13 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. As of December 31, 2013, the Company had $54.5 million outstanding on 17 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. The total amount available in those reserves to fund interest payments was $3.3 million and $4.3 million at June 30, 2014 and December 31, 2013, respectively. There were no relationships with interest reserves which were on non-accrual status at June 30, 2014 and December 31, 2013. Construction projects are monitored throughout their lives by professional inspectors engaged by the Company. The budgets for loan advances and borrower equity injections are developed at the time of underwriting in conjunction with the review of the plans and specifications for the project being financed. Advances of the Company's funds are based on the prepared budgets and will not be made unless the project has been inspected by the Company's professional inspector who must certify that the work related to the advance is in place and properly completed. As it relates to construction project financing, the Company does not extend, renew or restructure terms unless its borrower posts cash collateral in an interest reserve.



Table 1 provides detail regarding the Company's non-performing assets and TDRs at June 30, 2014 and December 31, 2013.

Table 1: Summary of Non-performing Assets and TDRs

June 30, 2014 December 31, 2013 Non-performing assets: Non-accrual loans $ 13,470 $ 29,814 Non-accrual loans held-for-sale 4,086 Troubled debt restructuring, non-accruing 583



8,163

Loans past due 90 days and accruing - - Real estate owned, net 1,327 2,503 Total non-performing assets $ 19,466 $ 40,480 The Company's allowance for losses on loans decreased to $28.4 million, or 1.53% of gross loans held-for-investment, at June 30, 2014 from $35.5 million, or 1.66% of gross loans held-for-investment, at December 31, 2013. Provision expense of $14.8 million was recorded during the six months ended June 30, 2014 compared to negative provision of $1.7 million for the same period in 2013. The decrease in reserve balances is due to net charge-offs of $21.9 million and the $14.8 million provision expense for that period. The charge-offs were primarily driven by loan sales, which occurred during the quarter ended June 30, 2014. Across the commercial and consumer loan portfolio, the Company continues to closely monitor areas of weakness and take expedient and appropriate action as necessary to ensure adequate reserves are in place to absorb losses inherent in the loan portfolio.



Total non-performing loans held-for-investment decreased $23.9 million to $14.1 million at June 30, 2014 from $38.0 million at December 31, 2013. Total non-accruing TDRs at June 30, 2014 were $584 thousand, a decrease of $7.6 million from December 31, 2013.

Real estate owned, net decreased $1.2 million to $1.3 million at June 30, 2014 as compared to $2.5 million at December 31, 2013. During the six months ended June 30, 2014, the Company transferred four residential properties totaling $567 thousand from loans into real estate owned. During the same period, the Company recorded $265 thousand of write-downs of real estate owned, of which $68 thousand related to two residential properties and $197 thousand related to one commercial property. There were 13 residential properties with a total carrying amount of $1.5 million sold resulting in a net loss of $252 thousand. At June 30, 2014, the Company had six properties in the real estate owned portfolio. The net deferred tax asset decreased $5.4 million from December 31, 2013 to a net deferred tax liability of $796 thousand at June 30, 2014 due to a decrease in the unrealized losses on investment securities. The Company maintains a valuation allowance of $131.0 million against the remaining portion of the gross deferred tax asset as the Company is a three-year cumulative loss company and it is more likely than not that the full deferred tax asset will not be realized. 48



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Investment securities available for sale decreased $3.1 million, or 0.7%, from $440.1 million at December 31, 2013 to $437.0 million at June 30, 2014 due primarily to investment sales and calls of $28.4 million, partially offset by purchases of $25.9 million. Investment securities held to maturity decreased $45 thousand, or 6.6%, from $681 thousand at December 31, 2013 to $636 thousand at June 30, 2014. Other assets decreased $7.0 million, or 20.8%, to $26.7 million at June 30, 2014 from $33.7 million at December 31, 2013. This decrease was primarily the result of $6.5 million in market value adjustments on swap transactions recorded during the six months ended June 30, 2014. For more information on the Company's financial derivative instruments, see Note 8 of the notes to unaudited condensed consolidated financial statements.



Total borrowings, excluding debentures held by trusts, decreased $31 thousand from $68.8 million at December 31, 2013 to $68.7 million at June 30, 2014.

Other liabilities increased $12.1 million, or 20.4%, to $71.2 million at June 30, 2014 from $59.1 million at December 31, 2013. The increase was primarily due to a trade date liability of $10.0 million recorded at June 30, 2014 for the purchase of an investment security and an increase of $3.4 million relating to normal cash settlements with the Federal Reserve Bank, partially offset by a decrease of $6.3 million in market value adjustments on swap transactions since December 31, 2013.



Comparison of Operating Results for the Three Months Ended June 30, 2014 and 2013

Overview. The Company's net loss available to shareholders for the three months ended June 30, 2014 was $24.2 million, or a loss of $0.28 per common share, compared to net income of $678 thousand, or $0.01 per common share, for the same period in 2013. During the three months ended June 30, 2014, the Company had provision expense of $14.8 million, as compared to negative provision of $1.9 million in the same prior year period, primarily due to commercial loan sale losses in the 2014 period. During the three months ended June 30, 2014 and 2013, the Company recorded mortgage banking revenue of $529 thousand and $5.6 million, respectively. This decrease was due to lower production volume during the three months ended June 30, 2014, in a higher interest rate environment. Net Interest Income. Net interest income is the most significant component of the Company's income from operations. Net interest income is the difference between interest earned on total interest-earning assets (primarily loans and investment securities), on a fully taxable equivalent basis, where appropriate, and interest paid on total interest-bearing liabilities (primarily deposits and borrowed funds). Fully taxable equivalent basis represents income on total interest-earning assets that is either tax-exempt or taxed at a reduced rate, adjusted to give effect to the prevailing incremental federal tax rate, and adjusted for nondeductible carrying costs and state income taxes, where applicable. Yield calculations, where appropriate, include these adjustments. Net interest income depends on the volume and interest rate earned on interest-earning assets and the volume and interest rate paid on interest-bearing liabilities. Net interest income, on a tax-equivalent basis, decreased $1.2 million to $20.8 million for the three months ended June 30, 2014, from $22.0 million for the same period in 2013. Tax equivalent interest income decreased $1.9 million, or 7.5%, from $25.9 million for the three months ended June 30, 2013, to $23.9 million for the three months ended June 30, 2014. Compared to the comparable prior year quarter, average total loans receivable decreased $229.6 million, which resulted in a decrease in interest income on loans of $2.9 million and the yield on total loans decreased nine basis points. This decrease was partially offset by an increase of $972 thousand in interest income from investments which was primarily due to an increase of 53 basis points in yield from the three months ended June 30, 2013 to the three months ended June 30, 2014. Interest expense decreased $772 thousand, or 19.6%, for the three months ended June 30, 2014, as compared to the same period in 2013. The decrease was primarily rate driven. The cost of interest-bearing deposit accounts decreased nine basis points compared to the prior year period resulting in a decrease in interest expense of $756 thousand.



The interest rate spread and net interest margin for the three months ended June 30, 2014 were 2.89% and 3.03%, respectively, compared to 2.83% and 2.96%, respectively, for the same period in 2013.

Table 2 provides detail regarding the Company's average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the three months ended June 30, 2014 and 2013. Average balances are derived from daily balances. 49



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Table 2: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands) For the Three Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost Interest-earning assets: Loans receivable (1),(2): Commercial and industrial $ 1,480,491$ 15,385 4.16 % $ 1,719,278$ 18,622 4.33 % Home equity 185,710 1,777 3.83 197,237 1,911 3.88 Second mortgage 24,358 326 5.35 28,679 432 6.03 Residential real estate 338,028 3,187 3.77 307,248 2,485 3.24 Other 23,196 391 6.74



28,929 495 6.84

Total loans receivable 2,051,783 21,066 4.11 2,281,371 23,945 4.20 Investment securities(3) 451,477 2,723 2.41 373,311 1,751 1.88 Interest-earning bank balances 243,052 154 0.25



307,348 192 0.25

Total interest-earning assets 2,746,312 23,943 3.49



2,962,030 25,888 3.50

Non-interest earning assets: Cash and due from banks 41,196



44,968

Restricted Cash 26,000



26,000

Bank properties and equipment, net 47,586



49,192

Goodwill and intangible assets, net 38,568



40,256

Other assets 82,765



99,607

Total non-interest-earning assets 236,115 260,023 Total assets $ 2,982,427$ 3,222,053 Interest-bearing liabilities: Interest-bearing deposit accounts: Interest-bearing demand deposits $ 1,099,385$ 790 0.29 % $ 1,244,074 1,094 0.35 % Savings deposits 264,386 177 0.27 269,624 220 0.33 Time deposits 582,840 1,223 0.84 677,738 1,632 0.96 Total interest-bearing deposit accounts 1,946,611 2,190 0.45



2,191,436 2,946 0.54

Short-term borrowings: Securities sold under agreements to repurchase-customers 598 - 0.09 2,304 1 0.17 Long-term borrowings: FHLBNY advances (4) 60,887 315 2.07 61,051 318 2.08 Obligations under capital lease 7,221 127 7.04 7,504 125 6.66 Junior subordinated debentures 92,786 533 2.30 92,786 547 2.36 Total borrowings 161,492 975 2.41 163,645 991 2.42



Total interest-bearing liabilities 2,108,103 3,165 0.60

2,355,081 3,937 0.67

Non-interest bearing liabilities: Non-interest-bearing demand deposits 573,290 531,210 Other liabilities 46,918 72,654 Total non-interest bearing liabilities 620,208 603,864 Total liabilities 2,728,311 2,958,945 Shareholders' equity 254,116 263,108 Total liabilities and shareholders' equity $ 2,982,427$ 3,222,053 Net interest income $ 20,778$ 21,951 Interest rate spread (5) 2.89 % 2.83 % Net interest margin (6) 3.03 % 2.96 % Ratio of average interest-earning assets to average interest-bearing liabilities 130.27 % 125.77 %



(1) Average balances include non-accrual loans, loans held-for-sale, branch

assets held-for-sale and deposits held-for-sale.

(2) Loan fees are included in interest income and the amount is not material for

this analysis.

(3) Interest earned on non-taxable investment securities is shown on a

tax-equivalent basis assuming a 35% marginal federal tax rate for all

periods. The fully taxable equivalent adjustments for the three months ended

June 30, 2014 and 2013 were $166 thousand and $175 thousand, respectively.

50



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Table of Contents (4) Amounts include Advances from FHLBNY and Securities sold under agreements to

repurchase-FHLBNY.

(5) Interest rate spread represents the difference between the average yield on

interest-earning assets and the average cost of interest-bearing liabilities.

(6) Net interest margin represents net interest income as a percentage of average interest-earning assets. Table 3: Rate/Volume(1) For the Three Months Ended June 30, 2014 vs. 2013 Increase (Decrease) Due To Volume Rate Net Interest income: Loans receivable: Commercial and industrial $ (2,505 )$ (732 )$ (3,237 ) Home equity lines of credit (111 ) (23 ) (134 ) Home equity term loan (61 ) (45 ) (106 ) Residential real estate 264 438 702 Other (97 ) (7 ) (104 ) Total loans receivable (2,510 ) (369 ) (2,879 ) Investment securities 417 520 937 Interest-earning deposits with banks (41 ) 3 (38 ) Total interest-earning assets (2,134 ) 154 (1,980 ) Interest expense: Interest-bearing deposit accounts: Interest-bearing demand deposits (118 ) (186 ) (304 ) Savings deposits (4 ) (39 ) (43 ) Time deposits (213 ) (196 ) (409 ) Total interest-bearing deposit accounts (335 ) (421 ) (756 ) Short-term borrowings: Securities sold under agreements to repurchase-customers - - - Long-term borrowings: FHLBNY advances(2) (1 ) (2 ) (3 ) Obligations under capital lease - (14 ) (14 ) Junior subordinated debentures (5 ) 7 2 Total borrowings (6 ) (9 ) (15 ) Total interest-bearing liabilities (341 ) (430 ) (771 ) Net change in net interest income $ (1,793 )$ 584$ (1,209 )



(1) For each category of interest-earning assets and interest-bearing

liabilities, information is provided on changes attributable to (i) changes

in volume (changes in average volume multiplied by old rate) and (ii) changes

in rate (changes in rate multiplied by old average volume). The combined

effect of changes in both volume and rate has been allocated to volume or

rate changes in proportion to the absolute dollar amounts of the change in

each.

(2) Amounts include Advances from FHLBNY and Securities sold under agreements to

repurchase - FHLBNY.

Provision for Loan Losses. The Company recorded a provision of $14.8 million for loan losses during the three months ended June 30, 2014, as compared to negative provision expense of $1.9 million for the same period in 2013. In the three months ended June 30, 2014, the Company recorded provision expense of $14.0 million related to commercial loan sales of $71.1 million and the transfer of $24.4 million in consumer loans to held-for-sale. Total non-performing loans held-for-investment decreased $23.9 million from $38.0 million at December 31, 2013 to $14.1 million at June 30, 2014. The ratio of allowance for loan losses to gross loans held-for-investment was 1.53% at June 30, 2014, as compared to 1.66% at December 31, 2013. Net charge-offs for the three months ended June 30, 2014 were $20.2 million as compared to net recoveries of $2.8 million during the same period in 2013. The provision recorded is the amount deemed appropriate by management based on the current risk profile of the portfolio to absorb losses existing at the balance sheet date. At least monthly, management performs an analysis to identify the inherent risk of loss in the Company's loan portfolio. This analysis includes a qualitative evaluation of concentrations of credit, past loss experience, current economic conditions, amount and composition of the loan portfolio (including loans being specifically monitored by management), estimated fair value of underlying collateral, delinquencies, and other factors. Additionally, management updates the migration analysis and historic loss and recovery experience on a quarterly basis. Non-Interest Income. Non-interest income decreased $6.3 million to $4.0 million for the three months ended June 30, 2014, as compared to $10.3 million for the same period in 2013. This decrease was primarily attributable to a decrease in mortgage banking revenue, net of $5.1 million due to a decline in residential mortgage production volume resulting from rising interest rates as well as a $1.2 million decline in the derivative credit adjustment primarily due to swap termination fees of $1.4 million, recorded in the three months ended June 30, 2014, associated with the commercial loan sales. 51



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Non-Interest Expense. Non-interest expense increased $438 thousand to $33.7 million for the three months ended June 30, 2014 as compared to $33.2 million for the same period in 2013. This increase was primarily due to increases in salaries and employee benefits expense of $3.0 million and other non-interest expense of $1.9 million, partially offset by decreases in commission expense of $1.7 million and professional fees of $2.4 million. The increase in salaries and employee benefits expense was due to severance and benefit accruals, the payment part of which is pending regulatory approval, associated with the Company's reduction in force of 242 full-time employees that occurred in connection with the initial implementation of the Company's comprehensive strategic restructuring plan and closing of Sun Home Loans. Other non-interest expense increased primarily as a result of loan sale transaction fees. Commission expense declined due to reduced mortgage origination volume and professional fees declined significantly as the Company reduced its reliance on external consultants for operational infrastructure improvements and regulatory remediation.



Comparison of Operating Results for the Six Months Ended June 30, 2014 and 2013

Overview. The Company recognized net loss available to shareholders for the six months ended June 30, 2014 of $26.2 million, or $0.30 per common share, compared to net income of $3.1 million, or $0.04 per common share, for the same period in 2013. During the six months ended June 30, 2014 and 2013, the Company recorded a loan loss provision of $14.8 million and negative provision of $1.7 million, respectively. Net Interest Income. Net interest income, on a tax-equivalent basis, decreased $2.9 million to $42.3 million for the six months ended June 30, 2014, from $45.2 million for the same period in 2013. Tax equivalent interest income decreased $4.4 million, or 8.3%, from $53.2 million for the six months ended June 30, 2013, to $48.7 million for the six months ended June 30, 2014. Average total loans receivable decreased $220.7 million, which resulted in a decrease in interest income on loans of $5.9 million and the yield on total loans decreased 12 basis points, from the six months ended June 30, 2013 to the same period in 2014. This decrease was partially offset by an increase of $1.5 million in interest income from investments, which was primarily due to an increase of 43 basis points in the yield from the six months ended June 30, 2013 to the six months ended June 30, 2014.



Interest expense decreased $1.5 million, or 19.3%, for the six months ended June 30, 2014, as compared to the same period in 2013. The decrease was primarily rate driven as the cost of interest-bearing deposits decreased nine basis points from 0.54% at June 30, 2013 to 0.45% at June 30, 2014.

The interest rate spread and net interest margin for the six months ended June 30, 2014 were 2.91% and 3.05%, respectively, compared to 2.93% and 3.06%, respectively, for the same period in 2013.

Table 4 provides detail regarding the Company's average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the six months ended June 30, 2014 and 2013. Average balances are derived from daily balances. 52



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Table 4: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands) For the Six Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost Interest-earning assets: Loans receivable (1),(2): Commercial and industrial $ 1,520,246$ 31,735 4.17 % $ 1,731,846$ 37,581 4.34 % Home equity 186,377 3,539 3.80 200,755 3,817 3.80 Second mortgage 24,609 683 5.55 29,508 860 5.83 Residential real estate 334,749 6,145 3.67 319,017 5,556 3.48 Other 24,100 814 6.76



29,665 1,030 6.94

Total loans receivable 2,090,081 42,916 4.11 2,310,791 48,844 4.23 Investment securities (3) 454,590 5,541 2.44 400,516 4,035 2.01 Interest-earning bank balances 231,645 292 0.25



243,658 303 0.25

Total interest-earning assets 2,776,316 48,749 3.51



2,954,965 53,182 3.60

Non-interest earning assets: Cash and due from banks 41,269



45,867

Restricted Cash 26,000



26,000

Bank properties and equipment, net 48,093



49,774

Goodwill and intangible assets, net 38,709



40,618

Other assets 85,303



97,114

Total non-interest-earning assets 239,374 259,373 Total assets $ 3,015,690$ 3,214,338 Interest-bearing liabilities: Interest-bearing deposit accounts: Interest-bearing demand deposits $ 1,124,284$ 1,597 0.28 % $ 1,242,974$ 2,205 0.35 % Savings deposits 265,837 357 0.27 267,519 435 0.33 Time deposits 595,459 2,515 0.84 683,431 3,321 0.97 Total interest-bearing deposit accounts 1,985,580 4,469 0.45



2,193,924 5,961 0.54

Short-term borrowings: Federal funds purchased - - - - - - Securities sold under agreements to repurchase-customers 502 - 0.08 2,613 2 0.15 Long-term borrowings: FHLBNY advances (4) 60,908 628 2.06 61,105 634 2.08 Obligations under capital lease 7,257 250 6.89 7,538 251 6.66 Junior subordinated debentures 92,786 1,065 2.30 92,786 1,093 2.36 Total borrowings 161,453 1,943 2.41 164,042 1,980 2.41



Total interest-bearing liabilities 2,147,033 6,412 0.60

2,357,966 7,941 0.67

Non-interest bearing liabilities: Non-interest-bearing demand deposits 566,486 518,973 Other liabilities 49,631 74,310 Total non-interest bearing liabilities 616,117 593,283 Total liabilities 2,763,150 2,951,249 Shareholders' equity 252,540 263,090 Total liabilities and shareholders' equity $ 3,015,690$ 3,214,339 Net interest income $ 42,337$ 45,241 Interest rate spread (5) 2.91 % 2.93 % Net interest margin (6) 3.05 % 3.06 % Ratio of average interest-earning assets to average interest-bearing liabilities 129.31 % 125.32 %



(1) Average balances include non-accrual loans, loans held-for-sale, branch

assets held-for-sale and deposits held-for-sale. 53



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Table of Contents (2) Loan fees are included in interest income and the amount is not material for

this analysis.

(3) Interest earned on non-taxable investment securities is shown on a

tax-equivalent basis assuming a 35% marginal federal tax rate for all

periods. The fully taxable equivalent adjustments for the six months ended

June 30, 2014 and 2013 were $333 thousand and $387 thousand, respectively.

(4) Amounts include Advances from FHLBNY and Securities sold under agreements to

repurchase-FHLBNY.

(5) Interest rate spread represents the difference between the average yield on

interest-earning assets and the average cost of interest-bearing liabilities.

(6) Net interest margin represents net interest income as a percentage of average interest-earning assets. Table 5: Rate/Volume(1) For the Six Months Ended June 30, 2014 vs. 2013 Increase (Decrease) Due To Volume Rate Net Interest income: Loans receivable: Commercial and industrial $ (4,459 )$ (1,387 )$ (5,846 ) Home equity lines of credit (273 ) (5 ) (278 ) Home equity term loan (137 ) (40 ) (177 ) Residential real estate 281 308 589 Other (189 ) (27 ) (216 ) Total loans receivable (4,777 ) (1,151 ) (5,928 ) Investment securities 568 1,114 1,682 Interest-earning deposits with banks (15 ) 4 (11 ) Total interest-earning assets (4,224 ) (33 ) (4,257 ) Interest expense: Interest-bearing deposit accounts: Interest-bearing demand deposits (197 ) (411 ) (608 ) Savings deposits (3 ) (75 ) (78 ) Time deposits (400 ) (406 ) (806 ) Total interest-bearing deposit accounts (600 ) (892 ) (1,492 ) Short-term borrowings: Federal funds purchased - - - Securities sold under agreements to repurchase-customers (2 ) - (2 ) Long-term borrowings: FHLBNY advances(2) (2 ) (4 ) (6 ) Obligations under capital lease (9 ) 8 (1 ) Junior subordinated debentures - (28 ) (28 ) Total borrowings (13 ) (24 ) (37 ) Total interest-bearing liabilities (613 ) (916 ) (1,529 ) Net change in net interest income $ (3,611 ) $ 883 $ (2,728 )



(1) For each category of interest-earning assets and interest-bearing

liabilities, information is provided on changes attributable to (i) changes

in volume (changes in average volume multiplied by old rate) and (ii) changes

in rate (changes in rate multiplied by old average volume). The combined

effect of changes in both volume and rate has been allocated to volume or

rate changes in proportion to the absolute dollar amounts of the change in

each.

(2) Amounts include Advances from FHLBNY and Securities sold under agreements to

repurchase - FHLBNY.

Provision for Loan Losses. The Company recorded provision expense of $14.8 million during the six months ended June 30, 2014, as compared to negative provision of $1.7 million for the same period in 2013. In the three months ended June 30, 2014, the Company recorded provision expense of $14.0 million related to commercial loan sales of $71.1 million and the transfer of $24.4 million in consumer loans to held-for-sale. Total non-performing loans held-for-investment decreased $23.9 million from $38.0 million at December 31, 2013 to $14.1 million at June 30, 2014. The ratio of allowance for loan losses to gross loans receivable was 1.53% at June 30, 2014 as compared to 1.66% at December 31, 2013. Net charge-offs for the six months ended June 30, 2014 were $21.9 million as compared to net recoveries of $3.8 million during the same period in 2013. The provision recorded is the amount deemed appropriate by management based on the current risk profile of the portfolio to absorb losses existing at the balance sheet date. At least monthly, management performs an analysis to identify the inherent risk of loss in the Company's loan portfolio. This analysis includes a qualitative evaluation of concentrations of credit, past loss experience, current economic conditions, amount and composition of the loan portfolio (including loans being specifically monitored by management), estimated fair value of underlying collateral, delinquencies, and other factors. Additionally, management updates the migration analysis and historic loss and recovery experience on a quarterly basis. 54



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Non-Interest Income. Non-interest income decreased $12.2 million to $8.9 million for the six months ended June 30, 2014, as compared to $21.1 million for the same period in 2013. During the six months ended June 30, 2014, the Company recorded $1.2 million of mortgage banking revenue, net, a decrease of $7.8 million compared to the prior year period, due to a significant volume reduction in the Company's mortgage operations. The decrease was also driven by a $3.4 million decrease in gain on sale of investment securities from $3.5 million recorded during the six months ended June 30, 2013 to $50 thousand recorded during the six months ended June 30, 2014. Non-Interest Expense. Non-interest expense decreased $3.0 million to $61.6 million for the six months ended June 30, 2014 as compared to $64.6 million for the same period in 2013. The decrease was primarily due to decreases of $3.7 million in professional fees and $2.9 million in commission expense, partially offset by increases of $2.2 million in other non-interest expense and $1.6 million in salaries and employee benefits expense. The increase in salaries and employee benefits expense was due to severance and benefit accruals associated with the Company's reduction in force. Other non-interest expense increased primarily as a result of loan sale transaction fees. Commission expense declined due to reduced mortgage origination volume and professional fees declined significantly as the Company reduced its reliance on external consultants for operational infrastructure improvements and regulatory remediation.



Liquidity and Capital Resources

The liquidity of the Company is the ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis in various market conditions. The ability of the Company to meet its current financial obligations is a function of balance sheet structure, the ability to liquidate assets and the availability of alternative sources of funds. To meet the needs of the clients and manage the risk of the Company, the Company engages in liquidity planning and management. The major source of the Company's funding on a consolidated basis is deposits, which management believes will be sufficient to meet the Company's daily and long-term operating liquidity needs. The ability of the Company to retain and attract new deposits is dependent upon the variety and effectiveness of its customer account products, customer service and convenience, and rates paid to customers. The Company also obtains funds from the repayment and maturities of loans, loan sales or participations and maturities or calls of investment securities. Additional liquidity can be obtained in a variety of wholesale funding sources as well, including, but not limited to, federal funds purchased, FHLBNY advances, securities sold under agreements to repurchase, and other securities and unsecured borrowings. Through the Bank, the Company also purchases brokered deposits for funding purposes; however, this funding source is currently limited to 6.0% of the Bank's total liabilities in accordance with a written agreement between the Bank and the OCC and the OCC's subsequent approved increase in the limit on brokered deposits, as discussed later in this section. In a continued effort to balance deposit growth and net interest margin, especially in the current interest rate environment and with competitive local deposit pricing, the Company continually evaluates these other funding sources for funding cost efficiencies. Deposit rates continued to decrease in 2014, but at a rate slower than in previous quarters. Core deposits, which exclude all certificates of deposit, decreased by $260.3 million to $1.75 billion, or 76.8% of total deposits at June 30, 2014, as compared to $2.01 billion, or 76.6% of total deposits at December 31, 2013. This decrease was primarily due to the reclassification of $160.8 million of deposits to deposits held-for-sale on the unaudited condensed consolidated statements of financial condition at June 30, 2014 as well as planned declines in public funds deposits. The Company has additional secured borrowing capacity with the Federal Reserve Bank of approximately $141.4 million, of which none was utilized, and the FHLBNY of approximately $174.4 million, of which $60.9 million was utilized. In addition to secured borrowings, the Company also has unsecured borrowing capacity through lines of credit with other financial institutions of $35.0 million, of which none were utilized as of June 30, 2014. Management continues to monitor the Company's liquidity and has taken measures to increase its borrowing capacity by providing additional collateral through the pledging of loans. As of June 30, 2014, the Company had a par value of $198.9 million and $172.6 million in loans and securities, respectively, pledged as collateral on secured borrowings. The Company's primary uses of funds are the origination of loans, the funding of the Company's maturing certificates of deposit, deposit withdrawals, the repayment of borrowings and general operating expenses. Certificates of deposit scheduled to mature during the 12 months ending June 30, 2015 total $353.8 million, or approximately 63.45% of total certificates of deposit. The Company continues to operate with a core deposit relationship strategy that values a long-term stable customer relationship. This strategy employs a pricing strategy that rewards customers that establish core accounts and maintain a certain minimum threshold account balance. Based on market conditions and other liquidity considerations, the Company may also avail itself to the secondary borrowings discussed above. The Company anticipates that deposits, cash and cash equivalents on hand, the cash flow from assets, as well as other sources of funds will provide adequate liquidity for the Company's future operating, investing and financing needs. The Bank's deposits are insured to applicable limits by the FDIC. Pursuant to the Dodd-Frank Act, the Federal Deposit Insurance Act was amended to increase the maximum deposit insurance amount from $100,000 to $250,000. On April 15, 2010, the Bank entered into the OCC Agreement which contained requirements to develop and implement a profitability and capital plan which provides for the maintenance of adequate capital to support the Bank's risk profile in the current economic environment. The capital plan was required to contain a dividend policy allowing 55



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dividends only if the Bank is in compliance with the capital plan, and obtains prior approval from the OCC. In addition, we are required to seek the prior approval of the Federal Reserve Bank before paying interest, principal or other sums on trust preferred securities or any related subordinated debentures, declaring or paying cash dividends or taking dividends from the Bank, repurchasing outstanding stock or incurring indebtedness. The Company is also required to take certain remedial steps and submit plans and progress reports to the Federal Reserve Bank. All requirements noted above were met as of June 30, 2014. The Bank also agreed to: (a) implement a program to protect the Bank's interest in criticized or classified assets, (b) review and revise the Bank's loan review program; (c) implement a program for the maintenance of an adequate allowance for loan losses; and (d) revise the Bank's credit administration policies. The Bank initially agreed that its brokered deposits would not exceed 3.5% of its total liabilities unless approved by the OCC. However, effective October 18, 2012, the OCC approved an increase to this limit to 6.0%. Management does not expect this restriction will limit its access to liquidity as the Bank does not rely on brokered deposits as a major source of funding. At June 30, 2014, the Bank's brokered deposits represented 3.9% of its total liabilities.



Management believes it is taking all necessary actions for the Bank to achieve full compliance with all requirements of the OCC Agreement and the Federal Reserve Bank requirements discussed above.

The Bank is also subject to individual minimum capital ratios established by the OCC for the Bank requiring the Bank to continue to maintain a Leverage ratio at least equal to 8.50% of adjusted total assets, to continue to maintain a Tier 1 Capital ratio at least equal to 9.50% of risk-weighted assets and maintain a Total Capital ratio at least equal to 11.50% of risk-weighted assets. At June 30, 2014, the Bank met all of the three capital ratios established by the OCC as its Leverage ratio was 9.12%, Tier 1 Capital ratio was 13.20%, and Total Capital ratio was 14.45%.



Effective June 30, 2014, the company contributed $7.5 million to the Bank, leaving the Company with cash and cash equivalents of approximately $10.5 million for debt service and operating expenses at June 30, 2014.

The following table provides both the Company's and the Bank's regulatory capital ratios as of June 30, 2014:

Table 6: Regulatory Capital Levels

For Capital To Be Well Capitalized Under Actual Adequacy Purposes Prompt Corrective Action Provision(1) Amount Ratio Amount Ratio Amount Ratio June 30, 2014 Total capital (to risk-weighted assets): Sun Bancorp, Inc. $ 304,987 15.00 % $ 162,675 8.00 % N/A Sun National Bank 293,434 14.45 162,403 8.00 $ 203,003 10.00 % Tier I capital (to risk-weighted assets): Sun Bancorp, Inc. 252,788 12.43 81,338 4.00 N/A Sun National Bank 268,016 13.20 81,201 4.00 121,802 6.00 Leverage ratio: Sun Bancorp, Inc. 252,788 8.59 117,764 4.00 N/A Sun National Bank 268,016 9.12 117,571 4.00 146,964 5.00



(1) Not applicable for bank holding companies.

The Company's capital securities qualify as Tier 1 capital under federal regulatory guidelines. These instruments are subject to a 25% capital limitation under risk-based capital guidelines developed by the FRB. Under FRB rules, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company's core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. However, under the Dodd-Frank Act, bank holding companies are prohibited from including in their Tier 1 capital hybrid debt and equity securities, including trust preferred securities, issued on or after May 19, 2010. Any such instruments issued before May 19, 2010 by a bank holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, may continue to be included as Tier 1 capital (subject to the 25% limitation). The portion that exceeds the 25 percent capital limitation qualifies as Tier 2, or supplementary capital of the Company. At June 30, 2014, $63.3 million of a total of $90.0 million in capital securities qualified as Tier 1 with $26.7 million qualifying as Tier 2.



Basel III Capital Rules

Regulatory reforms have recently been instituted, which will also impose restrictions on our current business practices. Recent items affecting us include the final Basel III rule.

On July 2, 2013, the federal banking regulators, including the FRB and the OCC, approved the final Basel III capital rules for U.S. banking organizations. The final rules establish an integrated regulatory capital framework and will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking 56



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Supervision and certain changes required by the Dodd-Frank Act. Under the final rule, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the final rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets that will apply to all covered financial institution holding companies and all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets and includes a minimum leverage ratio of 4 percent for all banking organizations. These new minimum capital ratios will become effective for us on January 1, 2015 and will be fully phased-in on January 1, 2019. These requirements are separate from the individual minimum capital ratios established by the OCC. In addition, the final rule will impose limits on capital distributions by, and discretionary bonus payments to executive officers of, banking organizations that do not maintain a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The capital conservation buffer will be phased-in over a transition period from January 1, 2016 to January 1, 2019. The final rule emphasizes common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The final rule also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. Banks and regulators use risk weighting to assign different levels of risk to different classes of assets.



The chart below contains the Basel III regulatory capital levels that we must satisfy during the applicable transition period, from January 1, 2015 until January 1, 2019, which are in addition to and separate from the individual minimum capital ratios established by the OCC.

Basel III Regulatory Capital Levels January 1, January 1,



January 1, January 1, January 1,

2015 2016 2017 2018 2019 Tier 1 common equity 4.5 % 5.125 % 5.75 % 6.375 % 7.0 % Tier 1 risk-based capital ratio 6.0 % 6.625 % 7.25 % 7.875 % 8.5 % Total risk-based capital ratio 8.0 % 8.625 % 9.25 % 9.875 % 10.5 % The Basel III Capital Rules also revise the "prompt corrective action" regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a common equity tier 1 capital ratio requirement at each level (other than critically undercapitalized), with the required common equity tier 1 capital ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%), and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category. We currently anticipate that our capital ratios, on a Basel III basis, will exceed the regulatory minimum requirements to be considered well-capitalized. However, we are evaluating options to mitigate the capital impact of the final rule prior to its effective implementation date.



Dividend Restrictions

The ability of the Bank to pay dividends to the Company is governed by certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay any dividends in an amount greater than its undivided profits and a national bank may not declare any dividends if such declaration would leave the bank inadequately capitalized. Therefore, the ability of the Bank to declare dividends will depend on its future net income and capital requirements. Also, banking regulators have indicated that national banks should generally pay dividends only out of current operating earnings. Following this guidance, the Bank was not able to pay a dividend to the Company at June 30, 2014. Moreover, per the OCC Agreement and the Federal Reserve Bank requirements, a dividend may only be declared if it is in accordance with the approved capital plan, the Bank remains in compliance with the capital plan following the payment of the dividend and the dividend is approved by the OCC and the Federal Reserve Bank. 57



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Volcker Rule

On December 10, 2013, the FRB, the OCC, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule contained in section 619 of the Dodd-Frank Act, generally to become effective on July 21, 2015. The Volcker Rule prohibits an insured depository institution and its affiliates (referred to as "banking entities") from: (i) engaging in "proprietary trading" and (ii) investing in or sponsoring certain types of funds ("covered funds") subject to certain limited exceptions. These prohibitions impact the ability of U.S. banking entities to provide investment management products and services that are competitive with nonbanking firms generally and with non-U.S. banking organizations in overseas markets. The rule also effectively prohibits short-term trading strategies by any U.S. banking entity if those strategies involve instruments other than those specifically permitted for trading. The final Volcker Rule regulations do provide certain exemptions allowing banking entities to continue underwriting, market-making and hedging activities and trading certain government obligations, as well as various exemptions and exclusions from the definition of "covered funds." However, the level of required compliance activity depends on the size of the banking entity and the extent of its trading. On January 14, 2014, the five federal agencies approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities from the investment prohibitions of the Volcker Rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. In addition, the agencies released a non-exclusive list of issuers that meet the requirements of the interim final rule. At June 30, 2014, the Company had an investment in one pool of trust preferred securities with an amortized cost of $8.8 million and estimated fair value of $6.7 million. This pool was included in the non-exclusive list of issuers that meet the requirements of the interim final rule released by the agencies and therefore will not be required to be sold by the Company. On April 17, 2014 the FRB released guidance stating that it would extend the conformance period for banks holding collateralized loan obligations by two years to July 2017. At June 30, 2014, the Bank had 12 collateralized loan obligation securities with an amortized cost of $71.9 million and an estimated fair value of $71.5 million. These securities are subject to the provisions of the Volcker Rule. However, a final determination has yet to be made on whether banks will be required to divest these investments. Discussion has been ongoing among the regulators, Congress and the investors in collateralized loan obligations. Based on the current status of these discussions and through the Bank's communication with its investment advisors, the Bank's management believes it will either be able to hold these collateralized loan obligation investments in its portfolio or have them modified such that the perceived risk will be adequately eliminated.



At June 30, 2014, the Bank had one non-rated single issuer security with an amortized cost of $3.8 million and an estimated fair value of $2.7 million. This security is not subject to the provisions of the Volcker Rule.

See Note 12 of the notes to unaudited condensed consolidated financial statements for additional information regarding regulatory matters.

Disclosures about Commitments

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. In the event of a draw by the beneficiary that complies with the terms of the letter of credit, the Company would be required to honor the commitment. The Company takes various forms of collateral, such as real estate assets and customer business assets, to secure the commitment. Additionally, all letters of credit are supported by indemnification agreements executed by the customer. The maximum undiscounted exposure related to these commitments at June 30, 2014 was $28.2 million and the portion of the exposure not covered by collateral was approximately $615 thousand. We believe that the utilization rate of these letters of credit will continue to be substantially less than the amount of these commitments, as has been our experience to date. The Company maintains a reserve for unfunded loan commitments and letters of credit, which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition, consistent with FASB ASC 825. As of the balance sheet date, the Company records estimated losses inherent with unfunded loan commitments in accordance with FASB ASC 450, Contingencies, and estimated future obligations under letters of credit in accordance with FASB ASC 460, Guarantees. The methodology used to determine the adequacy of this reserve is integrated in the Company's process for establishing the allowance for loan losses and considers the probability of future losses and obligations that may be incurred under these off-balance sheet agreements. The reserve for unfunded loan commitments and letters of credit at June 30, 2014 and December 31, 2013 was $431 thousand and $454 thousand, respectively. Management believes this reserve level is sufficient to absorb estimated probable losses related to these commitments. The Company maintains a reserve for residential mortgage loans sold with recourse to third-party purchasers which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition. As of June 30, 2014, the Company records estimated losses inherent with residential mortgage loans sold with recourse in accordance 58



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with FASB ASC 460, Guarantees. This reserve is determined based upon the probability of future losses which is calculated using historical Company and industry loss data. The reserve for residential mortgage loan recourse as of June 30, 2014 and December 31, 2013 was $1.0 million and $647 thousand, respectively. Management believes this reserve level is sufficient to address potential recourse exposure.


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Source: Edgar Glimpses


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