10-K 1 e19091_caro-10k.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

 

x     Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934    

For the fiscal year ended December 31, 2018

 

or

 

o    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934  

For the transition period from            to           

 

Commission file number 001-10897

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

 

Delaware   57-1039673
(State of Incorporation)   (I.R.S. Employer Identification No.)

 

288 Meeting Street, Charleston, South Carolina   29401
(Address of principal executive offices)   (Zip Code)

 

(843) 723-7700
(Issuer’s Telephone Number)

 

Securities registered pursuant to Section 12(b) of the Exchange Act:

 

  Title of Each Class   Name of each exchange on which registered  
  Common Stock, $0.01 par value per share   The Nasdaq Capital Market®  

 

Securities registered under Section 12(g) of the Exchange Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes x  No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes o  No x

 

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

Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically, if any, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

o

 

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

 

Large accelerated filer  x Accelerated filer  o
   

Non-accelerated filer  o

(Do not check if a smaller reporting company)

Smaller reporting company   o

 

Emerging growth company  o

 

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

o

 

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

Yes o  No x

 

The aggregate market value of the voting and nonvoting common equity held by non-affiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $911,858,620 as of the last business day of the registrant’s most recently completed second fiscal quarter.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

Class   Outstanding at February 25, 2019
Common Stock, $.01 par value per share   22,304,418 shares

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement relating to the registrant’s Annual Meeting of Shareholders, to be held on April 24, 2019, are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. 

 
 

TABLE OF CONTENTS

 

     
    Page
PART 1    
Item 1. Business 3
Item 1A. Risk Factors 22
Item 1B. Unresolved Staff Comments 35
Item 2. Properties 35
Item 3. Legal Proceedings 35
Item 4. Mine Safety Disclosures 35
     
PART II    
Item 5. Market for Common Equity and Related Shareholder Matters 36
Item 6. Selected Financial Data 37
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 69
Item 8. Financial Statements and Supplementary Data 70
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 140
Item 9A. Controls and Procedures 140
Item 9B. Other Information 141
     
PART III      
Item 10. Directors, Executive Officers and Corporate Governance 141
Item 11. Executive Compensation 141
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 142
Item 13. Certain Relationships and Related Transactions, and Director Independence 142
Item 14. Principal Accounting Fees and Services 142
Item 15. Exhibits, Financial Statement Schedules 142
     
SIGNATURES 143
     
EXHIBIT INDEX 144

 
 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K, including information included or incorporated by reference, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the “Securities “Act”) and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described below under “Item 1A- Risk Factors” and the following:

 

  · our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;

  · examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;

  · changes in economic conditions, either nationally or regionally and especially in our primary market areas, resulting in, among other things, a deterioration in credit quality;

  · changes in interest rates, or changes in regulatory environment resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;

  · greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;

  · greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

  · changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, North Carolina and national real estate markets;

  · the rate of delinquencies and amount of loans charged-off;

  · the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;

  · the rate of loan growth in recent or future years;

  · our ability to attract and retain key personnel;

  · our ability to retain our existing customers, including our deposit relationships;

  · significant increases in competitive pressure in the banking and financial services industries;

  · adverse changes in asset quality and resulting credit risk-related losses and expenses;

  · changes in the interest rate environment which could reduce anticipated or actual margins;

  · changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking, mortgage banking, and financial service industries;
  · changes occurring in business conditions and inflation;

  · increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;

  · the impact of recent and future hurricanes and other natural disasters on our loan portfolio and the economic prospects of our coastal markets;
  · our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;

  · changes in deposit flows;

  · changes in technology;

  · changes in monetary and tax policies;

  · changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board (the “PCAOB”) and the Financial Accounting Standards Board (the “FASB”);

  · loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;

  · our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;

  · our anticipated capital expenditures and our estimates regarding our capital requirements;

  · our liquidity and working capital requirements;

  · competitive pressures among depository and other financial institutions;

  · the growth rates of the markets in which we compete;

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  · our anticipated strategies for growth and sources of new operating revenues;

  · our current and future products, services, applications and functionality and plans to promote them;

  · anticipated trends and challenges in our business and in the markets in which we operate;

  · the evolution of technology affecting our products, services and markets;

  · our ability to retain and hire necessary employees and to staff our operations appropriately;

  · management compensation and the methodology for its determination;

  · our ability to compete in our industry and innovation by our competitors;
  · increased cybersecurity risk, including potential business disruptions or financial losses;

  · acquisition integration risks, including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related matters, and the inability to identify and successfully negotiate and complete additional combinations with potential merger or acquisition partners or to successfully integrate such businesses into the Company, including the ability to realize the benefits and cost savings from, and limit any unexpected liabilities associated with, any such business combinations;

  · our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business; and

  · estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices and stock-based compensation.

 

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of this report. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this report. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed in, or implied or projected by, the forward-looking statements.

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PART I

Item 1.  Business

 

General Overview

 

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

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

  

On June 11, 2016, the Company completed its acquisition of Congaree Bancshares, Inc. (“Congaree”), the holding company for Congaree State Bank. The Company issued 508,910 shares of its common stock, assumed and immediately redeemed $1.6 million in preferred stock and paid $5.7 million in cash to Congaree shareholders. In the transaction, the Company acquired $104.2 million of total assets, loans receivable of $74.6 million and deposits of $89.3 million.

 

On March 18, 2017, the Company completed its acquisition of Greer Bancshares Incorporated (“Greer”), the holding company for Greer State Bank. The Company issued 1,789,523 shares of its common stock and paid $4.4 million in cash to Greer shareholders. In the transaction, the Company acquired $384.5 million in total assets, loans receivable of $194.6 million and deposits of $311.1 million. In addition, the Company assumed aggregate subordinated debt principal of $11.3 million, which at the date of acquisition had a fair value of $7.5 million.

 

On November 1, 2017, the Company closed its acquisition of First South Bancorp, Inc., the holding company for First South Bank (“First South”). In the transaction, the Company acquired $1.1 billion in total assets, loans receivable of $759.2 million and deposits of $952.6 million. The Company issued 4,822,540 shares of its common stock to First South shareholders. In addition, the Company assumed aggregate subordinated debt principal of $10.3 million, which at the date of acquisition had a fair value of $8.6 million.

 

As of December 31, 2018, the Company had total assets of $3.8 billion, loans receivable, net of $2.5 billion, total deposits of $2.7 billion, and total stockholders’ equity of $575.3 million.  

 

Our main office is located at 288 Meeting Street, Charleston, South Carolina 29401.

 

Available Information

 

We provide our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act on our website at www.haveanicebank.com under the “Investor Relations” section. These filings are made accessible as soon as reasonably practicable after they have been filed electronically with the Securities and Exchange Commission (the “SEC”). These filings are also accessible on the SEC’s website at www.sec.gov. In addition, we make available under the Investor Relations section on our website (www.haveanicebank.com) the following, among other things, (i) Code of Ethics and Whistleblower Policy and (ii) the charters of the Audit, Corporate Governance and Nominating and Compensation and Benefits Committees of our board of directors. These materials are available to the general public on our website free of charge. Printed copies of these materials are also available free of charge to shareholders who request them in writing. Please address your request to: Investor Relations, Attn: William A. Gehman III, Carolina Financial Corporation, 288 Meeting Street, Charleston, South Carolina 29401. Statements of beneficial ownership of equity securities filed by directors, officers, and 10% or greater stockholders under Section 16 of the Exchange Act are also available through our website, www.haveanicebank.com. The information on our website is not incorporated by reference into this report.

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Our Market Area

 

Our primary market areas are the Coastal, Midlands, and Upstate regions of South Carolina, including the Charleston (Charleston, Dorchester and Berkeley Counties), Myrtle Beach (Horry and Georgetown Counties), Columbia (Richland and Lexington Counties), and the Upstate (Greenville and Spartanburg Counties) market areas. Our primary market areas in North Carolina include Wilmington (New Hanover County), Raleigh-Durham (Durham and Wake Counties) and the surrounding southeastern coastal region of North Carolina (Bladen, Brunswick, Columbus, Cumberland, Duplin and Robeson Counties).

 

The following table presents, for each of our above-described primary market areas, the number of branches of CresCom Bank, the approximate amount of deposits in the market areas as of June 30, 2018 and the approximate deposit market share in the market area at June 30, 2018 (the latest date for which such data is available).

 

   Number of   Deposits   Market 
Market Name  Branches   (in millions)   Share 
Charleston   8   $652    4.9%
Myrtle Beach   8   $410    5.0%
Midlands South Carolina   3   $125    2.5%
Upstate South Carolina   5   $327    2.8%
Inland North Carolina   9   $309    5.1%
Coastal North Carolina   4   $132    6.2%
Wilmington   3   $61    0.8%
Raleigh/Durham   2   $60    0.2%
Eastern NC   19   $631    5.1%

 

Our markets in or near Charleston, South Carolina are heavily influenced by the diverse economic mix of the Charleston region. The region is home to the Port of Charleston, one of the busiest container ports along the Southeast and Gulf Coasts, as well as a number of national and international manufacturers, including Boeing South Carolina and Robert Bosch LLC. The region also benefits from a thriving tourism industry. In addition, a number of academic institutions are located within the region, including the Medical University of South Carolina, The Citadel, The College of Charleston, Charleston Southern University, Trident Technical College and The Charleston School of Law. Charleston also hosts military installations for the U.S. Navy, Marine Corps, U.S. Air Force, U.S. Army and U.S. Coast Guard. Data obtained through SNL Financial LC projects population growth in the Charleston-North Charleston MSA of 8.5% from 2019 to 2024 as compared to a projection for national population growth of 8.1% during the same time period.

 

The Myrtle Beach area, also known as the Grand Strand, is a 60-mile stretch of beaches extending south from the South Carolina/North Carolina state line to Pawley’s Island and is consistently ranked as one of the top vacation destinations in the country. According to data published by the Myrtle Beach Area Chamber of Commerce, Myrtle Beach hosted an estimated 19 million visitors in 2018 with the economy of the region dominated by the tourism and retail industries. The Myrtle Beach-Conway-North Myrtle Beach MSA is also home to Coastal Carolina University in Conway and Webster University in Myrtle Beach. Data obtained through SNL Financial LC projects population growth in the Myrtle Beach-Conway-North Myrtle Beach MSA of 9.7% from 2019 to 2024.

 

Our Wilmington and other markets in southeastern North Carolina are contiguous to South Carolina and the Grand Strand. Wilmington has a diversified economy and is a major resort area and a center for light manufacturing. The city also serves as the retail and medical center for the region. Companies in the Wilmington area produce fiber optic cables for the communications industry, aircraft engine parts, pharmaceuticals, nuclear fuel components and various textile products. According to data published by the Wilmington Chamber of Commerce, major employers in the area include General Electric, PPD, Inc., and Corning, Inc. The area also benefits from the presence of the University of North Carolina-Wilmington, which is also a major employer for the market. Data obtained through SNL Financial LC projects population growth in the Wilmington MSA of 7.1% from 2019 to 2024.

 

The Upstate market includes five banking locations and one loan production office in the Greenville-Spartanburg market area. Major industries in the Upstate include the automobile industry, which is concentrated primarily along the corridor between Greenville and Spartanburg around the BMW manufacturing facility in Greer, South Carolina. The Greenville Health System and Bon Secours St. Francis Health System represent the healthcare and pharmaceuticals industry in the area. The Upstate is also home to significant private sector and university-based research including research and development facilities for Michelin, Fuji and General Electric and research centers to support the automotive, life sciences, plastics and photonics industries. The Upstate also benefits from being an academic center and is home to collegiate and university education facilities such as Clemson University, Furman University, Presbyterian College, University of South Carolina-Upstate, Anderson University, Lander University, Bob Jones University, Wofford College and Converse College, among others. Data obtained through SNL Financial LC projects population growth in the Greenville-Anderson MSA of 6.2% from 2019 to 2024.

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The Raleigh/Durham and other inland markets in North Carolina include 11 branches and one loan production office in the Durham, NC area. The largest research park in the United States is situated between Durham and Raleigh and is home to more than 250 companies including IBM, GlaxoSmithKline and Cisco Systems. The area is also home to university and research facilities of Duke University and the University of North Carolina – Chapel Hill. The area is among the most visited of the United States. Data obtained through SNL Financial LC projects population growth in the Raleigh-Cary and Durham-Chapel Hill MSAs of 7.6% from 2019 to 2024.

 

The Midlands market includes two branches in the Columbia, South Carolina market. Columbia, the state capital of South Carolina, is located within Richland County in the center of the state between the Upstate region and the coastal cities of Charleston and Myrtle Beach. Columbia’s central location has contributed greatly to its commercial appeal and growth, and the city benefits from a diverse economy composed of advanced manufacturing, healthcare, technology, shared services, logistics, and energy. The largest employers in the Columbia market area include the U.S. Army’s Fort Jackson, the University of South Carolina, Prisma Health (formerly Palmetto Health Alliance), Blue Cross Blue Shield, and Lexington Medical Center. Data obtained through SNL Financial LC projects population growth in the Columbia MSA of 5.6% from 2019 to 2024.

 

On January 21, 2019, the Company announced its planned expansion into the Charlotte, North Carolina market. The expansion brings the Company’s footprint to the center of the state as a natural extension to the existing footprint across Eastern North Carolina. Charlotte is one of the 25 largest cities in the U.S. and is the largest city in North Carolina. Charlotte is home to more than 10 Fortune 1000 companies including Bank of America, Wells Fargo, Belk, Shutterfly, Duke Energy, Lance and Nucor. Data obtained through SNL Financial LC projects population growth in the Charlotte-Concord-Gastonia MSA of 7.3% from 2019 to 2024.

 

Our markets have experienced steady economic and population growth over the past 10 years, and we expect that the areas, as well as the business and tourism industries needed to support it, will continue to grow.

 

Competition

 

The banking business is highly competitive, and we experience competition in our market areas from many other financial institutions.  Competition among financial institutions is based on interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services rendered, the convenience of banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.  We compete with commercial banks, credit unions, savings institutions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices in our market areas and elsewhere.

 

We compete with these institutions both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well-established, larger financial institutions, such as SunTrust, Bank of America, Wells Fargo, PNC and BB&T.  These institutions offer some services, including extensive and established branch networks, that we do not provide.  In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks.

 

Lending Activities

 

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

 

Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer lending limits, with approval processes for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds the maximum senior officer’s lending authority, the loan request will be considered by the management loan committee, or MLC, which is comprised of five members, all of whom are part of the senior management team of the Bank. The MLC meets weekly to approve loans with total loan commitment relationships generally exceeding $2.5 million. The loan authority of the MLC is equal to two-thirds of the legal lending limit of the Bank which is equivalent to the in-house loan limit. Total credit exposure above the in-house limit requires approval by the majority of the board of directors. We do not make any loans to any director, executive officer of the Bank, or the related interests of each, unless the loan is approved by the full Board of Directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.

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Our lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. This legal lending limit will increase or decrease as the Bank’s level of capital increases or decreases. Based upon the capitalization of the Bank at December 31, 2018, the maximum amount we could lend to one borrower was $70.3 million. However, our internal lending limit without board of director approval at December 31, 2018 was $46.9 million. The board of directors will adjust the internal lending limit as deemed necessary to continue to mitigate risk and serve the Bank’s clients. We are able to sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.

 

Real Estate Mortgage Loans. The principal component of our loan portfolio is loans secured by real estate mortgages. Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, creditworthiness, and ability to repay the loan. We obtain a security interest in real estate whenever possible, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan.

 

These loans generally fall into one of two categories:

 

  · Residential Mortgage Loans and Home Equity Loans. We generally originate and hold short-term and long-term first mortgages and traditional second mortgage residential real estate loans. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%. Loans over 80% LTV generally require private mortgage insurance. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We also offer a variety of lot loan options to consumers to purchase the lot on which they intend to build their home. The options available depend on whether the borrower intends to begin building within 12 months of the lot purchase or at an undetermined future date. We also offer traditional home equity loans and lines of credit. Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity loans typically have terms of 10 years or less.
     
  · Commercial Real Estate. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, generally does not exceed 80%. We also generally require that a borrower’s cash flow exceed 120% of monthly debt service obligations. In order to ensure secondary sources of payment and liquidity to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.

 

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

 

Commercial Loans. We make loans for commercial purposes in various lines of businesses, including the manufacturing industry, service industry, and professional service areas. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate.

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Equipment loans typically will be made for a term of 10 years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 75% of cost. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.

 

The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company purchases nationally syndicated commercial and industrial loans. These loans typically have terms of seven years and are generally tied to a floating rate index such as LIBOR or prime. To effectively manage this line of business, the Company has an experienced senior lending executive who leads a team with relevant experience to manage this area of this segment of the loan portfolio. In addition, the Company engaged a consulting firm that specializes in syndicated loans to assist in monitoring performance analytics. As of December 31, 2018 and December 31, 2017, there were approximately $99.8 million and $75.0 million in broadly syndicated loans outstanding. Syndicated loans are grouped within commercial business loans.

 

The Bank began originating leases, primarily on equipment utilized for business purposes, as a result of the First South acquisition. Lease terms generally range from 12 to 60 months and include options to purchase the leased equipment at the end of the lease. Most leases provide 100% of the cost of the equipment and are secured by the leased equipment. The Company requires the leased equipment to be insured and that we be listed as a loss payee and named as an additional insured on the insurance policy. We manage credit risk associated with our lease financing loan class based upon the dollar amount of the lease and the level of credit risk. We follow a formal review process that entails analysis of the following factors: equipment value/residual value, exposure levels, jurisdiction risk, industry risk, guarantor requirements, and regulatory compliance. As of December 31, 2018 and December 31, 2017, there were approximately $23.1 million and $24.0 million in lease receivables outstanding. Lease receivables are grouped within commercial business loans. 

 

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

 

Mortgage Operations

 

Mortgage Activities and Servicing. Our correspondent/wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans and is included in mortgage banking income in the accompanying consolidated statements of operations. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned.

 

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

 

Deposit Products

  

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

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Emerging Growth Company

 

On December 31, 2018, our status as an “emerging growth company”, as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), terminated because the market value of our common stock held by non-affiliates exceeded $700 million on June 30, 2018.  As an “emerging growth company,” we took advantage of some reduced disclosure and other requirements that were otherwise applicable generally to public companies.  As a result, the information that we provided to our stockholders prior to this report may be different from the information provided by other public reporting companies.  With the filing of this report, we began providing the information required from “large accelerated filers” as defined in Rule 12b-2 under the Exchange Act in periodic reports required under the Exchange Act.

 

Employees

 

As of February 25, 2019, we had 773 total employees, including 735 full-time employees.

 

SUPERVISION AND REGULATION

 

Both the Company and the Bank are subject to extensive state and federal banking laws and regulations that impose restrictions on and provide for general regulatory oversight of their operations.  These laws and regulations generally are intended to protect consumers and depositors and not stockholders.  The following summary is qualified by reference to the statutory and regulatory provisions discussed.  Changes in applicable laws or regulations may have a material effect on our business and prospects.  Our operations may be affected by legislative changes and the policies of various regulatory authorities.  We cannot predict the effect that fiscal or monetary policies, economic control or new federal or state legislation may have on our business and earnings in the future.

 

The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of those laws and regulations on our operations.  It is intended only to briefly summarize some material provisions.

 

Recent Legislative and Regulatory Initiatives

 

Banking statutes, regulations and policies are continually under review by Congress, state legislatures and federal and state regulatory agencies. In addition to laws and regulations, state and federal bank regulatory agencies may issue policy statements, interpretive letters and similar written guidance applicable to the Company and its subsidiaries. Any change in the statutes, regulations and regulatory policies applicable to us, including changes in their interpretation or implementation, could have a material effect on our business and organization.

 

Both the scope of the laws and regulations and the intensity of supervision to which we are subject have increased in recent years in response to the financial crisis, as well as other factors such as technological and market changes. Regulatory enforcement and fines have also increased across the banking and financial services sector. Many of these changes have occurred as a result of the Dodd-Frank Act and its implementing regulations, most of which are now in place. President Trump has issued an executive order that sets forth principles for the reform of the federal financial regulatory framework, and Congress has also suggested an agenda for financial regulatory change. It is too early to assess whether there will be any major changes in the regulatory environment or merely a rebalancing of the post financial crisis framework. The Company expects that its business will remain subject to extensive regulation and supervision.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed into law in 2010 (the “Dodd-Frank Act”), among other things, changes the oversight and supervision of financial institutions, includes new minimum capital requirements, creates a new federal agency to regulate consumer financial products and services and implements changes to corporate governance and compensation practices. The Dodd-Frank Act is focused in large part on the financial services industry, particularly bank holding companies with consolidated assets of $50 billion or more, and contains a number of provisions that will affect us, including:

 

Minimum Leverage and Risk-Based Capital Requirements. Under the Dodd-Frank Act, the Federal banking agencies are required to establish minimum leverage and risk-based capital requirements on a consolidated basis for all insured depository institutions and bank holding companies, which can be no less than the currently applicable leverage and risk-based capital requirements for depository institutions. As a result, the Bank will be subject to at least the same capital requirements and must include the same components in regulatory capital.

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Deposit Insurance Modifications. The Dodd-Frank Act modified the FDIC’s assessment base upon which deposit insurance premiums are calculated. The new assessment base equals our average total consolidated assets minus the sum of our average tangible equity during the assessment period. The Dodd-Frank Act also permanently raised the standard maximum insurance amount to $250,000.

 

Creation of New Governmental Authorities. The Dodd-Frank Act created various new governmental authorities such as the Financial Stability Oversight Council and the Consumer Financial Protection Bureau (the “CFPB”), an independent regulatory authority housed within the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The CFPB has broad authority to regulate the offering and provision of consumer financial products. The CFPB officially came into being on July 21, 2011, and rulemaking authority for a range of consumer financial protection laws (such as the Truth in Lending Act, the Electronic Funds Transfer Act and the Real Estate Settlement Procedures Act, among others) transferred from the Federal Reserve and other federal regulators to the CFPB on that date. The Dodd-Frank Act gives the CFPB authority to supervise and examine depository institutions with more than $10 billion in assets for compliance with these federal consumer laws. The authority to supervise and examine depository institutions with $10 billion or less in assets for compliance with federal consumer laws will remain largely with those institutions’ primary regulators. However, the CFPB may participate in examinations of these smaller institutions on a “sampling basis” and may refer potential enforcement actions against such institutions to their primary regulators. The CFPB also has supervisory and examination authority over certain nonbank institutions that offer consumer financial products. The Dodd-Frank Act identifies a number of covered nonbank institutions, and also authorizes the CFPB to identify additional institutions that will be subject to its jurisdiction. Accordingly, the CFPB may participate in examinations of the Bank, which currently has assets of less than $10 billion, and could supervise and examine our other direct or indirect subsidiaries that offer consumer financial products or services. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the CFPB, and state attorneys general are permitted to enforce consumer protection rules adopted by the CFPB against certain institutions.

 

The Dodd-Frank Act also authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay. Under the Dodd-Frank Act, financial institutions may not make a residential mortgage loan unless they make a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure but provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” On January 10, 2013, the CFPB published final rules to, among other things, specify the types of income and assets that may be considered in the ability-to-repay determination, the permissible sources for verification, and the required methods of calculating the loan’s monthly payments. Since then the CFPB made certain modifications to these rules. The rules extend the requirement that creditors verify and document a borrower’s “income and assets” to include all “information” that creditors rely on in determining repayment ability. The rules also provide further examples of third-party documents that may be relied on for such verification, such as government records and check-cashing or funds-transfer service receipts. The rules took effect January 10, 2014. The rules also define “qualified mortgages,” imposing both underwriting standards - for example, a borrower’s debt-to-income ratio may not exceed 43% - and limits on the terms of their loans. Points and fees are subject to a relatively stringent cap, and the terms include a wide array of payments that may be made in the course of closing a loan. Certain loans, including interest-only loans and negative amortization loans, cannot be qualified mortgages.

 

Executive Compensation and Corporate Governance Requirements. The Dodd-Frank Act requires public companies to include, at least once every three years, a separate non-binding “say on pay” vote in their proxy statement by which stockholders may vote on the compensation of the company’s named executive officers. In addition, if such companies are involved in a merger, acquisition, or consolidation, or if they propose to sell or dispose of all or substantially all of their assets, stockholders have a right to an advisory vote on any golden parachute arrangements in connection with such transaction (frequently referred to as “say-on-golden parachute” vote). Other provisions of the Dodd-Frank Act may impact our corporate governance. For instance, the Dodd-Frank Act requires the SEC to adopt rules:

 

  · prohibiting the listing of any equity security of a company that does not have an independent compensation committee; and
  · requiring all exchange-traded companies to adopt claw-back policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.

 

The Dodd-Frank Act also authorizes the SEC to issue rules allowing stockholders to include their own nominations for directors in a company’s proxy solicitation materials. Many provisions of the Dodd-Frank Act require the adoption of additional rules to implement the changes. In addition, the Dodd-Frank Act mandates multiple studies that could result in additional legislative action. Governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

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Regulatory Capital Requirements

 

Regulatory capital rules released by the federal bank regulatory agencies in July 2013 to implement capital standards, referred to as Basel III and developed by an international body known as the Basel Committee on Banking Supervision, impose higher minimum capital requirements for bank holding companies and banks. The rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies with more than $1 billion in total consolidated assets. We collectively refer to these organizations herein as “covered” banking organizations. In certain respects, the rules impose more stringent requirements on “advanced approaches” banking organizations—those organizations with $250 billion or more in total consolidated assets, $10 billion or more in total foreign exposures, or that have opted in to the Basel II capital regime. The requirements in the rules began to phase in on January 1, 2014 for advanced approaches banking organizations, and on January 1, 2015 for other covered banking organizations, including the Company and the Bank. The requirements in the rules were fully phased in by January 1, 2019.

 

The rules impose new and higher risk-based capital and leverage requirements than those previously in place. Specifically, the following minimum capital requirements apply to us:

 

  · a Common Equity Tier 1 capital ratio of 4.5%;
  · a Tier 1 capital ratio of 6%;
  · a total capital ratio of 8%; and
  · a leverage ratio of 4%.

 

Under the rules, Tier 1 capital is redefined to include two components: Common Equity Tier 1 capital and additional Tier 1 capital. The new and highest form of capital, Common Equity Tier 1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as non-cumulative perpetual preferred stock. The rules permit bank holding companies with less than $15 billion in total consolidated assets to continue to include trust preferred securities and cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not in Common Equity Tier 1 capital, subject to certain restrictions. Tier 2 capital consists of instruments that currently qualify in Tier 2 capital plus instruments that the rule has disqualified from Tier 1 capital treatment. Cumulative perpetual preferred stock, formerly includable in Tier 1 capital is now included only in Tier 2 capital. Accumulated other comprehensive income (“AOCI”) is presumptively included in Common Equity Tier 1 capital and often would operate to reduce this category of capital. The rules provided for a one-time opportunity at the end of the first quarter of 2015 for covered banking organization to opt-out of much of this treatment of AOCI. We made this opt-out election and, as a result, will retain the pre-existing treatment for AOCI.

 

In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three measurements (Common Equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer was phased in incrementally over time, becoming fully effective on January 1, 2019, and consists of an additional amount of common equity equal to 2.5% of risk-based assets. As of January 1, 2018, we are required to hold a capital conservation buffer of 1.875%, increasing to 2.5% effective January 1, 2019.

 

In general, the rules have had the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate, certain loans past due 90 days or more or in nonaccrual status, mortgage servicing rights not includable in Common Equity Tier 1 capital, equity exposures, and claims on securities firms, that are used in the denominator of the three risk-based capital ratios. 

 

Volcker Rule

 

Section 619 of the Dodd-Frank Act, known as the “Volcker Rule,” prohibits any bank, bank holding company, or affiliate (referred to collectively as “banking entities”) from engaging in two types of activities: “proprietary trading” and the ownership or sponsorship of private equity or hedge funds that are referred to as “covered funds.” Proprietary trading includes the purchase or sale of principal of any security, derivative, commodity future, or option on any such instrument for the purpose of benefitting from short-term price movements or realizing short-term profits. In December 2013, our primary federal regulators, the Federal Reserve and the FDIC, together with other federal banking agencies and the SEC and the Commodity Futures Trading Commission, finalized a regulation to implement the Volcker Rule.

 

Exceptions apply, however. Trading in U.S. Treasuries, obligations or other instruments issued by a government sponsored enterprise, state or municipal obligations, or obligations of the FDIC is permitted. A banking entity also may trade for the purpose of managing its liquidity, provided that it has a bona fide liquidity management plan. Trading activities as agent, broker or custodian; through a deferred compensation or pension plan; as trustee or fiduciary on behalf of customers; in order to satisfy a debt previously contracted; or in repurchase and securities lending agreements are permitted. Additionally, the Volcker Rule permits banking entities to engage in trading that takes the form of risk-mitigating hedging activities.

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The covered funds that a banking entity may not sponsor or hold an ownership interest in are, with certain exceptions, funds that are exempt from registration under the Investment Company Act of 1940 because they either have 100 or fewer investors or are owned exclusively by “qualified investors” (generally, high net worth individuals or entities). Wholly-owned subsidiaries, joint ventures and acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts (including bank-owned life insurance), public welfare investment funds, and entities formed by the FDIC for the purpose of disposing of assets are not covered funds, and a bank may invest in them. Most securitizations also are not treated as covered funds.

 

As issued on December 10, 2013, the regulation treated collateralized debt obligations backed by trust preferred securities as covered funds and accordingly subject to divestiture. In an interim final rule issued on January 14, 2014, the agencies exempted collateralized debt obligations, or CDOs, issued before May 19, 2010, that were backed by trust preferred securities issued before the same date by a bank with total consolidated assets of less than $15 billion or by a mutual holding company, and that the bank holding the CDO interest had purchased before December 10, 2013, from the Volcker Rule prohibition. This exemption does not extend to CDOs backed by trust-preferred securities issued by an insurance company.

 

Tax Cuts and Jobs Act

 

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was signed into law. The Tax Act includes a number of provisions that impact us, including the following:

 

  · Tax Rate. The Tax Act replaces the graduated corporate tax rates applicable under prior law, which imposed a maximum tax rate of 35%, with a reduced 21% flat tax rate. Although the reduced tax rate generally should be favorable to us by resulting in increased earnings and capital, it will decrease the value of our existing deferred tax assets. Generally accepted accounting principles (“GAAP”) require that the impact of the provisions of the Tax Act be accounted for in the period of enactment. Accordingly, the Company’s net income for the year ended December 31, 2017 was reduced by approximately $239,000, primarily due to a lower valuation of deferred income taxes. See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operation – Results of Operations – Income Tax Expense.

 

  · Employee Compensation. A “publicly held corporation” is not permitted to deduct compensation in excess of $1 million per year paid to certain employees. The Tax Act eliminates certain exceptions to the $1 million limit applicable under prior to law related to performance-based compensation, such as equity grants and cash bonuses that are paid only on the attainment of performance goals. As a result, our ability to deduct certain compensation that may be paid to our most highly compensated employees will now be limited.

 

  · Business Asset Expensing. The Tax Act allows taxpayers immediately to expense the entire cost (instead of only 50%, as under prior law) of certain depreciable tangible property and real property improvements acquired and placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain property). This 100% “bonus” depreciation is phased out proportionately for property placed in service on or after January 1, 2023 and before January 1, 2027 (with an additional year for certain property).

 

  · Interest Expense. The Tax Act limits a taxpayer’s annual deduction of business interest expense to the sum of (i) business interest income and (ii) 30% of “adjusted taxable income,” defined as a business’s taxable income without taking into account business interest income or expense, net operating losses, and, for 2018 through 2021, depreciation, amortization and depletion. Because we generate significant amounts of net interest income, we do not expect to be impacted by this limitation.

 

Proposed Legislation and Regulatory Action

 

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.

 

On May 24, 2018, President Trump signed into law the “Economic Growth, Regulatory Relief and Consumer Protection Act” (the “Regulatory Relief Act”), which amends parts of the Dodd-Frank Act, as well as other laws that involve regulation of the financial industry. While the Regulatory Relief Act keeps in place fundamental aspects of the Dodd-Frank Act’s regulatory framework, it does change the regulatory framework for depository institutions with assets under $10 billion, such as the Bank, and for large depository institutions with assets over $50 billion. The legislation includes a number of provisions which are favorable to bank holding companies with total consolidated assets of less than $10 billion, such as the Company, and also makes changes to consumer mortgage and credit reporting regulations and to the authorities of the agencies that regulate the financial industry. A number of the provisions included in the Regulatory Relief Act require the federal banking agencies to either promulgate regulations or amend existing regulations, and it will likely take some time for these agencies to implement the necessary changes.

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The following is a brief summary of select provisions of the Regulatory Relief Act.

 

·Modified Process for Designating Systemically Important Financial Institutions. The Regulatory Relief Act changes which bank holding companies will be designated as a systemically important financial institution (“SIFI”). Prior to passage of the Regulatory Relief Act, all bank holding companies with assets exceeding $50 billion were automatically designated as SIFIs and were subject to the enhanced prudential standards (“EPS”) of the Dodd-Frank Act, which required these bank holding companies to undergo special stress tests, develop resolution plans, and maintain certain levels of liquidity and financial capacity to absorb losses. The Regulatory Relief Act raised the $50 billion SIFI threshold to $250 billion, but staggered the application of this change for certain institutions, based on size. Upon enactment, bank holding companies with total consolidated assets of less than $100 billion are no longer subject to the EPS of the Dodd-Frank Act. Bank holding companies with total consolidated assets of more than $100 billion but less than $250 billion will no longer be subject to such requirements, beginning 18 months after the date of enactment. Because the Regulatory Relief Act does not amend the regulations that the federal banking agencies have promulgated to implement the EPS, it will likely take some time for these agencies to amend their regulations to account for the new thresholds included in the Regulatory Relief Act.

 

Many of the changes in the Regulatory Relief Act amend provisions of Dodd-Frank Act that apply at the bank holding company level, but not to subsidiary national banks or other insured depository institutions. The Office of the Comptroller of the Currency, or the OCC, and the FDIC have adopted their own counterparts to some EPS for the bank subsidiaries that they regulate, including recovery and resolution planning. The OCC and the FDIC will need to address whether they intend to take similar measures under their regulations and guidance to align asset thresholds with what is reflected in the Regulatory Relief Act.

 

·Provisions that are Favorable to Regional Banks. There are a number of provisions in the Regulatory Relief Act that will have a favorable impact on community banks such as the Bank. These are briefly referenced below.

 

oElimination of Company-Run Stress Tests. The Regulatory Relief Act exempts all banking organizations with less than $250 billion in total consolidated assets from the current requirement to conduct company-run stress tests.

 

oIncrease in Asset Threshold for Requirement to Establish a Risk Committee. The Regulatory Relief Act raises the asset threshold for the requirement that a publicly-traded bank holding company establish a risk committee from $10 billion to $50 billion or more in total consolidated assets.

 

oShort Form Call Reports. The Regulatory Relief Act requires the federal banking agencies to promulgate regulations allowing an insured depository institution with less than $5 billion in total consolidated assets (and that satisfies such other criteria as determined to be appropriate by the agencies) to submit a short-form call report for its first and third quarters of a calendar year.

 

·Consumer Protection Enhancements. The Regulatory Relief Act includes various provisions to address consumer protection challenges facing the credit reporting industry and borrowers in certain credit markets, specifically markets including active duty service members, veterans, and student loan borrowers. The Regulatory Relief Act subjects credit reporting agencies to additional requirements, including requirements to generally provide fraud alerts for consumer files for at least one year and to allow consumers to place security freezes on their credit reports. The Regulatory Relief Act also allows consumers to request that information related to a default on a qualified private student loan be removed from a credit report if the borrower satisfies the requirements of a loan rehabilitation program offered by a private lender. The Regulatory Relief Act prohibits lenders from declaring automatic default in the case of death or bankruptcy of the co-signer of a student loan and requires lenders to release cosigners from obligations related to a student loan in the event of the death of the student borrower. In addition, credit reporting agencies will be required to exclude certain medical debt from veterans’ credit reports.
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Carolina Financial Corporation

 

The Company owns 100% of the outstanding capital stock of the Bank, and therefore is required to be and is registered as a bank holding company under the federal Bank Holding Company Act of 1956 (the “BHCA”). As a result, the Company is primarily subject to the supervision, examination and reporting requirements of the Federal Reserve under the BHCA and its regulations promulgated thereunder. Moreover, as a bank holding company of a bank located in South Carolina, the Company also is subject to the South Carolina Banking and Branching Efficiency Act.

 

Permitted Activities. Under the BHCA, a bank holding company is generally permitted to engage in, or acquire direct or indirect control of more than 5% of the voting shares of any company engaged in the following activities:

 

  · banking or managing or controlling banks;
  · furnishing services to or performing services for our subsidiaries; and
  · any activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

 

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

 

  · factoring accounts receivable;
  · making, acquiring, brokering or servicing loans and usual related activities;
  · leasing personal or real property;
  · operating a non-bank depository institution, such as a savings association;
  · trust company functions;
  · financial and investment advisory activities;
  · conducting discount securities brokerage activities;
  · underwriting and dealing in government obligations and money market instruments;
  · providing specified management consulting and counseling activities;
  · performing selected data processing services and support services;
  · acting as agent or broker in selling credit life insurance and other types of insurance in connection with credit transactions; and
  · performing selected insurance underwriting activities.

 

A bank holding company that meets specified conditions, including that its depository institutions subsidiaries are “well capitalized” and “well managed,” can opt to become a “financial holding company.” On June 20, 2017, an election submitted by the Company to become a financial holding company was declared effective by the Federal Reserve Bank of Richmond. As a financial holding company, we are now permitted to engage in a broader array of activities that are financial in nature or incidental or complimentary to financial activities, including insurance underwriting, sales and brokerage activities, providing financial and investment advisory services, underwriting services and limited merchant banking activities.

 

The Federal Reserve has the authority to order a bank holding company or its subsidiaries to terminate any of these activities or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that the bank holding company’s continued ownership, activity or control constitutes a serious risk to the financial safety, soundness or stability of it or any of its bank subsidiaries.

 

Change in Control. Two statutes, the BHCA and the Change in Bank Control Act (the “CBCA”), together with regulations promulgated under them, require some form of regulatory review before any company may acquire “control” of a bank or a bank holding company. Under the BHCA, control is deemed to exist if a company acquires 25% or more of any class of voting securities of a bank holding company; controls the election of a majority of the members of the board of directors; or exercises a controlling influence over the management or policies of a bank or bank holding company. In guidance issued in 2008, the Federal Reserve has stated that it would not expect control to exist if a person acquires, in aggregate, less than 33% of the total equity of a bank or bank holding company (voting and nonvoting equity), provided such person’s ownership does not include 15% or more of any class of voting securities. Prior Federal Reserve approval is necessary before an entity acquires sufficient control to become a bank holding company. Natural persons, certain non-business trusts, and other entities are not treated as companies (or bank holding companies), and their acquisitions are not subject to review under the BHCA. State laws generally, including South Carolina law, require state approval before an acquirer may become the holding company of a state bank.

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Under the CBCA, a person or company is required to file a notice with the Federal Reserve if it will, as a result of the transaction, own or control 10% or more of any class of voting securities or direct the management or policies of a bank or bank holding company and either if the bank or bank holding company has registered securities or if the acquirer would be the largest holder of that class of voting securities after the acquisition. For a change in control at the holding company level, both the Federal Reserve and the subsidiary bank’s primary federal regulator must approve the change in control; at the bank level, only the bank’s primary federal regulator is involved. Transactions subject to the BHCA are exempt from CBCA requirements. For state banks, state laws, including that of South Carolina, typically require approval by the state bank regulator as well.

 

Source of Strength. There are a number of obligations and restrictions imposed by law and regulatory policy on bank holding companies with regard to their depository institution subsidiaries that are designed to minimize potential loss to depositors and to the FDIC insurance funds in the event that the depository institution becomes in danger of defaulting under its obligations to repay deposits. In accordance with Federal Reserve policy, the Company is required to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances in which it might not otherwise do so. Under the Federal Deposit Insurance Corporate Improvement Act of 1991, or FDICIA, to avoid receivership of its insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” within the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.

 

Under the BHCA, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary, other than a non-bank subsidiary of a bank, upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of a bank holding company. Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or non-bank subsidiaries if the agency determines that divestiture may aid the depository institution’s financial condition.

 

In addition, the “cross guarantee” provisions of the Federal Deposit Insurance Act, (“FDIA”), require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company, but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

 

The FDIA also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general or unsecured senior liability, subordinated liability, general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of the Bank.

 

Further, any capital loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level would be assumed by the bankruptcy trustee and entitled to priority payment.

 

Capital Requirements. The Federal Reserve imposes certain capital requirements on the bank holding company under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are essentially the same as those that apply to the Bank and are described below under “CresCom Bank.” Subject to our capital requirements and certain other restrictions, we are able to borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company. We are also able to raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

 

Dividends. Since the Company is a bank holding company, its ability to declare and pay dividends is dependent on certain federal and state regulatory considerations, including the guidelines of the Federal Reserve. The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the Federal Reserve’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Further, under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.

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In addition, since the Company is a legal entity separate and distinct from the Bank and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of the Bank to pay dividends to it, which is also subject to regulatory restrictions as described below in “CresCom Bank – Dividends.”

 

South Carolina State Regulation. As a South Carolina bank holding company under the South Carolina Banking and Branching Efficiency Act, we are subject to limitations on sale or merger and to regulation by the South Carolina Board of Financial Institutions (the “SCBFI”). We are not required to obtain the approval of the SCBFI prior to acquiring the capital stock of a national bank, but we must notify them at least 15 days prior to doing so. We must obtain approval from the SCBFI prior to engaging in the acquisition of branches, a South Carolina state chartered bank, or another South Carolina bank holding company.

 

CresCom Bank

 

The Bank’s primary federal regulator is the FDIC. In addition, the Bank is regulated and examined by the SCBFI. Deposits in the Bank are insured by the FDIC up to a maximum amount of $250,000 per depositor, per ownership category, pursuant to the provisions of the Dodd-Frank Act.

 

The SCBFI and the FDIC regulate or monitor virtually all areas of the Bank’s operations, including:

 

  · security devices and procedures;
  · adequacy of capitalization and loss reserves;
  · loans;
  · investments;
  · borrowings;
  · deposits;
  · mergers;
  · issuances of securities;
  · payment of dividends;
  · interest rates payable on deposits;
  · interest rates or fees chargeable on loans;
  · establishment of branches;
  · corporate reorganizations;
  · maintenance of books and records; and
  · adequacy of staff training to carry on safe lending and deposit gathering practices.

 

These agencies, and the federal and state laws applicable to the Bank’s operations, extensively regulate various aspects of our banking business, including among other things, permissible types and amounts of loans, investments, and other activities, capital adequacy, branching, interest rates on loans and deposits, maintenance of reserves and the safety and soundness of our banking practices. See additional discussion related to Basel III above.

 

All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

  · internal controls;
  · information systems and audit systems;
  · loan documentation;
  · credit underwriting;
  · interest rate risk exposure; and
  · asset quality.
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Prompt Corrective Action. As an insured depository institution, the Bank is required to comply with the capital requirements promulgated under the Federal Deposit Insurance Act and the prompt corrective action regulations thereunder, which set forth five capital categories, each with specific regulatory consequences. Under these regulations, the categories are:

 

  ·   Well Capitalized — The institution exceeds the required minimum level for each relevant capital measure.  A well capitalized institution (i) has a total capital ratio of 10% or greater, (ii) has a Tier 1 capital ratio of 8% or greater, (iii) has a Common Equity Tier 1 capital ratio of 6.5% or greater, (iv) has a leverage ratio of 5% or greater, and (v) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.
  ·   Adequately Capitalized — The institution meets the required minimum level for each relevant capital measure.  No capital distribution may be made that would result in the institution becoming undercapitalized.  An adequately capitalized institution (i) has a total capital ratio of 8% or greater, (ii) has a Tier 1 capital ratio of 6% or greater, (iii) has a Common Equity Tier 1 capital ratio of 4.5% or greater, and (iv) has a leverage ratio of 4% or greater.
  ·   Undercapitalized — The institution fails to meet the required minimum level for any relevant capital measure.  An undercapitalized institution (i) has a total capital ratio of less than 8%, (ii) has a Tier 1 capital ratio of less than 6%, (iii) has a Common Equity Tier 1 capital ratio of less than 4.5%, or (iv) has a leverage ratio of less than 4%.
  ·   Significantly Undercapitalized — The institution is significantly below the required minimum level for any relevant capital measure.  A significantly undercapitalized institution (i) has a total capital ratio of less than 6%, (ii) has a Tier 1 capital ratio of less than 4%, (iii) has a Common Equity Tier 1 capital ratio of less than 3%, or (iv) has a leverage ratio of less than 3%.
  ·   Critically Undercapitalized — The institution fails to meet a critical capital level set by the appropriate federal banking agency.  A critically undercapitalized institution has a ratio of tangible equity to total assets that is equal to or less than 2%.

 

If the applicable federal regulator determines, after notice and an opportunity for hearing, that the institution is in an unsafe or unsound condition, the regulator is authorized to reclassify the institution to the next lower capital category.

 

If the FDIC determines, after notice and an opportunity for hearing, that a bank is in an unsafe or unsound condition, the regulator is authorized to reclassify the bank to the next lower capital category (other than critically undercapitalized) and require the submission of a plan to correct the unsafe or unsound condition.

 

If a bank is not well capitalized, it cannot accept brokered deposits without prior regulatory approval. 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 FDIC generally 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 FDIC determines 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.

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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.

 

As of December 31, 2018, the Bank was deemed to be “well capitalized.”

 

Standards for Safety and Soundness. The Federal Deposit Insurance Act also requires the federal banking regulatory agencies to prescribe, by regulation or guideline, operational and managerial standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; and (v) asset growth. The agencies also must prescribe standards for asset quality, earnings, and stock valuation, as well as standards for compensation, fees and benefits. The federal banking agencies have adopted regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness to implement these required standards. These guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. Under the regulations, if the FDIC determines that the Bank fails to meet any standards prescribed by the guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIC. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

 

Regulatory Examination. The FDIC also requires the Bank to prepare annual reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with its minimum standards and procedures.

 

All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

  · internal controls;
  · information systems and audit systems;
  · loan documentation;
  · credit underwriting;
  · interest rate risk exposure; and
  · asset quality.

 

Transactions with Affiliates and Insiders. The Company is a legal entity separate and distinct from the Bank and its other subsidiaries. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company or its non-bank subsidiaries. The Company and the Bank are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W.

 

Section 23A of the Federal Reserve Act places limits on the amount of loans or extensions of credit by a bank to any affiliate, including its holding company, and on a bank’s investments in, or certain other transactions with, affiliates and on the amount of advances to third parties collateralized by the securities or obligations of any affiliates of the bank. Section 23A also applies to derivative transactions, repurchase agreements and securities lending and borrowing transactions that cause a bank to have credit exposure to an affiliate. The aggregate of all covered transactions is limited in amount, as to any one affiliate, to 10% of the Bank’s capital and surplus and, as to all affiliates combined, to 20% of the Bank’s capital and surplus. Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements. The Bank is forbidden to purchase low quality assets from an affiliate.

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Section 23B of the Federal Reserve Act, among other things, prohibits an institution from engaging in certain transactions with certain affiliates unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve decides to treat these subsidiaries as affiliates.

 

The Bank is also subject to certain restrictions on extensions of credit to executive officers, directors, certain principal stockholders, and their related interests. Such extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral requirements, as those prevailing at the time for comparable transactions with unrelated third parties and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.

 

Dividends. The Company’s principal source of cash flow, including cash flow to pay dividends to its stockholders, is dividends it receives from the Bank. Statutory and regulatory limitations apply to the Bank’s payment of dividends to the Company. As a South Carolina chartered bank, the Bank is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the SCBFI, the Bank is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SCBFI. The FDIC also has the authority under federal law to enjoin a bank from engaging in what in its opinion constitutes an unsafe or unsound practice in conducting its business, including the payment of a dividend under certain circumstances.

 

Branching. Federal legislation permits out-of-state acquisitions by bank holding companies, interstate branching by banks, and interstate merging by banks. The Dodd-Frank Act removed previous state law restrictions on de novo interstate branching in states such as South Carolina. This change effectively permits out-of-state banks to open de novo branches in states where the laws of such state would permit a bank chartered by that state to open a de novo branch.

 

Anti-Tying Restrictions. Under amendments to the BHCA and Federal Reserve regulations, a bank is prohibited from engaging in certain tying or reciprocity arrangements with its customers. In general, a bank may not extend credit, lease, sell property, or furnish any services or fix or vary the consideration for these on the condition that (i) the customer obtain or provide some additional credit, property, or services from or to the bank, the bank holding company or subsidiaries thereof or (ii) the customer may not obtain some other credit, property, or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended. Certain arrangements are permissible: a bank may offer combined-balance products and may otherwise offer more favorable terms if a customer obtains two or more traditional bank products; and certain foreign transactions are exempt from the general rule. A bank holding company or any bank affiliate also is subject to anti-tying requirements in connection with electronic benefit transfer services.

 

Community Reinvestment Act. The Community Reinvestment Act, (or “CRA”), requires that the FDIC evaluate the record of the Bank in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on our Bank.

 

The Gramm-Leach-Bliley Act, (or “GLBA”), made various changes to the CRA. Among other changes, CRA agreements with private parties must be disclosed and annual CRA reports must be made available to a bank’s primary federal regulator. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a satisfactory CRA rating in its latest CRA examination.

 

On May 21, 2018, the “as of” date of its most recent examination, the Bank received a “satisfactory” CRA rating.

 

Financial Subsidiaries. Under the GLBA, subject to certain conditions imposed by their respective banking regulators, national and state-chartered banks are permitted to form “financial subsidiaries” that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible. The GLBA imposes several safeguards and restrictions on financial subsidiaries, including that the parent bank’s equity investment in the financial subsidiary be deducted from the bank’s assets and tangible equity for purposes of calculating the bank’s capital adequacy. In addition, the GLBA imposes new restrictions on transactions between a bank and its financial subsidiaries similar to restrictions applicable to transactions between banks and non-bank affiliates.

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Consumer Protection Regulations. Activities of the Bank are subject to a variety of statutes and regulations designed to protect consumers. Interest and other charges collected or contracted for by the Bank are subject to state usury laws and federal laws concerning interest rates. The Bank’s loan operations are also subject to federal laws applicable to credit transactions, such as:

 

  · the Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
  · the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
  · the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
  ·   the Community Reinvestment Act, encourages banks to help meet the credit needs of their entire community, including low- and moderate-income areas consistent with safe and sound lending practices;
  · the Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act and Regulation V, as well as the rules and regulations of the FDIC, governing the use and provision of information to credit reporting agencies, certain identity theft protections and certain credit and other disclosures;
    the Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;
  · the Real Estate Settlement Procedures Act and Regulation X, which governs aspects of the settlement process for residential mortgage loans.
  · the Military Lending Act and Service Members Civil Relief Act both protect active duty members and their families from certain lending practices in consumer credit and provide meaningful benefits for Service Members; and
  · the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

 

The deposit operations of the Bank also are subject to:

 

  · the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and
  · the Electronic Funds Transfer Act and Regulation E, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.
  · the Expedited Funds Availability Act, Regulation CC, establishes time limits the bank must follow for making check deposits available for withdrawal or transfer; and
  · the Truth in Savings Act and Regulation DD, which requires depositary institutions to provide certain consumer disclosures.

 

Anti-Money Laundering. Financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls; a designated compliance officer; an ongoing employee training program; and testing of the program by an independent audit function. The Company and the Bank are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and “knowing your customer” in their dealings with foreign financial institutions and foreign customers. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions, and recent laws provide law enforcement authorities with increased access to financial information maintained by banks. Anti-money laundering obligations have been substantially strengthened as a result of the USA Patriot Act, enacted in 2001 and renewed in 2006. Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications. The regulatory authorities have been active in imposing cease and desist orders and money penalty sanctions against institutions that have not complied with these requirements.

 

USA PATRIOT Act/Bank Secrecy Act. The USA PATRIOT Act, amended, in part, the Bank Secrecy Act and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering by enhancing anti-money laundering and financial transparency laws, as well as enhanced information collection tools and enforcement mechanics for the U.S. government, including: (i) requiring standards for verifying customer identification at account opening; (ii) rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iii) reports by nonfinancial trades and businesses filed with the U.S. Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000; and (iv) filing suspicious activities reports if a bank believes a customer may be violating U.S. laws and regulations and requires enhanced due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons. The rule was further enhanced in 2018 by requiring the identification of beneficial owners of each legal entity customer. Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications.

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The Office of Foreign Assets Control, (or “OFAC”), which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify OFAC. The Bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications. The Bank actively checks high-risk OFAC areas such as new accounts, wire transfers and customer files. The Bank performs these checks utilizing software, which is updated each time a modification is made to the lists provided by OFAC and other agencies of Specially Designated Nationals and Blocked Persons.

 

Privacy, Data Security and Credit Reporting. Financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under narrow circumstances, such as the processing of transactions requested by the consumer. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers. It is the Bank’s policy not to disclose any personal information unless required by law.

 

Recent cyber-attacks against banks and other institutions that resulted in unauthorized access to confidential customer information have prompted the Federal banking agencies to issue several warnings and extensive guidance on cyber security. The agencies are likely to devote more resources to this part of their safety and soundness examination than they have in the past.

 

In addition, pursuant to the Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”) and the implementing regulations of the federal banking agencies and Federal Trade Commission, the Bank is required to have in place an “identity theft red flags” program to detect, prevent and mitigate identity theft. The Bank has implemented an identity theft red flags program designed to meet the requirements of the FACT Act and the joint final rules. Additionally, the FACT Act amends the Fair Credit Reporting Act to generally prohibit a person from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and a reasonable opportunity and a reasonable and simple method to opt out of the making of such solicitations.

 

Effect of Governmental Monetary Policies. Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies. The Federal Open Market Committee raised the target range for the federal funds rate by 25 basis points each on December 15, 2016, March 16, 2017, June 15, 2017 and December 14, 2017. During 2018, the rate was increased by 25 basis points on March 21, June 13, September 26 and December 19. The potential for further gradual increases in the federal funds rate depends on the economic outlook.

 

Insurance of Accounts and Regulation by the FDIC. The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC insured institutions. It also may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the bank’s regulatory authority an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

As an FDIC-insured bank, the Bank must pay deposit insurance assessments to the FDIC based on its average total assets minus its average tangible equity. The Bank’s assessment rates are currently based on its risk classification (i.e., the level of risk it poses to the FDIC’s deposit insurance fund). Institutions classified as higher risk pay assessments at higher rates than institutions that pose a lower risk. In addition, following the fourth consecutive quarter (and any applicable phase-in period) where an institution’s total consolidated assets equal or exceed $10 billion, the FDIC will use a performance score and a loss-severity score to calculate an initial assessment rate. In calculating these scores, the FDIC uses an institution’s capital level and regulatory supervisory ratings and certain financial measures to assess an institution’s ability to withstand asset-related stress and funding-related stress. The FDIC also has the ability to make discretionary adjustments to the total score based upon significant risk factors that are not adequately captured in the calculations. In addition to ordinary assessments described above, the FDIC has the ability to impose special assessments in certain instances.

 

The FDIC has raised assessment rates and imposed special assessments on certain institutions during recent years to raise funds. Under the Dodd-Frank Act, the minimum designated reserve ratio for the deposit insurance fund is 1.35% of the estimated total amount of insured deposits. In October 2010, the FDIC adopted a restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.

 

In addition, FDIC insured institutions are required to pay a Financing Corporation assessment to fund the interest on bonds issued to resolve thrift failures in the 1980s. These assessments, which may be revised based upon the level of deposits, will continue until the bonds mature in the years 2017 through 2019. The amount assessed on individual institutions is in addition to the amount, if any, paid for deposit insurance according to the FDIC’s risk-related assessment rate schedules. Assessment rates may be adjusted quarterly to reflect changes in the assessment base.

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The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any practice, condition or violation that might lead to termination of the Bank’s deposit insurance.

 

Incentive Compensation. The Dodd-Frank Act requires the federal bank regulators and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits that could lead to a material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies proposed such regulations in April 2011, which reflected the guidance previously issued in June 2010 by the bank regulators. However, the 2011 proposal was replaced with a new proposal in May 2016, which makes explicit that the involvement of risk management and control personnel includes not only compliance, risk management and internal audit, but also legal, human resources, accounting, financial reporting and finance roles responsible for identifying, measuring, monitoring or controlling risk-taking. A final rule has not yet been adopted.

 

In June 2010, the Federal Reserve, the FDIC and the OCC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

 

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

 

Concentrations in Commercial Real Estate. Concentration risk exists when FDIC-insured institutions deploy too many assets to any one industry or segment. A concentration in commercial real estate is one example of regulatory concern. The interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices guidance (“CRE Guidance”) provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (i) total non-owner-occupied commercial real estate loans, including loans secured by apartment buildings, investor commercial real estate, and construction and land loans, represent 300% or more of an institution’s total risk-based capital and the outstanding balance of the commercial real estate loan portfolio has increased by 50% or more in the preceding three years or (ii) construction and land development loans exceed 100% of capital. The CRE Guidance does not limit banks’ levels of commercial real estate lending activities, but rather guides institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations. On December 18, 2015, the federal banking agencies issued a statement to reinforce prudent risk-management practices related to commercial real estate lending, having observed substantial growth in many commercial real estate asset and lending markets, increased competitive pressures, rising commercial real estate concentrations in banks, and an easing of commercial real estate underwriting standards. The federal bank agencies reminded FDIC-insured institutions to maintain underwriting discipline and exercise prudent risk-management practices to identify, measure, monitor and manage the risks arising from commercial real estate lending. In addition, FDIC-insured institutions must maintain capital commensurate with the level and nature of their commercial real estate concentration risk.

 

Based on the Bank’s loan portfolio as of December 31, 2018, the Bank did not exceed the 300% or the 100% guidelines for commercial real estate loans.

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Item 1A.  Risk Factors

 

Our business is subject to certain risks, including those described below.  If any of the events described in the following risk factors actually occurs then our business, results of operations and financial condition could be materially adversely affected.  More detailed information concerning these risks is contained in other sections of this report, including “Part I, Item 1: Business” and “Part II, Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Risks Related to Our Business

 

Our business may be adversely affected by economic conditions.

 

Our financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services we offer, is highly dependent upon the business environment in the primary markets where we operate and in the U.S. as a whole. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors. While economic conditions in our local markets in South Carolina and North Carolina have improved since the end of the economic recession, concerns still exist over the federal deficit, government spending, and economic risks. A return of recessionary conditions or negative developments in the domestic and international credit markets may significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. Declines in real estate value and sales volumes and high unemployment levels may result in higher than expected loan delinquencies and a decline in demand for our products and services. These negative events may cause us to incur losses and may adversely affect our capital, liquidity, and financial condition.

 

Furthermore, the Federal Reserve, in an attempt to help the overall economy, has among other things, kept interest rates low through its targeted federal funds rate and the purchase of U.S. Treasury and mortgage-backed securities. The Federal Reserve increased the target range by 25 basis points each on December 15, 2016, March 16, 2017, June 15, 2017 and December 14, 2017. During 2018, the rate was increased by 25 basis points on March 21, June 13, September 26 and December 19. The potential for further gradual increases in the federal funds rate depends on the economic outlook. As the federal funds rate increases, market interest rates will likely rise, which may negatively impact the housing markets and the U.S. economic recovery.

 

On July 27, 2017, the Chief Executive of the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it intends to stop persuading or compelling banks to submit rates for the calibration of LIBOR to the administrator of LIBOR after 2021. The announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. It is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR and it is impossible to predict the effect of any such alternatives on the value of LIBOR-based securities and variable rate loans, subordinated debentures, or other securities or financial arrangements, give LIBOR’s role in determining market interest rates globally. Uncertainty as to the nature of alternative reference rates and as to potential changes or other reforms to LIBOR may adversely affect LIBOR rates and other interest rates. In the event that a published LIBOR rate is unavailable after 2021, the value of certain of the Company’s assets and liabilities could be adversely affected. Currently, the manner and impact of this transition and related developments, as well as the effect of these developments on our funding costs, securities portfolio and business, is uncertain.

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Our mortgage banking profitability could be significantly reduced if we are not able to originate and resell a high volume of mortgage loans.

 

Mortgage production, especially refinancing activity, typically declines in a rising interest rate environment. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking business depends in large part upon our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (i) the existence of an active secondary market and (ii) our ability to profitably sell loans or securities into that market. As our level of mortgage production declines, the profitability from our mortgage operations will depend upon our ability to reduce our costs commensurate with the reduction of revenue from our mortgage operations.

 

Our ability to originate and sell mortgage loans readily is dependent upon the availability of an active secondary market for single-family mortgage loans, which in turn depends in part upon the continuation of programs currently offered by the government sponsored entities, or GSEs, and other institutional and non-institutional investors. These entities account for a substantial portion of the secondary market in residential mortgage loans. Because the largest participants in the secondary market are government-sponsored enterprises whose activities are governed by federal law, any future changes in laws that significantly affect the activity of the GSEs could, in turn, adversely affect our operations. In September 2008, the GSEs were placed into conservatorship by the U.S. government. Although to date the conservatorship has not had a significant or adverse effect on our operations, it remains unclear whether these events or further changes would significantly and adversely affect our operations. The government and others have provided options to reform the GSEs, but the results of any such reform, and their impact on us, are difficult to predict. To date, no reform proposal has been enacted. In addition, our ability to sell mortgage loans readily is dependent upon our ability to remain eligible for the programs offered by the GSEs and other institutional and non-institutional investors. Our ability to remain eligible to originate and securitize government insured loans may also depend on having an acceptable peer-relative delinquency ratio for FHA loans and maintaining a delinquency rate with respect to Ginnie Mae pools that are below Ginnie Mae guidelines.

 

Any significant impairment of our eligibility with any of the GSEs would materially adversely affect our operations. Further, the criteria for loans to be accepted under such programs may be changed from time-to-time by the sponsoring entity which could result in a lower volume of corresponding loan originations. The profitability of participating in specific programs may vary depending on a number of factors, including our administrative costs of originating and purchasing qualifying loans and our costs of meeting such criteria.

 

An increase in our nonperforming assets would adversely impact our earnings.

 

Our nonperforming assets may increase in future periods. Nonperforming assets adversely affect our net income in various ways. We do not record interest income on non-accrual loans or investments or on real estate owned. We must establish an allowance for loan losses that reserves for losses inherent in the loan portfolio that are both probable and reasonably estimable through current period provisions for loan losses, which are recorded as a charge to income. From time to time, we also write down the other real estate owned portfolio to reflect changing market values. Additionally, there are legal fees associated with the resolution of problem assets as well as carrying costs such as taxes, insurance and maintenance related to the other real estate owned. Further, the resolution of nonperforming assets requires the active involvement of management, which can distract them from our overall supervision of operations and other income-producing activities.

 

We could record other-than-temporary impairment on our securities portfolio. In addition, we may not receive full future interest payments on these securities.

 

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

 

At December 31, 2018, the Company had 214 individual securities available-for-sale in an unrealized loss position. The Company believes, based on OTTI evaluations, that the deterioration in the value of these securities is attributable primarily to changes in interest rates. There are three additional trust preferred securities classified as available-for-sale securities that had OTTI expense recorded in prior years, but did not incur OTTI expense during fiscal 2018, 2017 or 2016. Management believes that there are no other securities other-than-temporarily impaired at December 31, 2018. The Company does not intend to sell these securities, and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. Management continues to monitor these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of the securities may be sold or are other-than-temporarily impaired, which would require a charge to earnings in such periods.

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A number of factors or combinations of factors could require us to conclude in one or more future reporting periods that an unrealized loss that exists with respect to our securities portfolio constitutes additional impairment that is other than temporary, which could result in material losses to us. These factors include, but are not limited to, a continued failure by an issuer to make scheduled interest payments, an increase in the severity of the unrealized loss on a particular security, an increase in the continuous duration of the unrealized loss without an improvement in value or changes in market conditions and/or industry or issuer specific factors that would render us unable to forecast a full recovery in value. In addition, the fair values of securities could decline if the overall economy and the financial condition of some of the issuers continue to deteriorate and there remains limited liquidity for these securities.

 

We may not be able to continue to support the realization of our deferred tax asset.

 

We calculate income taxes in accordance with the FASB Accounting Standards Codification (“ASC”) Topic 740, Income Taxes, which requires the use of the asset and liability method. In accordance with this, we regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered from reversals of deferred tax liabilities, potential utilization of net operating loss carrybacks, tax planning strategies and future taxable income. At December 31, 2018, our net deferred tax asset was $5.8 million. We recognized the deferred tax asset because management believes, based on earnings and detailed financial projections, that it is more likely than not that we will have sufficient future earnings to utilize this asset to offset future income tax liabilities. Realization of a deferred tax asset requires us to apply significant judgment and is inherently speculative because it requires the future occurrence of circumstances that cannot be predicted with certainty. There can be no assurance that we will achieve sufficient future taxable income as the basis for the ultimate realization of our deferred tax asset and therefore we may have to establish a full or partial valuation allowance at some point in the future. If we determine that a valuation allowance is necessary, this would require us to incur a charge to operations that would adversely affect our capital position. There is no assurance that we will be able to continue to recognize any, or all, of the deferred tax asset for regulatory capital purposes.

 

We may be terminated as a servicer of mortgage loans, be required to repurchase a mortgage loan or reimburse investors for credit losses on a mortgage loan, or incur costs, liabilities, fines and other sanctions if we fail to satisfy our servicing obligations, including our obligations with respect to mortgage loan foreclosure actions.

 

We act as servicer for approximately $4.0 billion of mortgage loans owned by third parties as of December 31, 2018. As a servicer for those loans we have certain contractual obligations, including foreclosing on defaulted mortgage loans or, to the extent applicable, considering alternatives to foreclosure such as loan modifications or short sales. If we commit a material breach of our obligations as servicer, we may be subject to termination as servicer if the breach is not cured within a specified period of time following notice, causing us to lose servicing income.

 

In some cases, we may be contractually obligated to repurchase a mortgage loan or reimburse the investor for credit losses incurred on the loan as a remedy for servicing errors with respect to the loan. If we have increased repurchase obligations because of claims that we did not satisfy our obligations as a servicer, or increased loss severity on such repurchases, we may have a significant reduction to net servicing income within our mortgage banking noninterest income. We may incur costs if we are required to, or if we elect to, re-execute or re-file documents or take other action in our capacity as a servicer in connection with pending or completed foreclosures. We may incur litigation costs if the validity of a foreclosure action is challenged by a borrower. If a court were to overturn a foreclosure because of errors or deficiencies in the foreclosure process, we may have liability to the borrower and/or to any title insurer of the property sold in foreclosure if the required process was not followed. These costs and liabilities may not be legally or otherwise reimbursable to us. In addition, if certain documents required for a foreclosure action are missing or defective, we could be obligated to cure the defect or repurchase the loan. We may incur liability to securitization investors relating to delays or deficiencies in our processing of mortgage assignments or other documents necessary to comply with state law governing foreclosures. The fair value of our mortgage servicing rights may be negatively affected to the extent our servicing costs increase because of higher foreclosure costs. We may be subject to fines and other sanctions imposed by federal or state regulators as a result of actual or perceived deficiencies in our foreclosure practices or in the foreclosure practices of other mortgage loan servicers. Any of these actions may harm our reputation or negatively affect our home lending or servicing business.

 

We may be required to repurchase mortgage loans or indemnify buyers against losses in some circumstances, which could harm liquidity, results of operations and financial condition.

 

When mortgage loans are sold, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to purchasers, guarantors and insurers, including the government sponsored enterprises, about the mortgage loans and the manner in which they were originated. Whole loan sale agreements require repurchase or substitute mortgage loans, or indemnification of buyers against losses, in the event we breach these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of early payment default of the borrower on a mortgage loan. With respect to loans that are originated through our broker or correspondent channels, the remedies available against the originating broker or correspondent, if any, may not be as broad as the remedies available to purchasers, guarantors and insurers of mortgage loans against us. We face further risk that the originating broker or correspondent, if any, may not have financial capacity to perform remedies that otherwise may be available. Therefore, if a purchaser, guarantor or insurer enforces its remedies against us, we may not be able to recover losses from the originating broker or correspondent. If repurchase and indemnity demands increase and such demands are valid claims and are in excess of our provision for potential losses, our liquidity, results of operations and financial condition may be adversely affected.

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Our decisions regarding credit risk and reserves for loan losses may materially and adversely affect our business.

 

Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, our loans and other extensions of credit may not be repaid. The risk of nonpayment is affected by a number of factors, including:

 

  · the duration of the credit;
  · credit risks of a particular customer;
  · changes in economic and industry conditions; and
  · in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.

 

We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:

 

  · an ongoing review of the quality, mix, and size of our overall loan portfolio;
  · our historical loan loss experience;
  · evaluation of economic conditions;
  · regular reviews of loan delinquencies and loan portfolio quality; and
  · the amount and quality of collateral, including guarantees, securing the loans.

 

There is no precise method of predicting credit losses; therefore, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income, and possibly our capital.

 

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

 

We may have higher loan losses than we have allowed for in our allowance for loan losses.

 

Like all financial institutions, we maintain an allowance for loan losses to provide for probable losses caused by customer loan defaults. The allowance for loan losses may not be adequate to cover actual loan losses, and in this case additional and larger provisions for loan losses would be required to replenish the allowance. Provisions for loan losses are a direct charge against income.

 

We establish the amount of the allowance for loan losses based on historical loss rates, as well as estimates and assumptions about future events. Because of the extensive use of estimates and assumptions, our actual loan losses could differ, possibly significantly, from our estimate. We believe that our allowance for loan losses is adequate to provide for probable losses, but it is possible that the allowance for loan losses will need to be increased for credit reasons or that regulators will require us to increase this allowance. Either of these occurrences could materially and adversely affect our earnings and profitability.

 

A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market could hurt our business.

 

A significant portion of our loan portfolio is secured by real estate. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in our primary market areas could result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which could be exacerbated by potential climate change and may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.

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We have a concentration of credit exposure in commercial real estate and challenges faced by the commercial real estate market could adversely affect our business, financial condition, and results of operations.

 

As of December 31, 2018, we had approximately $1.0 billion in loans outstanding to borrowers whereby the collateral securing the loan was commercial real estate, representing approximately 40.9% of our total loans outstanding as of that date. Approximately 29.7%, or $298.7 million, of this real estate are owner-occupied properties. Commercial real estate loans are generally viewed as having more risk of default than residential real estate loans. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. Cash flows may be affected significantly by general economic conditions, and a downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our level of nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the related provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

 

The banking regulators are giving commercial real estate lending greater scrutiny, and may require banks with higher levels of commercial real estate loans to implement more stringent underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital levels as a result of commercial real estate lending growth and exposures.

 

Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.

 

At December 31, 2018, commercial business loans comprised 14.2% of our total loan portfolio. Our commercial business loans are originated primarily based on the identified cash flow and general liquidity of the borrower and secondarily on the underlying collateral provided by the borrower and/or repayment capacity of any guarantor. The borrower’s cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectable and inventories may be obsolete or of limited use. In addition, business assets may depreciate over time, may be difficult to appraise, and may fluctuate in value based on the success of the business. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral value provided by the borrower and liquidity of the guarantor.

 

Further downturns or a slower recovery in the real estate markets in our primary market areas could significantly adversely impact our business.

 

Our primary market areas are the Coastal, Midlands, and Upstate regions of South Carolina, including the Charleston (Charleston, Dorchester and Berkeley Counties), Myrtle Beach (Horry and Georgetown Counties), Columbia (Richland and Lexington Counties), and the Upstate (Greenville and Spartanburg Counties) market areas. Our primary market areas in North Carolina include Wilmington (New Hanover County), Raleigh-Durham (Durham and Wake Counties) and the surrounding southeastern coastal region of North Carolina (Bladen, Brunswick, Columbus, Cumberland, Duplin and Robeson Counties).

 

The Company’s primary markets are heavily influenced the military, the medical industry, national and international industries, tourism, retirement living, retail and real estate. If economic conditions were to deteriorate in these markets, the industries in our markets could suffer, which could impact our business. The real estate markets experienced a significant decline in these markets in recent years and, if these economic drivers were to experience further downturns or recover more slowly than expected, real estate in the Company’s markets may experience further declines. If real estate values in our markets decline, the collateral for these loans will provide less security. As a result, the borrower’s ability to pay, or the Company’s ability to recover on defaulted loans by selling the underlying collateral, would be diminished.

 

Our focus on lending to small to mid-sized community-based businesses may increase our credit risk.

 

Most of our commercial business and commercial real estate loans are made to small business or middle market customers. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the markets in which we operate negatively impact this important customer sector, our results of operations and financial condition and the value of our common stock may be adversely affected. Moreover, a portion of these loans have been made by us in recent years and the borrowers may not have experienced a complete business or economic cycle. Furthermore, the deterioration of our borrowers’ businesses may hinder their ability to repay their loans with us, which could have a material adverse effect on our financial condition and results of operations.

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We face strong competition for customers, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract customers.

 

The banking business is highly competitive, and we experience competition in our markets from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in our primary market areas and elsewhere. We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established, larger financial institutions. These institutions offer some services, such as extensive and established branch networks, that we do not provide. There is a risk that we will not be able to compete successfully with other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits, resulting in reduced profitability. In addition, competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us. 

 

The accuracy of our financial statements and related disclosures could be affected if the judgments, assumptions or estimates used in our critical accounting policies are inaccurate.

 

The preparation of financial statements and related disclosure in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are included in the section captioned “Management’s Discussion and Analysis of Results of Operations and Financial Condition”, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider “critical” because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures.

 

Our funding sources may prove insufficient to replace deposits and support future growth.

 

We rely on customer deposits, including brokered deposits, advances from the Federal Home Loan Bank of Atlanta (the “FHLB”) and the Federal Reserve, and other borrowings to fund operations. Although the Company has historically been able to replace maturing deposits and advances, if desired, no assurance can be given that we would be able to replace such funds in the future if the financial condition of the FHLB or programs sponsored by the Federal Reserve, regulatory restrictions on brokered deposits or regulatory restrictions on the pricing of local deposits or other market conditions were to change. In addition, certain borrowing sources are on a secured basis. The FHLB has become more restrictive on the types of collateral it will accept and the amount of borrowings allowed on acceptable collateral. Due to changes applied by rating agencies on bonds, changes in collateral requirements or deteriorating loan quality, outstanding borrowings could be required to be repaid, incurring prepayment penalties. Our financial flexibility will be severely constrained if we are unable to maintain access to funding at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future operations, our revenues may not increase proportionally to cover these costs. In addition, Crescent Mortgage Company may fund mortgage loans held for sale through a line of credit with the Bank. A decline in economic conditions could affect Crescent Mortgage Company’s ability to fund loans held for sale.

 

Our operating results may fluctuate based upon the results of our mortgage subsidiary, Crescent Mortgage Company.

 

There are a number of items that could adversely affect the volumes and margin of the Company’s mortgage banking operations. These include, but are not limited to, the Federal Reserve’s monetary policy including its quantitative easing program, aggressively low rates, reduction in prices paid by the mortgage banking aggregators, aggressive competition, the housing market recovery, the status and financial condition of the FNMA and FHLMC, potential changes in FNMA and FHLMC lending guidelines and programs, proposed changes in the FHA lending requirements, extensive regulatory changes and liquidity. Should these factors significantly impact production of mortgages, it is likely that the Company’s earnings would be adversely affected.

 

Our mortgage subsidiary’s operations are exposed to significant repurchase risk.

 

Crescent Mortgage Company is exposed to significant repurchase risk on mortgage loan production related to potential reimbursements for loans sold to third parties for borrower fraud, underwriting and documentation issues, early defaults and prepayments of sold loans. If the Company experiences significant losses related to repurchase risk, it is possible that the reserve established for such exposure is not adequate. The Company continues to receive repurchase requests. The Company evaluates each request and provides estimated reserves as necessary. We believe that the reserve related to repurchase risk is adequate to absorb probable losses; however, we cannot predict these losses or whether our reserve will be adequate. Any of these occurrences could materially and adversely affect our business, financial condition and profitability.

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The value of our loan servicing portfolio may become impaired in the future.

 

As of December 31, 2018, the Company serviced approximately $4.0 billion of loans. At that date, our mortgage loan servicing rights were recorded as an asset with a carrying value of approximately $32.9 million. We expect that our loan servicing portfolio will increase in the future. If interest rates decline and the actual and expected mortgage loan prepayment rates increase or other factors that cause a reduction of the valuation of our mortgage servicing asset, the Company could incur an impairment of its mortgage loan servicing asset.

 

Hurricanes and other natural disasters may adversely affect loan portfolios and operations and increase the cost of doing business.

 

The Company operates in markets that are susceptible to hurricanes and other natural disasters. Large-scale natural disasters may significantly affect loan portfolios by damaging properties pledged as collateral, affecting the economies our borrowers live in, and by impairing the ability of the borrower to repay their loans.

 

Changes in prevailing interest rates may reduce our profitability.

 

Our results of operations depend in large part upon the level of our net interest income, which is the difference between interest income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Depending on the terms and maturities of our assets and liabilities, we believe it is more likely than not a significant change in interest rates could have a material adverse effect on our profitability. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities, and pricing of our assets and liabilities, our efforts may not be effective and our financial condition and results of operations could suffer.

 

We are dependent on key individuals, and the loss of one or more of these key individuals could curtail our growth and adversely affect our prospects.

 

Jerold L. Rexroad, the Company’s President and Chief Executive Officer, has extensive and long-standing ties within our primary markets. Mr. Rexroad has substantial experience in banking operations, correspondent/wholesale mortgage operations, investment securities, and mergers and acquisitions. The services of Mr. Rexroad would be difficult to replace and our business and development could be materially and adversely affected.

 

David L. Morrow, the Bank’s Chief Executive Officer, also has extensive and long-standing ties within our primary markets and substantial commercial lending experience within our Charleston and Myrtle Beach markets. The services of Mr. Morrow would be difficult to replace and our business and development could be materially and adversely affected.

 

Fowler C. Williams, Crescent Mortgage Company’s President and Chief Executive Officer, has extensive knowledge and long-standing ties with the mortgage industry. The services of Mr. Williams would be difficult to replace and our wholesale mortgage company results could be materially and adversely affected.

 

M.J. Huggins, III, the Company’s Executive Vice President and Secretary, and the Bank’s President, has extensive and long-standing ties within our primary markets and substantial commercial and retail lending experience. The services of Mr. Huggins would be difficult to replace and our business and development could be materially and adversely affected.

 

Our success also depends, in part, on our continued ability to attract and retain experienced commercial and mortgage loan officers, as well as other management personnel. Competition for personnel is intense, and we may not be successful in attracting or retaining qualified personnel. Our failure to compete for these personnel, or the loss of the services of several of such key personnel, could adversely affect our business strategy and seriously harm our business, results of operations, and financial condition.

 

The Dodd-Frank Act may have a material adverse effect on our operations.

 

The Dodd-Frank Act imposes significant regulatory and compliance changes on banks and bank holding companies. The key effects of the Dodd-Frank Act on our business are:

 

  · changes to regulatory capital requirements;
  · exclusion of hybrid securities, including trust preferred securities, issued on or after May 19, 2010 from Tier 1 capital;
  · creation of new government regulatory agencies (such as the Financial Stability Oversight Council, which oversees systemic risk, and the CFPB, which develops and enforces rules for bank and non-bank providers of consumer financial products);
  · potential limitations on federal preemption;
  · changes to deposit insurance assessments;
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  · regulation of debit interchange fees we earn;
  · changes in retail banking regulations, including potential limitations on certain fees we may charge; and
  · changes in regulation of consumer mortgage loan origination and risk retention.

 

In addition, the Dodd-Frank Act restricts the ability of banks to engage in certain proprietary trading or to sponsor or invest in private equity or hedge funds. The Dodd-Frank Act also contains provisions designed to limit the ability of insured depository institutions, their holding companies and their affiliates to conduct certain swaps and derivatives activities and to take certain principal positions in financial instruments.

 

Some provisions of the Dodd-Frank Act became effective immediately upon its enactment. Many provisions, however, will require regulations to be promulgated by various federal agencies in order to be implemented, some but not all of which have been proposed or finalized by the applicable federal agencies. The provisions of the Dodd-Frank Act may have unintended effects, which will not be clear until after implementation. Certain changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements. Failure to comply with the new requirements may negatively impact our results of operations and financial condition. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to investors in our common stock.

On May 24, 2018, President Trump signed into law the “Economic Growth, Regulatory Relief and Consumer Protection Act,” or the Regulatory Relief Act, which amends parts of the Dodd-Frank Act, as well as other laws that involve regulation of the financial industry. While the Regulatory Relief Act keeps in place fundamental aspects of the Dodd-Frank Act’s regulatory framework, it does change the regulatory framework for depository institutions with assets under $10 billion, such as the Bank, as well as easing some requirements for larger depository institutions. As more fully discussed under “Supervision and Regulation—Proposed Legislation and Regulatory Action,” the legislation includes a number of provisions which are favorable to bank holding companies with total consolidated assets of less than $10 billion, such as the Company, and also makes changes to consumer mortgage and credit reporting regulations and to the authorities of the agencies that regulate the financial industry. Because a number of the provisions included in the Regulatory Relief Act require the federal banking agencies to undertake notice and comment rulemaking, it will likely take some time before these provisions are fully implemented.

The final Basel III capital rules generally require insured depository institutions and their holding companies to hold more capital, which could adversely affect our financial condition and operations.

 

On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDIC adopted the same provisions in the form of an “interim final.”  The requirements in the rule began to phase in on January 1, 2014 for advanced approaches banking organizations, and on January 1, 2015 for other covered banking organizations, including the Company and the Bank. The requirements in the rule were fully phased in by January 1, 2019. These rules substantially amend the regulatory risk-based capital rules applicable to us.  

 

The final rules increase capital requirements and generally include two new capital measurements that will affect us, a risk-based Common Equity Tier 1 ratio and a capital conservation buffer. Common Equity Tier 1 (“CET1”) capital is a subset of Tier 1 capital and is limited to common equity (plus related surplus), retained earnings, accumulated other comprehensive income and certain other items. Other instruments that have historically qualified for Tier 1 treatment, including non-cumulative perpetual preferred stock, are consigned to a category known as additional Tier 1 capital and must be phased out over a period of nine years beginning in 2015. The rules permit bank holding companies with less than $15 billion in assets (such as us) to continue to include trust preferred securities and non-cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not CET1. Tier 2 capital consists of instruments that have historically been placed in Tier 2, as well as cumulative perpetual preferred stock.

 

The final rules adjust all three categories of capital by requiring new deductions from and adjustments to capital that will result in more stringent capital requirements and may require changes in the ways we do business. Among other things, the current rule on the deduction of mortgage servicing assets from Tier 1 capital has been revised in ways that are likely to require a greater deduction than we currently make and that will require the deduction to be made from CET1.  We closely monitor our mortgage servicing assets, and we expect to maintain our mortgage servicing asset at levels that approximate the deduction thresholds through a combination of sales of portions of these assets from time to time either on a flowing basis as we originate mortgages or through bulk sale transactions. Additionally, any gains on sales from mortgage loans sold into securitizations must be deducted in full from CET1. 

29
 

Beginning in 2015, our minimum capital requirements were increased to (i) a CET1 ratio of 4.5%, (ii) a Tier 1 capital (CET1 plus Additional Tier 1 capital) of 6% and (iii) a total capital ratio of 8%. Our leverage ratio requirement will remain at the 4% level now required. Beginning in 2016, a capital conservation buffer began to phase in over three years, ultimately resulting in a requirement of 2.5% on top of the CET1, Tier 1 and total capital requirements, resulting in a require CET1 ratio of 7%, a Tier 1 ratio of 8.5%, and a total capital ratio of 10.5%. Failure to satisfy any of these three capital requirements will result in limits on paying dividends, engaging in share repurchases and paying discretionary bonuses. These limitations will establish a maximum percentage of eligible retained income that could be utilized for such actions. While the final rules will result in higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to us.

 

In addition to the higher required capital ratios and the new deductions and adjustments, the final rules increased the risk weights for certain assets, meaning that we will have to hold more capital against these assets. For example, commercial real estate loans that do not meet certain new underwriting requirements must be risk-weighted at 150%, rather than the previous requirement of 100%. There are also new risk weights for unsettled transactions and derivatives. We also are required to hold capital against short-term commitments that are not unconditionally cancelable; currently, there are no capital requirements currently for these off-balance sheet assets.

 

In addition, in the current economic and regulatory environment, bank regulators may impose capital requirements that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Implementation of changes to asset risk weightings for risk-based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, could result in management modifying our business strategy and could limit our ability to make distributions, including paying dividends or buying back our shares.

 

We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

 

The federal Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by OFAC. Federal and state bank regulators also have begun to focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient we would be subject to liability, including fines and regulatory actions, such as restrictions on our ability to pay dividends, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.

 

Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.

 

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Since 2013, the CFPB has issued several rules on mortgage lending, notably a rule requiring all home mortgage lenders to determine a borrower’s ability to repay the loan.  Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations.  In either case, we may find it necessary to tighten our mortgage loan underwriting standards in response to the CFPB rules, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

30
 

The requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain executive management and qualified board members.

 

Our common stock was registered under the Exchange Act in 2014, thereby subjecting the Company to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act, the Dodd-Frank Act, and other applicable securities rules and regulations. Compliance with these rules and regulations have and will continue to increase our legal and financial compliance costs, make some activities more difficult, time-consuming or costly and increase demand on our systems and resources. The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and operating results. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. In order to maintain and, if required, improve our disclosure controls and procedures and internal control over financial reporting to meet this standard, significant resources and management oversight may be required. As a result, management’s attention may be diverted from other business concerns, which could adversely affect our business and operating results. Although we have hired additional employees to comply with these requirements, we may need to hire more employees in the future or engage outside consultants, which will increase our costs and expenses.

 

In addition, changing laws, regulations and standards relating to corporate governance and public disclosure are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to their application and practice, regulatory authorities may initiate legal proceedings against us and our business may be adversely affected.

 

We also expect that being a public reporting company, our higher market capitalization, and these new rules and regulations will increase the costs of our director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These factors could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee and compensation committee, and qualified executive officers.

 

As a result of disclosure of information in this report and in filings required of a public company, our business and financial condition will become more visible, which may result in threatened or actual litigation, including by competitors and other third parties. If such claims are successful, our business and operating results could be adversely affected, and even if the claims do not result in litigation or are resolved in our favor, these claims, and the time and resources necessary to resolve them, could divert the resources of our management and adversely affect our business and operating results.

 

We may be adversely affected by the soundness of other financial institutions.

 

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by the bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the bank. Any such losses could have a material adverse effect on our financial condition and results of operations.

 

We may face risks as we seek to expand through acquisitions or mergers.

 

From time to time, we seek to acquire other financial institutions or parts of those institutions. We may also expand into new markets or lines of business or offer new products or services. These activities would involve a number of risks, including:

 

  · the potential inaccuracy of the estimates and judgments used to evaluate credit, operations, management, and market risks with respect to a target institution;
  · the time and costs of evaluating new markets, hiring or retaining experienced local management, and opening new offices and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;
  · the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse effects on our results of operations; and
  · the risk of loss of key employees and customers.

31
 

We depend on the accuracy and completeness of information about clients and counterparties and our financial condition could be adversely affected if we rely on misleading information.

 

In deciding whether to extend credit or to enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information, which we do not independently verify. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, we may assume that a customer’s audited financial statements conform with generally accepted accounting principles (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.

 

Our ability to pay cash dividends is limited, and we may be unable to pay future dividends even if we desire to do so.

 

The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the Federal Reserve’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. In addition, under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.

 

Our ability to pay cash dividends may be limited by regulatory restrictions, by our Bank’s ability to pay cash dividends to the Company and by our need to maintain sufficient capital to support our operations. As a South Carolina chartered bank, the Bank is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the SCBFI, the Bank is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SCBFI. If our Bank is not permitted to pay cash dividends to the Company, it is unlikely that we would be able to pay cash dividends on our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, and if declared by our board of directors. Although we have historically paid cash dividends on our common stock, we are not required to do so and our board of directors could reduce or eliminate our common stock dividend in the future.

 

A failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers or other third parties, including as a result of cyber-attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs, and cause losses.

 

We rely heavily on communications and information systems to conduct our business. Information security risks for financial institutions such as ours have generally increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, and terrorists, activists, and other external parties. As customer, public, and regulatory expectations regarding operational and information security have increased, our operating systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, and data processing systems, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunication outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and as described below, cyber-attacks. 

32
 

As noted above, our business relies on our digital technologies, computer and email systems, software and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems, networks, and our customers’ devices may become the target of cyber-attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of our or our customers’ or other third parties’ confidential information. Third parties with whom we do business or that facilitate our business activities, including financial intermediaries, or vendors that provide service or security solutions for our operations, and other unaffiliated third parties could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.

 

While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. Our risk and exposure to these matters remains heightened because of the evolving nature of these threats. As a result, cyber security and the continued development and enhancement of our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and clients, or cyber-attacks or security breaches of the networks, systems or devices that our clients use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputation damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could have a material effect on our results of operations or financial condition.

 

Negative public opinion surrounding our Company and the financial institutions industry generally could damage our reputation and adversely impact our earnings and our ability to make loans or to acquire deposits.

 

Reputation risk, or the risk to our business, earnings and capital from negative public opinion surrounding our company and the financial institutions industry generally, is inherent in our business. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action. Although we take steps to minimize reputation risk in dealing with our clients and communities, this risk will always be present given the nature of our business.

33
 

Risks Related to Our Common Stock

 

Our stock price may be volatile, which could result in losses to our investors and litigation against us.

 

Several factors could cause our stock price to fluctuate substantially in the future. These factors include but are not limited to: actual or anticipated variations in earnings, changes in analysts’ recommendations or projections, our announcement of developments related to our businesses, operations and stock performance of other companies deemed to be peers, new technology used or services offered by traditional and non-traditional competitors, news reports of trends, irrational exuberance on the part of investors, new federal banking regulations, and other issues related to the financial services industry. Our stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to our performance. General market declines or market volatility in the future, especially in the financial institutions sector, could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Moreover, in the past, securities class action lawsuits have been instituted against some companies following periods of volatility in the market price of its securities. We could in the future be the target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources from our normal business.

 

Future sales of our stock by our stockholders or the perception that those sales could occur may cause our stock price to decline.

 

Although our common stock is listed on the Nasdaq Global Market under the symbol “CARO,” the trading volume in our common stock is lower than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the relatively low trading volume of our common stock, significant sales of our common stock in the public market, or the perception that those sales may occur, could cause the trading price of our common stock to decline or to be lower than it otherwise might be in the absence of those sales or perceptions.

 

Economic and other circumstances may require us to raise capital at times or in amounts that are unfavorable to us. If we have to issue shares of common stock, they will dilute the percentage ownership interest of existing stockholders and may dilute the book value per share of our common stock and adversely affect the terms on which we may obtain additional capital.

 

We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments or to strengthen our capital position. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control and our financial performance. We cannot provide assurance that such financing will be available to us on acceptable terms or at all, or if we do raise additional capital that it will not be dilutive to existing stockholders.

 

If we determine, for any reason, that we need to raise capital, our board generally has the authority, without action by or vote of the stockholders, to issue all or part of any authorized but unissued shares of stock for any corporate purpose, including issuance of equity-based incentives under or outside of our equity compensation plans. Additionally, we are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur. Any issuance of additional shares of stock will dilute the percentage ownership interest of our stockholders and may dilute the book value per share of our common stock. Shares we issue in connection with any such offering will increase the total number of shares and may dilute the economic and voting ownership interest of our existing stockholders.

 

Our board of directors may issue shares of preferred stock that would adversely affect the rights of our common stockholders.

 

Our authorized capital stock includes 1,000,000 shares of preferred stock of which no preferred shares are issued and outstanding. Our board of directors, in its sole discretion, may designate and issue one or more series of preferred stock from the authorized and unissued shares of preferred stock. Subject to limitations imposed by law or our certificate of incorporation, our board of directors is empowered to determine:

 

  · the designation of, and the number of, shares constituting each series of preferred stock;
  · the dividend rate for each series;
  · the terms and conditions of any voting, conversion and exchange rights for each series;
  · the amounts payable on each series on redemption or our liquidation, dissolution or winding-up;
  · the provisions of any sinking fund for the redemption or purchase of shares of any series; and
  · the preferences and the relative rights among the series of preferred stock.

 

We could issue preferred stock with voting and conversion rights that could adversely affect the voting power of the shares of our common stock and with preferences over the common stock with respect to dividends and in liquidation.

34
 

Our securities are not FDIC insured.

 

Our securities, including our common stock, are not savings or deposit accounts or other obligations of the Bank, are not insured by the Deposit Insurance Fund, the FDIC or any other governmental agency and are subject to investment risk, including the possible loss of principal.

 

Item 1B. Unresolved Staff Comments.

 

None.

 

Item 2. Properties.

 

Our main office is located at 288 Meeting Street, Charleston, South Carolina 29401-1575.  Including our main office, the Bank operates 61 full service branches and two loan production offices located in South Carolina and North Carolina. In addition to our main office, branches, and loan production offices, we also operate the Bank’s retail mortgage division headquartered in Myrtle Beach, South Carolina, Crescent Mortgage Company, the Bank’s correspondent/wholesale mortgage subsidiary, headquartered in Atlanta, Georgia, and Carolina Services Corporation of Charleston, located in Charleston, South Carolina.

 

The Bank owns 33 of the branch offices, plus six additional branch offices for which the land is leased and the building is owned. The remaining offices are subject to leases. The Company also owns the building occupied by the Bank’s retail mortgage division. For each property that we lease, we believe that, based upon current market conditions, upon expiration of the lease we will be able to extend the lease on satisfactory terms or relocate to another acceptable location. We believe these premises will be adequate for present and anticipated needs and that we have adequate insurance to cover our owned and leased premises. For additional information relating to the Company’s premises, equipment and lease commitments, see Note 7—Premises and Equipment and Note 14—Commitments and Contingencies to our audited consolidated financial statements included elsewhere in this report.

 

Item 3. Legal Proceedings.

 

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

 

Item 4. Mine Safety Disclosures.

 

None.

35
 

PART II

 

Item 5. Market for Common Equity and Related Shareholder Matters.

 

As of February 25, 2019, there were approximately 1,900 stockholders of record of our common stock. Our common stock was listed on the NASDAQ Capital Market on July 1, 2014. The following table sets forth the high and low sales price information as reported by NASDAQ for each quarter of 2017 and 2018, and the dividends per share declared on our common stock in each quarter of 2017 and 2018. All information has been adjusted for any stock splits and stock dividends effected during the periods presented.

 

   High   Low   Dividends 
2018               
Quarter Ended December 31, 2018  $38.14   $27.62   $0.07 
Quarter Ended September 30, 2018   45.49    37.45    0.07 
Quarter Ended June 30, 2018   45.58    38.14    0.06 
Quarter Ended March 31, 2018   42.42    36.37    0.05 
                
2017               
Quarter Ended December 31, 2017  $39.33   $35.39   $0.05 
Quarter Ended September 30, 2017   35.88    31.75    0.04 
Quarter Ended June 30, 2017   32.98    28.56    0.04 
Quarter Ended March 31, 2017   31.48    28.35    0.04 

 

We are authorized to pay dividends as declared by our board of directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis. Future dividends will be subject to board approval. As we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders is dividends we receive from the Bank. For that reason, our ability to pay dividends is subject to the limitations that apply to the Bank. For more information on restrictions on payments of dividends, see Note 20 “Capital Requirements and Other Restrictions” included in Part II, Item 8 – Financial Statements and Supplementary Data.

 

 

 

Index  07/01/14  12/31/14  12/31/15  12/31/16  12/31/17  12/31/18
Carolina Financial Corporation   100.00    139.71    217.37    374.16    453.74    363.81 
NASDAQ Composite Index   100.00    106.84    114.28    124.41    161.28    156.70 
SNL Southeast Bank Index   100.00    108.82    107.12    142.20    175.90    145.33 

36
 

Prepared by S&P Global Market Intelligence, a division of S&P Global Inc.

 

The performance graph above compares the Company’s cumulative total return from July 1, 2014 through December 31, 2018 with the NASDAQ Composite and the SNL Southeast Bank Index, a banking industry performance index for the Southeastern United States. The Company was listed on the NASDAQ exchange on July 1, 2014. Returns are shown on a total return basis, assuming the reinvestment of dividends and a beginning stock index value of $100 per share. The value of the Company’s common stock as shown in the graph is based on published prices for the transactions in the Company’s stock.

 

Issuer Purchases of Equity Securities

Period  (a)
Total number
of shares (or
units)
purchased
  (b)
Average
price paid
per share (or
unit)
  (c)
Total number of shares
(or units) purchased as
part of publicly
announced plans or
programs
  (d)
Maximum number (or
approximate dollar value) of
shares (or units) that may yet
be purchased under the plans
or programs
 December 4, 2018-
December 31, 2018
    175,633   $30.64    175,633    19,618,605 
 Total    175,633   $30.64    175,633    19,618,605 

   

Item 6. Selected Financial Data

 

   For The Years Ended December 31, 
   2018   2017   2016   2015   2014 
  (In thousands) 
Operating Data:                    
                     
Interest income  $161,058    95,087    60,914    49,604    37,656 
Interest expense   27,248    13,253    8,753    6,604    5,602 
Net interest income   133,810    81,834    52,161    43,000    32,054 
Provision for loan losses   2,059    779             
Net interest income after provision for loan losses   131,751    81,055    52,161    43,000    32,054 
Noninterest income   39,896    33,916    29,297    27,679    21,148 
Noninterest expense   109,208    73,445    56,040    49,199    41,443 
Income before income taxes   62,439    41,526    25,418    21,480    11,759 
Income tax expense   12,769    12,961    7,848    7,060    3,448 
Net income  $49,670    28,565    17,570    14,420    8,311 
     
   At December 31, 
   2018   2017   2016   2015   2014 
  (In thousands) 
Balance Sheet Data:                    
                     
Total assets  $3,790,748    3,519,017    1,683,736    1,409,669    1,199,017 
Interest-bearing cash   33,276    55,998    14,591    16,421    10,694 
Securities available-for-sale   842,801    743,239    335,352    306,474    251,717 
Securities held-to-maturity               17,053    25,544 
Federal Home Loan Bank stock   21,696    19,065    11,072    9,919    5,405 
Loans held for sale   16,972    35,292    31,569    41,774    40,912 
Loans receivable, net   2,509,873    2,308,050    1,167,578    912,582    768,122 
Allowance for loan losses   14,463    11,478    10,688    10,141    9,035 
Deposits   2,718,193    2,604,929    1,258,260    1,031,528    964,190 
Short-term borrowed funds   405,500    340,500    203,000    120,000    57,800 
Long-term debt   59,436    72,259    38,465    103,465    61,740 
Stockholders’ equity   575,285    475,381    163,190    139,859    93,700 

37
 

   For The Years Ended December 31, 
   2018   2017   2016   2015   2014 
   (Dollars in thousands) 
Selected Average Balances:                    
                     
Total assets  $3,629,490    2,306,667    1,537,654    1,303,402    990,773 
Loans receivable   2,388,856    1,526,109    1,035,115    827,787    613,144 
Deposits   2,697,908    1,761,087    1,197,688    1,012,659    777,622 
Stockholders’ equity   526,701    280,877    151,285    101,896    88,474 
                          
Performance Ratios:                         
                          
Return on average equity   9.43%    10.17%   11.61%   14.15%   9.39%
Return on average assets   1.37%    1.24%   1.14%   1.11%   0.84%
Average earning assets to average total assets   89.62%   90.98%   93.56%   91.92%   91.43%
Average loans receivable to average deposits   88.54%   86.66%   86.43%   81.74%   78.85%
Average equity to average assets   14.51%   12.18%   9.84%   7.82%   8.93%
Net interest margin   4.11%   3.90%   3.63%   3.59%   3.54%
Net interest margin - tax equivalent(1)   4.15%   4.02%   3.71%   3.68%   3.62%
Net recoveries (charge-offs) to average loans receivable   0.04%   0.00%   0.05%   0.13%   0.15%
Non-performing assets to total loans receivable   0.53%   0.30%   0.58%   0.72%   0.73%
Non-performing assets to total assets   0.35%   0.20%   0.40%   0.47%   0.47%
Non-performing loans to total loans   0.47%   0.17%   0.48%   0.47%   0.31%
Allowance for loan losses as a percentage of gross loans receivable (end of period)(2)   0.57%   0.49%   0.91%   1.10%   1.16%
Allowance for loan losses as a percentage of nonperforming loans   123.13%   291.84%   190.01%   235.73%   371.20%

 

   At or For The Years Ended December 31, 
   2018   2017   2016   2015   2014 
Per Share Data:                    
                     
Book value (end of period)  $25.83    22.76    13.23    11.92    10.02 
Basic earnings   2.28    1.75    1.45    1.51    0.89 
Diluted earnings   2.26    1.73    1.42    1.48    0.87 
                          
Average common shares - basic   21,756,595    16,317,501    12,080,128    9,537,358    9,314,048 
Average common shares - diluted   21,972,857    16,550,357    12,352,246    9,718,356    9,507,425 

 

Note: Book value is calculated using outstanding common shares less unvested restricted shares.

 

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

 

(2)Included in loans receivable are approximately $686.4 million, $952.2 million and $119.4 million in acquired loans at December 31, 2018, 2017 and 2016, respectively.
38
 

On January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2014, payable on February 28, 2014.

 

On October 15, 2014, the Board of Directors of the Company declared an additional two-for-one stock split to stockholders of record as of October 31, 2014, payable on November 14, 2014.

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

All share, earnings per share, and per share data have been retroactively adjusted to reflect these stock splits for all periods presented in accordance with generally accepted accounting principles.

39
 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.  Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods.

 

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters.  Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties.  Actual results may differ materially from those contained in these forward-looking statements.  For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.

 

Company Overview

 

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

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

 

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

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

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

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

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Executive Summary of Operating Results

 

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

·The Company reported an increase in net income for the year ended December 31, 2018 to $49.7 million, or $2.26 per diluted share, as compared to $28.6 million, or $1.73 per diluted share, for the year ended December 31, 2017. Included in net income for the year ended December 31, 2018 and 2017 were pretax merger-related expenses of $15.2 million and $8.3 million, respectively.
·Operating earnings for the year ended December 31, 2018, which excludes certain non-operating income and expenses, increased 85.9% to $62.8 million, or $2.86 per diluted share, from $33.8 million, or $2.04 per diluted share, from the same period of 2017.
·Total assets increased $272 million from December 31, 2017. The largest components of our total assets are loans receivable, net and securities which were $2.5 billion and $842.8 million, respectively at December 31, 2018. Comparatively, our loans receivable, net and securities totaled $2.3 billion and $743.2 million, respectively, at December 31, 2017. At December 31, 2018, loans held for sale were $16.9 million compared to $35.3 million as of December 31, 2017.
·Asset quality remained steady, with nonperforming assets to total assets of 0.35% as of December 31, 2018 compared to 0.20% as of December 31, 2017. Nonperforming loans were $11.7 million as of December 31, 2018 as compared to $4.0 million at December 31, 2017.
·The allowance for loan losses was $14.5 million, or 0.57% of total loans (0.79% of total non-acquired loans), at December 31, 2018, compared to $11.5 million, or 0.49% of total loans (0.84% of total non-acquired loans) at December 31, 2017. The Company experienced net recoveries of $926,000 during 2018 compared to net recoveries of $11,000 during 2017. Provision for loan loss during 2018 was $2.1 million.
·The Company reported book value per common share of $25.83 and $22.76 as of December 31, 2018 and December 31, 2017, respectively. Tangible book value per common share was $19.36 and $15.71 as of December 31, 2018 and December 31, 2017, respectively.
·At December 31, 2018, the Company’s regulatory capital ratios exceeded the minimum levels currently required. Stockholders’ equity totaled $575.3 million as of December 31, 2018 compared to $475.4 million at December 31, 2017. Tangible equity to tangible assets at December 31, 2018 was 11.83% compared to 9.73% at December 31, 2017.
·On June 11, 2018 Carolina Financial Corporation completed the sale of 1.5 million shares of its common stock. The net proceeds of the offering to the Company, after estimated expenses, were approximately $63.0 million.
·During the fourth quarter of 2018, the Company repurchased approximately 176,000 shares of its common stock at an average price of $30.64. Subsequent to December 31, 2018 through February 25, 2019, the Company repurchased an additional 116,000 shares at an average price of $32.16.

 

Operating earnings and related per share measures, as well as core deposits, tangible common equity and tangible book value per common share are non-GAAP financial measures. For reconciliations to the most comparable GAAP measures, see “Non-GAAP Financial Measures” below.

 

Critical Accounting Policies

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in Note 1 to our consolidated financial statements within Item 8 “Financial Statements and Supplementary Data” elsewhere in this report.

 

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations. Management has reviewed and approved these critical accounting policies and discussed them with the audit committee of the Board of Directors.

 

Non-GAAP Financial Measures

  

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

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

 

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

Reconciliation of Non-GAAP Financial Measures
(Unaudited)

(In thousands, except share data)

 

   For the Twelve Months Ended 
   December 31, 
   2018   2017   2016 
As Reported:               
Income before income taxes  $62,439    41,526    25,418 
Tax expense   12,769    12,961    7,848 
Net income  $49,670    28,565    17,570 
                
Average equity  $526,701    280,877    151,285 
Average assets  $3,629,490    2,306,667    1,537,654 
Return on average assets   1.37%    1.24%   1.14%
Return on average equity   9.43%   10.17%   11.61%
                
Weighted average common shares outstanding:               
Basic   21,756,595    16,317,501    12,080,128 
Diluted   21,972,857    16,550,357    12,352,246 
Earnings per common share:               
Basic  $2.28    1.75    1.45 
Diluted  $2.26    1.73    1.42 
                
Operating:               
Income before income taxes  $62,439    41,526    25,418 
Loss (gain) on sale of securities   1,946    (933)   (706)
Net loss on extinguishment of debt           1,868 
Fair value adjustments on interest rate swaps   340    (382)   (590)
Merger related costs   15,216    8,301    3,245 
Operating earnings before income taxes   79,941    48,512    29,235 
Tax expense (1)   17,105    14,706    9,027 
Operating earnings (Non-GAAP)  $62,836    33,806    20,208 
                
Average equity  $526,701    280,877    151,285 
Average assets  $3,629,490    2,306,667    1,537,654 
Operating return on average assets (Non-GAAP)   1.73%   1.47%   1.31%
Operating return on average equity (Non-GAAP)   11.93%   12.04%   13.36%
                
Weighted average common shares outstanding:               
Basic   21,756,595    16,317,501    12,080,128 
Diluted   21,972,857    16,550,357    12,352,246 
Operating earnings per common share:               
Basic (Non-GAAP)  $2.89    2.07    1.67 
Diluted (Non-GAAP)  $2.86    2.04    1.64 

 

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

(Unaudited) 

(In thousands, except share data)

 

   At December 31, 
   2018   2017 
         
Core deposits:          
Noninterest-bearing demand accounts  $547,022    525,615 
Interest-bearing demand accounts   566,527    551,308 
Savings accounts   192,322    213,142 
Money market accounts   431,246    452,734 
Total core deposits (Non-GAAP)   1,737,117    1,742,799 
           
Certificates of deposit:          
Less than $250,000   875,749    755,887 
$250,000 or more   105,327    106,243 
Total certificates of deposit   981,076    862,130 
Total deposits  $2,718,193    2,604,929 

  

   At December 31, 
   2018   2017 
         
Tangible book value per share:          
Total stockholders’ equity  $575,285    475,381 
Less intangible assets   (144,054)   (147,193)
Tangible common equity (Non-GAAP)  $431,231    328,188 
           
Issued and outstanding shares   22,387,009    21,022,202 
Less nonvested restricted stock awards   (117,966)   (134,302)
Period end shares used for tangible book value   22,269,043    20,887,900 
           
Total stockholders’ equity  $575,285    475,381 
Divided by period end shares used for tangible book value   22,269,043    20,887,900 
Common book value per share  $25.83    22.76 
           
Tangible common equity (Non-GAAP)  $431,231    328,188 
Divided by period end shares used for tangible book value   22,269,043    20,887,900 
Tangible common book value per share (Non-GAAP)  $19.36    15.71 

 

Recent Accounting Standards and Pronouncements

 

For information relating to recent accounting standards and pronouncements, see Note 1 to the audited consolidated financial statements within Item 8 “Financial Statements and Supplementary Data.”

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Results of Operations

 

Summary

 

2018 compared to 2017

 

The Company reported net income available to common stockholders of approximately $49.7 million, or $2.26 per diluted share, for the year ended December 31, 2018, compared to $28.6 million, or $1.73 per diluted share for the year ended December 31, 2017. Our 2018 and 2017 results include pretax merger related expenses of $15.2 million and $8.3 million, respectively. Operating earnings, which exclude certain non-operating income and expenses, for the year ended December 31, 2018 increased 85.9% to $62.8 million, or $2.86 per diluted share, from $33.8 million, or $2.04 per diluted share, for the year ended December 31, 2017. Operating earnings and related per share measures are non-GAAP financial measures. For a reconciliation to the most compared GAAP measure, see “Non-GAAP Financial Measures”.

 

2017 compared to 2016

 

The Company reported net income available to common stockholders of approximately $28.6 million, or $1.73 per diluted share, for the year ended December 31, 2017, compared to $17.6 million, or $1.42 per diluted share for the year ended December 31, 2016. Our 2017 and 2016 results include pretax merger related expenses of $8.3 million and $3.2 million, respectively. Operating earnings, which exclude certain non-operating income and expenses, for the year ended December 31, 2017 increased 67.3% to $33.8 million, or $2.04 per diluted share, from $20.2 million, or $1.64 per diluted share, for the year ended December 31, 2016. Operating earnings and related per share measures are non-GAAP financial measures. For a reconciliation to the most compared GAAP measure, see “Non-GAAP Financial Measures”.

  

Details of the changes in the various components of net income are further discussed below.

 

Net Interest Income and Margin

 

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

 2018 compared to 2017

 

For the years ended December 31, 2018 and 2017, our net interest income was $133.8 million and $81.8 million, respectively. The increase in net interest income is a result of the increase in average interest-earning assets balances. The increase in average earnings assets for the year ended December 31, 2018 is primarily the result of increased balances of loans receivable as well as higher available-for-sale securities. Average loans receivable increased $862.7 million, or 56.5%, from 2017 to 2018, primarily attributable to the Greer and First South acquisitions as well as organic loan growth. Average yields on loans receivable, net increased 0.40% from December 31, 2017 to 5.54% for the year ended December 31, 2018.

 

2017 compared to 2016

 

For the years ended December 31, 2017 and 2016, our net interest income was $81.8 million and $52.2 million, respectively. The increase in net interest income is a result of the increase in average interest-earning assets balances. The increase in average earnings assets for the year ended December 31, 2017 is primarily the result of increased balances of loans receivable. Average loans receivable increased $491.0 million, or 47.4%, from 2016 to 2017.

  

The growth in average loan balances was primarily the result of the following:

 

  · Greer Acquisition – On March 18, 2017, the Company acquired approximately $194.6 million of loans, net of purchase accounting adjustments.
     
  · First South Acquisition - On November 1, 2017, the Company acquired approximately $759.2 million of loans, net of purchase accounting adjustments.
     
  · Organic loan growth, excluding acquired loans, was $187.5 million.
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The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the periods indicated (dollars in thousands). We derived these yields or costs by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. Nonaccrual loans are included in earning assets in the following tables. Loan yields reflect the negative impact on our earnings of loans on nonaccrual status. The net capitalized loan costs and fees, which are considered immaterial, are amortized into interest income on loans.

 

   For The Years Ended December 31, 
   2018   2017   2016 
       Interest   Average       Interest   Average       Interest   Average 
   Average   Paid/   Yield/   Average   Paid/   Yield/   Average   Paid/   Yield/ 
   Balance   Earned   Rate   Balance   Earned   Rate   Balance   Earned   Rate 
   (Dollars in thousands) 
Interest-earning assets:                                             
Loans held for sale  $22,149    963    4.35%   23,199    885    3.81%   28,779    1,000    3.47%
Loans receivable (1)   2,388,856    132,289    5.54%   1,526,109    78,415    5.14%   1,035,115    50,137    4.84%
Interest-bearing cash   25,628    479    1.87%   31,715    350    1.10%   29,644    75    0.25%
Securities available-for-sale   795,100    26,222    3.30%   504,555    14,836    2.90%   327,516    9,057    2.73%
Securities held-to-maturity                           7,089    217    3.06%
Federal Home Loan Bank stock   17,744    1,004    5.66%   11,032    496    4.50%   7,884    374    4.74%
Other investments   3,437    101    2.94%   2,108    105    4.98%   2,657    54    2.03%
Total interest-earning assets   3,252,914    161,058    4.95%   2,098,718    95,087    4.53%   1,438,684    60,914    4.23%
Non-earning assets   376,576              207,949              98,970           
Total assets  $3,629,490              2,306,667              1,537,654           
                                              
Interest-bearing liabilities:                                             
Demand accounts   564,282    3,121    0.55%   319,190    817    0.26%   151,704    235    0.15%
Money market accounts   459,774    3,048    0.66%   374,770    1,747    0.47%   274,774    808    0.29%
Savings accounts   201,741    630    0.31%   89,598    170    0.19%   44,646    59    0.13%
Certificates of deposit   910,433    11,928    1.31%   622,424    6,653    1.07%   485,942    4,870    1.00%
Short-term borrowed funds   316,189    6,064    1.92%   176,169    1,888    1.07%   92,332    509    0.55%
Long-term debt   59,465    2,457    4.13%   58,539    1,978    3.38%   77,210    2,272    2.94%
Total interest-bearing liabilities   2,511,884    27,248    1.08%   1,640,690    13,253    0.81%   1,126,608    8,753    0.78%
Noninterest-bearing deposits   561,678              355,105              240,622           
Other liabilities   29,227              29,995              19,139           
Stockholders’ equity   526,701              280,877              151,285           
Total liabilities and                                             
Stockholders’ equity  $3,629,490              2,306,667              1,537,654           
Net interest spread             3.87%             3.72%             3.45%
Net interest margin   4.11             3.90%             3.63%          
                                              
Net interest margin (tax equivalent) (2)   4.15%             4.02%             3.71%          
Net interest income        133,810              81,834              52,161      

 

(1)Average balances of loans include nonaccrual loans.

 

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

 

2018 compared to 2017

 

Our net interest margin was 4.11%, or 4.15% on a tax-equivalent basis, for the twelve months ended December 31, 2018 compared to 3.90%, or 4.02% on a tax equivalent basis, for the twelve months ended December 31, 2017. The increase in margin from period to period is the result of a shift to higher yielding earning assets as well as an increase in yield on securities available for sale and loans receivable, net of the increase in cost of funds. Average loans receivable comprised 73.4% of interest earning assets for the twelve months ended December 31, 2018 compared to 72.7% for the twelve months ended December 31, 2017. The yield on loans receivable during the twelve months ended December 31, 2018 and 2017 reflects accretion income from loans purchased in acquisitions of $8.9 million and $4.3 million, respectively.

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Our net interest spread, which is not on a tax-equivalent basis, was 3.87% for the twelve months ended December 31, 2018 as compared to 3.72% for the same period in 2017. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 15 basis point increase in net interest spread is a result of the 42 basis point increase in yield on interest-earning assets as well as a 27 basis point increase in rates paid on interest-bearing liabilities.

 

The increase in the rate realized on loans is primarily the result of variable rate loans repricing as a result of the increases in the prime rate.

 

2017 compared to 2016

 

Our net interest margin was 3.90%, or 4.02% on a tax-equivalent basis, for the twelve months ended December 31, 2017 compared to 3.63%, or 3.71% on a tax equivalent basis, for the twelve months ended December 31, 2016. The increase in margin from period to period is the result of a shift to higher yielding earning assets as well as an increase in yield on securities available for sale and loans receivable, net of the increase in cost of funds. Average loans receivable comprised 72.7% of earnings assets for the twelve months ended December 31, 2018 compared to 71.9% for the twelve months ended December 31, 2016. The yield on loans receivable during the twelve months ended December 31, 2018 and 2017 reflects accretion income from loans purchased in acquisitions of $4.3 million and $0.8 million, respectively.

 

Our net interest spread, which is not on a tax-equivalent basis, was 3.72% for the twelve months ended December 31, 2017 as compared to 3.45% for the same period in 2016. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 27 basis point increase in net interest spread is a result of the 30 basis point increase in yield on interest-earning assets as well as a 3 basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing as a result of the increases in the prime rate.

 

Rate/Volume Analysis

 

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

  

   For The Years Ended December 31, 
   2018 vs. 2017   2017 vs. 2016 
   Increase (decrease)       Net   Increase (decrease)       Net 
   due to   Rate/   Dollar   due to   Rate/   Dollar 
   Volume   Rate   Volume   Change   Volume   Rate   Volume   Change 
               (In thousands)             
Loans held for sale  $(46)   118    6    78   $(213)   79    19    (115)
Loans receivable, net   47,777    9,544    (3,447)   53,874    25,229    4,496    (1,447)   28,278 
Interest-bearing cash   (114)   196    47    129    23    270    (18)   275 
Securities available-for-sale   9,582    2,843    (1,039)   11,386    5,206    883    (310)   5,779 
Securities held-to-maturity                           (217)   (217)
FHLB stock   380    206    (78)   508    141    (27)   8    122 
Other investments   39    (70)   27    (4)   (27)   62    16    51 
Interest income   57,618    12,837    (4,484)   65,971    30,359    5,763    (1,949)   34,173 
Demand accounts  $1,356    1,677    (728)   2,305   $429    323    (169)   583 
Money market accounts   564    905    (167)   1,302    466    645    (172)   939 
Savings accounts   350    247    (137)   460    85    52    (26)   111 
Certificates of deposit   3,773    2,196    (695)   5,274    1,459    415    (91)   1,783 
Short-term borrowed funds   2,685    2,675    (1,185)   4,175    898    917    (436)   1,379 
Long-term debt   38    448    (7)   479    (631)   255    81    (295)
Interest expense  $8,766    8,148    (2,919)   13,995   $2,706    2,607    (813)   4,500 
Net interest income                  51,976                   29,673 
46
 

   For the Years Ended December 31, 
   2016 vs. 2015 
   Increase (decrease)       Net 
   due to   Rate/   Dollar 
   Volume   Rate   Volume   Change 
       (In thousands)     
Loans held for sale  $(339)   (99)   (34)   (472)
Loans receivable, net   10,042    684    (137)   10,589 
Interest-bearing cash   39    1        40 
Securities available-for-sale   1,126    354    (44)   1,436 
Securities held-to-maturity   (380)   15    27    (338)
FHLB stock   9    37    (1)   45 
Other investments   (16)   20    6    10 
Interest income   10,481    1,012    (183)   11,310 
Demand accounts  $(19)   51    4    36 
Money market accounts   116    274    (39)   351 
Savings accounts   8    1        9 
Certificates of deposit   910    368    (69)   1,209 
Short-term borrowed funds   (119)   241    56    178 
Long-term debt   584    (293)   75    366 
Interest expense  $1,480    642    27    2,149 
Net interest income                  9,161 

 

Provision for Loan Loss

 

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of operations. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.

 

Following is a summary of the activity in the allowance for loan losses during the years ended December 31, 2018, 2017 and 2016.

 

   For the Years 
   Ended December 31, 
   2018   2017   2016 
   (Dollars in thousands) 
Balance, beginning of period  $11,478    10,688    10,141 
Provision for loan losses   2,059    779     
Loan charge-offs   (872)   (272)   (264)
Loan recoveries   1,798    283    811 
Balance, end of period  $14,463    11,478    10,688 

 

2018 compared to 2017

  

The Company experienced net recoveries of $926,000 for the twelve months ended December 31, 2018 and net recoveries of $11,000 for the twelve months ended December 31, 2017. Asset quality has remained relatively consistent since December 31, 2017, with nonperforming assets of 0.35% as of December 31, 2018 and 0.20% as of December 31, 2017. While December 2017 reflected historical NPA ratio lows and ratios continue to remain favorable, we have experienced an increase in NPA frequency. Approximately half of the increase relates to five purchased non-credit impaired loans with balances in excess of $500,000. Provision for loan losses of $2.1 million was recorded during 2018 primarily driven by organic loan growth and unknown storm related impacts in the third quarter of 2018. Provision expense for loan losses of $779,000 was recorded during 2017.

47
 

2017 compared to 2016

  

The Company experienced net recoveries of $11,000 for the twelve months ended December 31, 2017 and net recoveries of $547,000 for the twelve months ended December 31, 2016. Nonperforming assets were 0.20% as of December 31, 2017 and 0.40% as of December 31, 2016. Provision for loan losses of $779,000 was recorded during 2017. No provision expense for loan losses was recorded during 2016 primarily due to the net recoveries experienced and asset quality.

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

 

Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. In 2018, 2017 and 2016, noninterest income comprised 19.8%, 26.3% and 32.4%, respectively, of total interest and noninterest income. The major components of noninterest income for the Company are listed below:

 

   For the Years 
   Ended December 31, 
   2018   2017   2016 
   (In thousands) 
Noninterest income:               
Mortgage banking income  $15,295    15,140    17,226 
Deposit service charges   7,755    4,643    3,688 
Net loss on extinguishment of debt           (1,868)
Net (loss) gain on sale of securities   (1,946)   933    706 
Fair value adjustments on interest rate swaps   (340)   382    590 
Net increase in cash value life insurance   1,530    1,116    902 
Mortgage loan servicing income   9,052    6,790    5,748 
Debit card income, net   4,809    2,308    1,189 
Other   3,741    2,604    1,116 
Total noninterest income  $39,896    33,916    29,297 

  

2018 compared to 2017 

 

Noninterest income increased to $39.9 million for the twelve months ended December 31, 2018 from $33.9 million for the twelve months ended December 31, 2017. The increase in noninterest income for the twelve months ended December 31, 2018 over the comparable period in 2017 primarily relates to an increase in mortgage loan servicing income due to higher average balances of serviced loans and an increase in deposit service charges, debit card income and other noninterest income due to organic growth in addition to the impact of the First South and Greer acquisitions in 2017, partially offset by a net loss on sale of securities.

48
 

The following table provides a break out of mortgage banking:

 

   For the Year Ended December 31, 
   Loan Originations   Mortgage Banking Income   Margin 
   2018   2017   2018   2017   2018   2017 
Additional segment information:                              
Community banking  $108,721    86,732    2,352    2,009    2.16%    2.32%
Wholesale mortgage banking   744,208    824,282    12,943    13,131    1.74%   1.59%
Total  $852,929    911,014    15,295    15,140    1.79%   1.66%

  

Mortgage loan servicing income increased $2.3 million for the twelve months ended December 31, 2018 compared to the twelve months ended December 31, 2017. The increase in mortgage loan servicing income was primarily driven by an increase in loans serviced for the comparative periods.

2017 compared to 2016

 

Noninterest income increased $4.6 million to $33.9 million for the year ended December 31, 2017 compared to $29.3 million for the year ended December 31, 2016.  The increase in noninterest income for the twelve months ended December 31, 2017 over the comparable period in 2016 primarily relates to an increase in mortgage loan servicing income due to higher average balances of serviced loans and an increase in deposit service charges and debit card income as a result of the increase in deposits acquired with the acquisitions of First South and Greer in 2017, Congaree in 2016, and organic growth.

 

The following table provides a breakout of mortgage banking:

 

   For the Year Ended December 31, 
   Loan Originations   Mortgage Banking Income   Margin 
   2017   2016   2017   2016   2017   2016 
Additional segment information:                              
Community banking  $86,732    97,062    2,009    2,063    2.32%   2.13%
Wholesale mortgage banking   824,282    875,360    13,131    15,163    1.59   1.73%
Total  $911,014    972,422    15,140    17,226    1.66%   1.77%

  

Mortgage loan servicing income increased $1.0 million for the twelve months ended December 31, 2017 compared to the twelve months ended December 31, 2016. The increase in mortgage loan servicing income was primarily driven by an increase in loans serviced for the comparative periods.

49
 

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

 

   For the Years Ended December 31, 
   2018   2017   2016 
   (In thousands) 
Noninterest expense:               
Salaries and employee benefits  $53,517    37,827    31,475 
Occupancy and equipment   15,961    10,347    7,942 
Marketing and public relations   1,330    1,417    1,428 
FDIC insurance   1,090    721    702 
Recovery of mortgage loan repurchase losses   (600)   (900)   (1,000)
Legal expense   422    507    306 
Other real estate (income) expense, net   (13)   54    (20)
Mortgage subservicing expense   2,468    1,986    1,857 
Amortization of mortgage servicing rights   4,206    2,966    2,312 
Amortization of core deposit intangible   3,139    1,037    407 
Merger-related expenses   15,216    8,301    3,245 
Other   12,472    9,182    7,386 
Total noninterest expense  $109,208    73,445    56,040 

 

2018 compared to 2017

  

Noninterest expense increased to $109.2 million for the twelve months ended December 31, 2018 from $73.4 million for the twelve months ended December 31, 2017. The increase in noninterest expense is primarily the result of an increase in salaries and employee benefits and occupancy and equipment as well as merger related expenses related to the acquisitions of First South and Greer during 2017. Merger related expenses totaled $15.2 million for the twelve months ended December 31, 2018 as compared to $8.3 million for the twelve months ended December 31, 2017.

2017 compared to 2016

 

Noninterest expense increased $17.4 million to $73.4 million for the year ended December 31, 2017 compared to $56.0 million for the year ended December 31, 2016. The increase in noninterest expense for 2017 compared to the prior periods is primarily a result of the increase in salaries and employee benefits paid as well as merger related expenses incurred as a result of the acquisitions of Greer and First South during 2017.

  

Income Tax Expense

 

2018 compared to 2017

 

Our effective tax rate was 20.4% for twelve month period ended December 31, 2018, compared to 31.2% for the twelve month period ended December 31, 2017. The decrease in the effective tax rate from period to period reflects a reduction in the federal income tax rate from 35% to 21% as enacted in the 2017 Tax Cuts and Jobs Act on December 22, 2017. In addition to the lower federal tax rate, the decrease in the effective tax rate from period to period reflects an increase in interest income on municipal securities during 2018 and tax benefits related to excess stock-based compensation.

  

2017 compared to 2016

 

Our effective tax rate increased to 31.2% for the year ended December 31, 2017 compared to 30.9% for the year ended December 31, 2016.

 

The Company’s net income for the year ended December 31, 2017 was reduced by approximately $239,000 related to application of the Tax Cuts and Jobs Act implementation on deferred tax assets and liabilities.

50
 

Balance Sheet Review

 

Investment Securities

 

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

At December 31, 2018, our securities portfolio, excluding FHLB stock and other investments, was $842.8 million or approximately 22.2% of our assets. Our available-for-sale securities portfolio included US agency securities, municipal securities, collateralized loan obligations, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $842.8 million and an amortized cost of $844.5 million resulting in a net unrealized loss of $1.7 million.

The increase in securities from period to period is attributable to an increase in mortgage-backed securities and collateralized loan obligations partially offset by a decrease in municipal securities in line with the Company’s asset and liability management objectives.

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

 

During the second quarter of 2016, the Company tainted its securities held-to-maturity portfolio as a result of a change in the intent to hold the securities until maturity to provide opportunities to maximize its asset utilization. As a result, approximately $17.0 million in securities were moved to available-for-sale and resulted in an increase to accumulated other comprehensive income of $655,000.

 

The amortized costs and the fair value of our investments are as follows:

 

   At December 31, 
   2018   2017   2016 
   Amortized   Fair   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value   Cost   Value 
Securities available-for-sale:  (In thousands) 
Municipal securities  $212,215    213,714    240,904    247,350    92,792    93,212 
US government agencies   24,772    25,277    11,983    12,008    3,438    3,386 
Collateralized loan obligations   231,172    230,699    128,080    128,643    76,202    76,249 
Corporate securities   6,915    6,960    6,891    7,006    474    491 
Mortgage-backed securities:                              
Agency   199,518    197,520    243,075    243,595    90,477    90,986 
Non-agency   158,803    157,531    94,834    95,125    63,628    63,864 
Total mortgage-backed securities   358,321    355,051    337,909    338,720    154,105    154,850 
Trust preferred securities   11,066    11,100    11,208    9,512    11,203    7,164 
Total securities available-for-sale  $844,461    842,801    736,975    743,239    338,214    335,352 

51
 

The Company uses prices from third party pricing services to estimate the fair value of our investment securities. While we obtain fair value information from multiple sources, we generally obtain one price/quote for each individual security. For securities priced by third party pricing services, we determine the most appropriate and relevant pricing service for each security class and have that vendor provide the price for each security in the class. We record the value provided by the third party pricing service/broker in our consolidated financial statements, subject to our internal price verification procedures, which include periodic comparisons to other brokers and Bloomberg pricing screens.

 

Contractual maturities and yields on our investments are shown in the following table. Municipal yields were not tax effected in the table below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities available-for-sale are presented at fair value and held-to-maturity securities are presented at amortized cost.

 

   At December 31, 2018 
   Less than 12
Months
   One to Five
Years
   Five to Ten
Years
   Over Ten
Years
   Total 
   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield 
   (Dollars in thousands) 
Securities available-for-sale:                                                  
Municipal securities  $235    1.67%   1,964    2.48%   42,496    2.82%   169,019    3.16%   213,714    3.08%
US government agencies       0.00%       0.00%   25,277    3.34%       0.00%   25,277    3.34%
Collateralized loan obligations       0.00%           38,340    4.36%   192,359    4.17%   230,699    4.20%
Corporate securities       0.00%   4,003    4.24%   2,957    5.11%       0.00%   6,960    4.61%
Mortgage-backed securities:                                                  
Agency   1,278    1.83%    131    0.76%    15,516    2.73%    180,595    3.33%    197,520    3.27% 
Non-agency       0.00%   24    4.01%       0.00%   157,507    3.66%   157,531    3.66%
Total mortgage-backed securities   1,278    1.83%   155    1.26%   15,516    2.73%   338,102    3.48%   355,051    3.44%
Trust preferred securities       0.00%                   11,100    5.14%   11,100    5.14%
Total securities available-for-sale   $1,513    1.81%   6,122    3.60%   124,586    3.44%   710,580    3.62%   842,801    3.59%

 

For disclosures related to the Company’s evaluation of securities for OTTI, see Note 4 “Securities” within Item 8. “Financial Statements and Supplementary Data.”

 

Non-marketable investments are comprised of the following and are recorded at cost which approximates fair value since no readily available market exists for these securities.

 

   At December 31, 
   2018   2017 
   (In thousands) 
Community Reinvestment Act fund  $2,334    2,330 
Investment in Statutory Business Trusts   1,116    1,116 
Total other investments   3,450    3,446 
           
Federal Home Loan Bank stock   21,696    19,065 
Total non-marketable investments  $25,146    22,511 

  

Loans by Type

 

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Gross loans receivable at December 31, 2018 and 2017 were $2.5 billion and $2.3 billion, respectively.

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of December 31, 2018, our loan portfolio included $2.1 billion, or 84.8%, of gross loans secured by real estate. As of December 31, 2017, our loan portfolio included $2.0 billion, or 85.6%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

52
 

As shown in the table below, gross loans receivable increased $204.8 million since December 31, 2017. The growth in loan balances was primarily the result of strong organic growth in both commercial and residential lending.

  

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

  

   At December 31, 
   2018   2017   2016 
       % of Total       % of Total       % of Total 
   Amount   Loans   Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                              
One-to-four family  $ 732,717    29.03%   665,774    28.70%   411,399    34.91%
Home equity   83,770    3.32%   90,141    3.89%   36,026    3.06%
Commercial real estate   1,034,117    40.96%    933,820    40.26%   445,344    37.80%
Construction and development   290,494    11.51%   294,793    12.71%   115,682    9.82%
Consumer loans   23,845    0.94%   19,990    0.86%   5,714    0.48%
Commercial business loans   359,393    14.24%   315,010    13.58%   164,101    13.93%
Total gross loans receivable   2,524,336    100.00%   2,319,528    100.00%   1,178,266    100.00%
Less:                              
Allowance for loan losses   14,463         11,478         10,688      
Total loans receivable, net  $2,509,873         2,308,050         1,167,578      

 

   At December 31, 
   2015   2014 
       % of Total       % of Total 
   Amount   Loans   Amount   Loans 
   (Dollars in thousands) 
Loans secured by real estate:                    
One-to-four family  $344,928    37.38%   253,364    32.59%
Home equity   23,256    2.52%   27,399    3.53%
Commercial real estate   341,658    37.03%   317,162    40.81%
Construction and development   91,362    9.90%   91,531    11.78%
Consumer loans   5,179    0.56%   5,650    0.73%
Commercial business loans   116,340    12.61%   82,051    10.56%
Total gross loans receivable   922,723    100.00%   777,157    100.00%
Less:                    
Allowance for loan losses   10,141         9,035      
Total loans receivable, net  $912,582         768,122      
53
 

Maturities and Sensitivity of Loans to Changes in Interest Rates

 

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

 

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

 

   At December 31, 2018 
       After one         
   One Year   but within   After five     
   or Less   five years   years   Total 
   (In thousands) 
Loans secured by real estate:                    
One-to-four family  $24,694    139,437    568,586    732,717 
Home equity   11,426    20,434    51,910    83,770 
Commercial real estate   100,776    661,012    272,329    1,034,117 
Construction and development   87,428    169,187    33,879    290,494 
Consumer loans   1,605    10,537    11,703    23,845 
Commercial business loans   54,026    191,822    113,545    359,393 
Total gross loans receivable  $279,955    1,192,429    1,051,952    2,524,336 
                     
Loans maturing - after one year:                    
Variable rate loans                  765,875 
Fixed rate loans                  1,478,506 
                  $2,244,381 

  

Nonperforming and Problem Assets

 

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of six consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of December 31, 2018, the Company had $0.6 million of PCI loans that were 90 days past due and accruing. At December 31, 2017, the Company had $1.9 million of PCI loans that were 90 days past due and still accruing.

  

Troubled Debt Restructurings (“TDRs”)

 

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

54
 

The following table summarizes nonperforming and problem assets, excluding purchased credit impaired loans, at the end of the periods indicated.

 

   At December 31, 
   2018   2017   2016   2015   2014 
   (In thousands) 
Loans receivable:                         
Nonaccrual loans-renegotiated loans  $3,086    1,140    1,227    1,136    58 
Nonaccrual loans-other   8,635    2,793    4,398    3,166    2,376 
Accruing loans 90 days or more delinquent   20                 
Real estate acquired through foreclosure, net   1,534    3,106    1,179    2,374    3,239 
Total Non-Performing Assets  $13,275    7,039    6,804    6,676    5,673 
                          
Problem Assets not included in Non-Performing Assets-                         
Accruing renegotiated loans outstanding  $3,327    5,324    5,216    13,212    14,251 

  

At December 31, 2018, nonperforming assets were $13.3 million, or 0.35% of total assets. Comparatively, nonperforming assets were $7.0 million, or 0.20% of total assets, at December 31, 2017. Nonperforming loans were 0.47% and 0.17% of gross loans receivable at December 31, 2018 and December 31, 2017, respectively.

 

At December 31, 2017, nonperforming assets were $7.0 million, or 0.20% of total assets, and nonperforming loans were $3.9 million, or 0.17% of gross loans. Comparatively, at December 31, 2016, nonperforming assets were $6.8 million, or 0.40% of total assets, and nonperforming loans were $5.6 million, or 0.48% of gross loans.

 

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $3.3 million at December 31, 2018, compared to $5.3 million at December 31, 2017. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

 

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $5.3 million at December 31, 2017, compared to $5.2 million at December 31, 2016. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have concerns about the borrower’s ability to comply with present repayment terms.

 

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans for fiscal years 2018 and 2017 are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on loans greater than $250,000 at a minimum of every 18 months, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.

 

Allowance for Loan Losses

 

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

55
 

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

 

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

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

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

  

To the extent that current information indicates it is probable that the Company will collect all amounts according to the contractual terms thereof, such loan is not considered impaired and is not considered in the determination of the required allowance for loan losses. To the extent that current information indicates it is probable that the Company will not be able to collect all amounts according to the contractual terms thereon, such loan is considered impaired and is considered in the determination of the required level of allowance for loan and lease losses.

 

The allowance for loan losses was $14.5 million, or 0.79% of non-acquired loans, at December 31, 2018, compared to $11.5 million, or 0.84% of total non-acquired loans, at December 31, 2017. Loans acquired in business combinations were $686.4 million and $952.2 million at December 31, 2018 and December 31, 2017, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. At December 31, 2018 and December 31, 2017, acquired non-credit impaired loans had a purchase discount remaining of $10.9 million and $17.7 million, respectively.

 

The allowance for loan losses was $11.5 million, or 0.49% of total loans (0.84% of total non-acquired loans), at December 31, 2017, compared to $10.7 million, or .91% of total loans (1.01% of total non-acquired loans) at December 31, 2016. Loans acquired in business combinations totaled $952.2 million and $119.4 million at December 31, 2017 and 2016, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk as discussed above.

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

 

   At December 31, 
   2018   2017 
Acquired and non-acquired loans:          
Acquired loans receivable  $686,401    952,220 
Non-acquired loans receivable   1,837,935    1,367,308 
Total loans receivable  $2,524,336    2,319,528 
% Acquired   27.19%   41.05%
           
Non-acquired loans  $1,837,935    1,367,308 
Allowance for loan losses   14,463    11,478 
Allowance for loan losses to non-acquired loans (Non-GAAP)   0.79   0.84%
           
Total loans receivable  $2,524,336    2,319,528 
Allowance for loan losses   14,463    11,478 
Allowance for loan losses to total loans receivable   0.57%   0.49%

  

The Company experienced net recoveries of $926,000 for the twelve months ended December 31, 2018 and net recoveries of $11,000 for the twelve months ended December 31, 2017. Asset quality has remained relatively consistent with nonperforming assets of 0.35% as of December 31, 2018 and 0.20% as of December 31, 2017. Provision expense was $2.1 million and $779,000 for 2018 and 2017, respectively.

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The following table summarizes the activity related to our allowance for loan losses for the five years ended December 31, 2018.

 

   For the Years Ended December 31, 
   2018   2017   2016   2015   2014 
   (Dollars in thousands) 
Balance, beginning of period  $11,478    10,688    10,141    9,035    8,091 
Provision for loan losses   2,059    779             
Loan charge-offs:                         
Loans secured by real estate:                         
One-to-four family   (226   (253)   (84)   (1,050)   (80)
Home equity   (31                
Commercial real estate   (86               (28)
Construction and development   (24           (90)   (172)
Consumer loans   (308   (19)   (53)   (20)   (24)
Commercial business loans   (197       (127)   (70)   (59)
Total loan charge-offs   (872   (272)   (264)   (1,230)   (363)
Loan recoveries:                         
Loans secured by real estate:                         
One-to-four family   142    4    464    576    158 
Home equity   7    3        150     
Commercial real estate   77    31        350    100 
Construction and development   1,112    81    76    479    457 
Consumer loans   93    45    24    38    71 
Commercial business loans   367    119    247    743    521 
Total loan recoveries   1,798    283    811    2,336    1,307 
Net loan recoveries (charge-offs)   926    11    547    1,106    944 
Balance, end of period  $14,463    11,478    10,688    10,141    9,035 
                          
Allowance for loan losses as a percentage of loans receivable (end of period)   0.57%   0.49%   0.91%   1.10%   1.16%
Net recoveries (charge-offs) to average loans receivable   0.04   0.00%   0.05%   0.13%   0.15%

   

The following table summarizes an allocation of the allowance for loan losses and the related percentage of loans outstanding in each category for the five years ended December 31, 2018.

  

   At December 31, 
   2018   2017   2016   2015   2014 
   Amount   %   Amount   %   Amount   %   Amount   %   Amount   % 
   (Dollars in thousands) 
Loans receivable:                                                  
One-to-four family  $3,540    29.03%   2,719    28.70%   2,636    34.91%   2,903    37.23%   2,888    32.48%
Home equity   203    3.32%   168    3.89%   197    3.06%   151    2.52%   221    3.54%
Commercial real estate   5,097    40.96%   3,986    40.26%   3,344    37.80%   3,402    37.10%   3,283    40.85%
Construction and development   1,969    11.51   1,201    12.71%   1,132    9.82%   1,138    9.94%   1,069    11.82%
Consumer loans   352    0.94%   79    0.86%   80    0.48%   27    0.56%   30    0.73%
Commercial business loans   2,940    14.24%   2,840    13.58%   2,805    13.93%   2,100    12.65%   1,430    10.58%
Unallocated   362        485        494        420        114     
Total  $14,463    100.00%   11,478    100.00%   10,688    100.00%   10,141    100.00%   9,035    100.00%
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Mortgage Operations

 

Mortgage Activities and Servicing

 

Our wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans and is included in mortgage banking income in the accompanying consolidated statements of operations. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations is provided in “Results of Operations – Noninterest Income and Expense”. Additional segment information is provided in Note 21 “Supplemental Segment Information” in the accompanying financial statements.

  

Loan Servicing

 

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

 

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

The Company was servicing $4.0 billion loans for others at December 31, 2018 and $2.9 billion at December 31, 2017. Mortgage servicing rights asset had a balance of $32.9 million and $21.0 million at December 31, 2018 and December 31, 2017, respectively. The economic estimated fair value of the mortgage servicing rights was $40.9 million and $26.3 million at December 31, 2018 and December 31, 2017, respectively. Amortization expense related to the mortgage servicing rights was $4.2 million and $3.0 million during the twelve months ended December 31, 2018 and 2017, respectively.

59
 

Below is a roll-forward of activity in the balance of the servicing assets for the years ended December 31, 2018 and 2017 respectively:

 

   December 31, 
   2018   2017 
   (In thousands) 
MSR beginning balance  $21,003    15,032 
Amount capitalized   6,283    6,061 
Amount acquired   9,853    2,876 
Amount amortized   (4,206)   (2,966)
MSR ending balance  $32,933    21,003 

 

Reserve for Mortgage Repurchase Losses

 

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

 

The following table demonstrates the activity for the mortgage repurchase reserve for the years ended December 31, 2018, 2017, and 2016:

 

   December 31, 
   2018   2017   2016 
   (In thousands) 
Beginning Balance  $1,892    2,880    3,876 
Losses paid       (88)   (21)
Recoveries           25 
Recovery for mortgage repurchase losses   (600)   (900)   (1,000)
Ending balance  1,292    1,892    2,880 

  

For the twelve months ended December 31, 2018 and 2017, the Company recorded a recovery for mortgage repurchase losses of $600,000 and $900,000, respectively. The recovery for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. As a result of the Company’s analysis of its reserve for mortgage loan repurchase losses, the reserve was reduced accordingly.

 

Deposits

 

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

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

 

   For the Years Ended December 31, 
   2018   2017   2016 
       Average       Average       Average 
   Average   Yield/   Average   Yield/   Average   Yield/ 
   Balance   Rate   Balance   Rate   Balance   Rate 
   (Dollars in thousands) 
                         
Interest-bearing demand accounts  $564,282    0.55%   319,190    0.26%   151,704    0.15%
Money market accounts   459,774    0.66%   374,770    0.47%   274,774    0.29%
Savings accounts   201,741    0.31%   89,598    0.19%   44,646    0.13%
Certificates of deposit less than $100,000   330,815    1.18%    220,742    0.92%   266,808    0.92%
Certificates of deposit of $100,000 or more   579,618    1.38%   401,682    1.10%   219,134    1.10%
Total interest-bearing average deposits   2,136,230    0.88%   1,405,982    0.67%   957,066    0.62%
                               
Noninterest-bearing deposits   561,678         355,105         240,622      
Total average deposits  $2,697,908         1,761,087         1,197,688      

  

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

 

   At December 31, 
   2018   2017 
   (In thousands) 
         
Three months or less   $126,653    52,139 
Over three through six months   75,425    33,455 
Over six through twelve months   110,300    97,555 
Over twelve months   160,006    113,668 
Total  $472,384    296,817 

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Borrowings

 

The following table outlines our various sources of short-term borrowed funds during the years ended December 31, 2018, 2017, and 2016, and the amounts outstanding at the end of each period, the maximum amount for each component during the periods, the average amounts for each period, and the average interest rate that we paid for each borrowing source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the periods shown. Stated period end rates are contractual rates. The average for the period rates reflect the impact of purchase accounting.

 

       Stated   Maximum         
       Period   Month   Average for the 
   Ending   End   End   Period 
At or for the year ended December 31, 2018   Balance   Rate   Balance   Balance   Rate(1) 
       (Dollars in thousands)     
Short-term borrowed funds                         
Short-term FHLB advances  $405,500    1.05%-2.78%     405,500    316,189    1.92
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2019 through 2020   27,000    1.72%-2.60%     42,500    27,117    1.59%
Subordinated debentures, due 2032 through 2037   32,436    4.25%-5.75%     32,436    32,348    6.26%

 

 

       Stated   Maximum         
       Period   Month   Average for the 
   Ending   End   End   Period 
At or for the year ended December 31, 2017  Balance   Rate   Balance   Balance   Rate 
   (Dollars in thousands) 
Short-term borrowed funds                         
Short-term FHLB advances  $340,500    0.87%-2.71%    338,000    176,169    1.07%
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2019 through 2020   40,000    1.05%-1.98%    52,000    35,357    2.33%
Subordinated debentures, due 2032 through 2037   32,259    3.11%-4.75%    32,259    23,182    4.97%

 

 

       Stated   Maximum         
       Period   Month   Average for the 
   Ending   End   End   Period 
At or for the year ended December 31, 2016  Balance   Rate   Balance   Balance   Rate 
   (Dollars in thousands) 
Short-term borrowed funds                         
Short-term FHLB advances  $203,000    0.49%-1.20%    203,000    92,332    0.55%