UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2019

OR

☐ 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

(Exactname of registrant as specified in its charter)

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

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of1934 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 ☒ No ☐

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

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

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

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

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

Title of Each Class:	Trading Symbol	Name of exchange on which registered
Common Stock, $0.01 par value per share	CARO	Nasdaq Capital Market

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 November 1, 2019
Common Stock, $0.01 par value per share	22,244,536 shares

TABLE OF CONTENTS

		Page
PART 1 –	FINANCIAL INFORMATION	3
Item 1.	Financial Statements	3
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	49
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	82
Item 4.	Controls and Procedures	82
PART II –	OTHER INFORMATION	82
Item 1.	Legal Proceedings	82
Item 1A.	Risk Factors	82
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	83
Item 3.	Defaults Upon Senior Securities	83
Item 4.	Mine Safety Disclosures	83
Item 5.	Other Information	83
Item 6.	Exhibits	83

2

PART 1 - FINANCIAL INFORMATION
Item 1 - Financial Statements

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

	September 30, 2019		December 31, 2018
	(Unaudited)		(Audited)
	(In thousands)
ASSETS
Cash and due from banks	$	25,519		28,857
Interest-bearing cash		51,358		33,276
Cash and cash equivalents		76,877		62,133
Securities available-for-sale (cost of $781,504 at September 30, 2019 and $844,461 at December 31, 2018)		796,097		842,801
Federal Home Loan Bank stock, at cost		21,707		21,696
Other investments		3,520		3,450
Derivative assets		2,303		4,032
Loans held for sale		36,882		16,972
Loans receivable, net of allowance for loan losses of $16,125 at September 30, 2019 and $14,463 at December 31, 2018		2,706,056		2,509,873
Premises and equipment, net		59,841		60,866
Right of use operating lease asset		17,551		—
Accrued interest receivable		13,029		13,494
Real estate acquired through foreclosure, net		1,832		1,534
Deferred tax assets, net		1,174		5,786
Mortgage servicing rights		26,528		32,933
Cash value life insurance		59,699		58,728
Core deposit intangible		14,257		16,462
Goodwill		127,592		127,592
Other assets		14,943		12,396
Total assets	$	3,979,888		3,790,748
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Noninterest-bearing deposits	$	611,959		547,022
Interest-bearing deposits		2,231,255		2,171,171
Total deposits		2,843,214		2,718,193
Short-term borrowed funds		417,000		405,500
Long-term debt		42,570		59,436
Right of use operating lease liability		17,905		—
Derivative liabilities		4,952		1,232
Drafts outstanding		6,518		8,129
Advances from borrowers for insurance and taxes		6,923		4,100
Accrued interest payable		2,009		1,591
Reserve for mortgage repurchase losses		992		1,292
Dividends payable to stockholders		2,003		1,576
Accrued expenses and other liabilities		14,207		14,414
Total liabilities		3,358,293		3,215,463
Stockholders' equity:
Preferred stock, par value $.01; 1,000,000 shares authorized at September 30, 2019
and December 31, 2018; no shares issued or outstanding		—		—
Common stock, par value $.01; 50,000,000 shares authorized at September 30, 2019
and December 31, 2018, respectively; 22,249,424 and 22,387,009 issued
and outstanding at September 30, 2019 and December 31, 2018, respectively		222		224
Additional paid-in capital		403,700		408,224
Retained earnings		207,535		167,173
Accumulated other comprehensive income (loss), net of tax		10,138		(336	)
Total stockholders' equity		621,595		575,285
Total liabilities and stockholders' equity	$	3,979,888		3,790,748

See accompanying notes to consolidated financial statements.

3

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2019			2018		2019		2018
	(In thousands, except share data)
Interest income
Loans	$	38,604		33,623		110,152		98,037
Investment securities		6,745		6,912		21,209		18,979
Dividends from Federal Home Loan Bank stock		331		313		923		751
Other interest income		134		137		446		371
Total interest income		45,814		40,985		132,730		118,138
Interest expense
Deposits		7,125		5,029		20,224		12,919
Short-term borrowed funds		1,931		1,529		6,676		4,488
Long-term debt		575		544		1,893		1,813
Total interest expense		9,631		7,102		28,793		19,220
Net interest income		36,183		33,883		103,937		98,918
Provision for loan losses		620		750		2,000		1,309
Net interest income after provision for loan losses		35,563		33,133		101,937		97,609
Noninterest income
Mortgage banking income		6,063		3,685		13,799		11,701
Deposit service charges		1,742		2,084		5,088		6,096
Net loss on extinguishment of debt		(70	)	—		(101	)	—
Net gain (loss) on sale of securities		756		(849	)	3,891		(2,292	)
Fair value adjustments on interest rate swaps		(996	)	628		(4,531	)	1,883
Net increase in cash value life insurance		400		378		1,196		1,153
Mortgage loan servicing income		2,490		2,313		7,694		6,428
Debit card income, net		1,148		1,086		3,339		3,562
Other		1,183		975		3,444		2,846
Total noninterest income		12,716		10,300		33,819		31,377
Noninterest expense
Salaries and employee benefits		13,634		13,451		40,264		40,660
Occupancy and equipment		4,286		4,113		12,523		11,860
Marketing and public relations		432		312		1,306		1,011
FDIC insurance		—		285		502		805
Recovery of mortgage loan repurchase losses		(100	)	(150	)	(300	)	(450	)
Legal expense		159		94		372		327
Other real estate expense (income), net		36		(13	)	330		(2	)
Mortgage subservicing expense		702		640		2,176		1,772
Amortization of mortgage servicing rights		1,572		1,099		4,151		2,967
Impairment of mortgage servicing rights		1,800		—		3,100		—
Amortization of core deposit intangible		720		778		2,204		2,375
Merger related expenses		484		—		484		15,216
Other		3,182		3,393		9,421		9,431
Total noninterest expense		26,907		24,002		76,533		85,972
Income before income taxes		21,372		19,431		59,223		43,014
Income tax expense		4,744		4,227		12,976		8,788
Net income	$	16,628		15,204		46,247		34,226
Earnings per common share:
Basic	$	0.75		0.67		2.09		1.58
Diluted	$	0.74		0.66		2.07		1.57
Dividends declared per common share	$	0.09		0.07		0.26		0.18
Weighted average common shares outstanding:
Basic		22,149,567		22,678,681		22,177,483		21,616,485
Diluted		22,336,383		22,898,983		22,365,193		21,842,769

See accompanying notes to consolidated financial statements.                                

4

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Net income	$	16,628			15,204			46,247			34,226
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities		4,310			(3,872	)		20,189			(12,195	)
Tax effect		(1,078	)		968			(5,047	)		3,049
Reclassification adjustment for (gain) loss included in earnings		(756	)		849			(3,891	)		2,292
Tax effect		189			(212	)		973			(573	)
Unrealized (loss) gain on interest rate swaps designated as cash flow hedges		(528	)		331			(2,334	)		1,694
Tax effect		133			(83	)		584			(424	)
Other comprehensive income (loss), net of tax		2,270			(2,019	)		10,474			(6,157	)
Comprehensive income	$	18,898			13,185			56,721			28,069

See accompanying notes to consolidated financial statements.         

5

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(Unaudited)

													Accumulated
							Additional						Other
	Common Stock						Paid-in			Retained			Comprehensive
	Shares			Amount			Capital			Earnings			Income (Loss)			Total
	(In thousands, except share data)
Balance, December 31, 2017		21,022,202		$	210			348,037			123,537			3,597			475,381
Stock awards, net of forfeitures		42,807			1			105			—			—			106
Vested stock awards surrendered in cashless exercise		(12,534	)		—			(210	)		(279	)		—			(489	)
Stock options exercised		5,064			—			56			—			—			56
Stock-based compensation expense, net		—			—			633			—			—			633
Net income		—			—			—			4,056			—			4,056
Dividends declared to stockholders		—			—			—			(1,052	)		—			(1,052	)
Other comprehensive loss, net of tax		—			—			—			—			(3,645	)		(3,645	)
Balance, March 31, 2018		21,057,539			211			348,621			126,262			(48	)		475,046
Issuance of common stock, net of offering expenses		1,500,000			15			63,007			—			—			63,022
Stock awards, net of forfeitures		15,198			—			8			—			—			8
Vested stock awards surrendered in cashless exercise		(2,555	)		—			(36	)		(74	)		—			(110	)
Stock options exercised		—			—			—			—			—			—
Stock-based compensation expense, net		—			—			700			—			—			700
Net income		—			—			—			14,966			—			14,966
Dividends declared to stockholders		—			—			—			(1,355	)		—			(1,355	)
Other comprehensive loss, net of tax		—			—			—			—			(493	)		(493	)
Balance, June 30, 2018		22,570,182			226			412,300			139,799			(541	)		551,784
Issuance of common stock, net of offering expenses		—			—			—			—			—			—
Stock awards, net of forfeitures		1,300			—			—			—			—			—
Vested stock awards surrendered in cashless exercise		(3,569	)		—			(6	)		(52	)		—			(58	)
Stock options exercised		2,532			—			—			—			—			—
Stock-based compensation expense, net		—			—			696			—			—			696
Net income		—			—			—			15,204			—			15,204
Dividends declared to stockholders		—			—			—			(1,580	)		—			(1,580	)
Other comprehensive loss, net of tax		—			—			—			—			(2,019	)		(2,019	)
Balance, September 30, 2018		22,570,445		$	226			412,990			153,371			(2,560	)		564,027
Balance, December 31, 2018		22,387,009		$	224			408,224			167,173			(336	)		575,285
Stock awards, net of forfeitures		35,708			—			124			—			—			124
Vested stock awards surrendered in cashless exercise		(11,421	)		—			(315	)		(88)			—			(403	)
Stock options exercised		13,674			—			246			—			—			246
Stock repurchase plan, net of commissions		(128,598	)		(1	)		(4,156	)		—			—			(4,157	)
Stock-based compensation expense, net		—			—			746			—			—			746
Net income		—			—			—			14,545			—			14,545
Dividends declared to stockholders		—			—			—			(1,785	)		—			(1,785	)
Other comprehensive income, net of tax		—			—			—			—			4,549			4,549
Balance, March 31, 2019		22,296,372			223			404,869			179,845			4,213			589,150
Stock awards, net of forfeitures		9,197			—			1			—			—			1
Vested stock awards surrendered in cashless exercise		(811	)		—			(28	)		(2	)		—			(30)
Stock options exercised		10,128			—			83			—			—			83
Stock repurchase plan, net of commissions		(29,905	)		—			(1,027	)		—			—			(1,027	)
Stock-based compensation expense, net		—			—			680			—			—			680
Net income		—			—			—			15,074			—			15,074
Dividends declared to stockholders		—			—			—			(2,007	)		—			(2,007	)
Other comprehensive income, net of tax		—			—			—			—			3,655			3,655
Balance, June 30, 2019		22,284,981			223			404,578			192,910			7,868			605,579
Stock awards, net of forfeitures		7,705			—			—			—			—			—
Vested stock awards surrendered in cashless exercise		—			—			—			—			—			—
Stock options exercised		3,545			—			51			—			—			51
Stock repurchase plan, net of commissions		(46,807	)		(1	)		(1,602	)		—			—			(1,603	)
Stock-based compensation expense, net		—			—			673			—			—			673
Net income		—			—			—			16,628			—			16,628
Dividends declared to stockholders		—			—			—			(2,003	)		—			(2,003	)
Other comprehensive income, net of tax		—			—			—			—			2,270			2,270
Balance, September 30, 2019		22,249,424		$	222			403,700			207,535			10,138			621,595

See accompanying notes to consolidated financial statements.                                                

6

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	For the Nine Months
	Ended September 30,
	2019			2018
	(In thousands)
Cash flows from operating activities:
Net income	$	46,247			34,226
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses		2,000			1,309
Amortization of unearned discount/premium on investments, net		3,011			3,617
Accretion of deferred loan fees		(1,969	)		(981	)
Accretion of acquired loans		(5,926	)		(7,035	)
Amortization of core deposit intangibles		2,204			2,376
(Gain) loss on sale of available-for-sale securities, net		(3,891	)		2,292
Mortgage banking income		(13,799	)		(11,701	)
Originations of loans held for sale		(645,350	)		(667,991	)
Proceeds from sale of loans held for sale		639,239			689,628
Loss on extinguishment of debt		101			—
Amortization of fair value adjustments on subordinated debentures		134			132
Recovery of mortgage loan repurchase losses		(300	)		(450	)
Fair value adjustments on interest rate swaps		4,531			(1,883	)
Stock-based compensation		2,099			2,029
Increase in cash surrender value of bank owned life insurance		(1,196	)		(1,153	)
Depreciation		3,242			3,084
Loss (gain) on disposals of premises and equipment		—			(2	)
Loss (gain) on sale of real estate acquired through foreclosure		149			(79	)
Write-down of real estate acquired through foreclosure		—			126
Purchases of mortgage servicing rights		—			(9,970	)
Originations of mortgage servicing rights		(846	)		(4,989	)
Impairment of mortgage servicing rights		3,100			—
Amortization of mortgage servicing rights		4,151			2,967
Decrease (increase) in:
Accrued interest receivable		465			(1,398	)
Other assets		(3,443	)		9,708
Increase (decrease) in:
Accrued interest payable		418			667
Dividends payable to stockholders		427			529
Accrued expenses and other liabilities		647			2,447
Cash flows provided by operating activities		35,445			47,505
Continued

 

7

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

(Unaudited)

	For the Nine Months
	Ended September 30,
	2019			2018
	(In thousands)
Cash flows from investing activities:
Activity in available-for-sale securities:
Purchases	$	(169,476	)		(286,485	)
Maturities, payments and calls		81,924			76,972
Proceeds from sales		151,389			116,624
(Increase) decrease in Federal Home Loan Bank stock		(11	)		1,619
(Increase) in loans receivable, net		(191,562	)		(129,360	)
Purchases of premises and equipment		(2,226	)		(3,400	)
Proceeds from disposals of premises and equipment		—			10
Proceeds from sale of real estate acquired through foreclosure		827			1,726
Cash flows used in investing activities		(129,135	)		(222,294	)
Cash flows from financing activities:
Net increase in deposit accounts		125,021			154,694
Net (decrease) in Federal Home Loan Bank advances		(5,601	)		(48,000	)
Net (decrease) increase in drafts outstanding		(1,611	)		1,269
Net increase in advances from borrowers for insurance and taxes		2,823			2,430
Cash dividends paid on common stock		(5,795	)		(3,987	)
Proceeds from exercise of stock options		380			56
Proceeds from issuance of common stock		—			63,022
Cash paid for common stock repurchase		(6,783	)		—
Cash flows provided by financing activities		108,434			169,484
Net increase (decrease) in cash and cash equivalents		14,744			(5,305	)
Cash and cash equivalents, beginning of period		62,133			81,252
Cash and cash equivalents, end of period	$	76,877			75,947
Supplemental disclosure:
Cash paid for:
Interest on deposits and borrowed funds	$	28,375			18,553
Income taxes paid, net of refunds		10,342			4,470
Noncash investing activities:
Transfer of loans receivable to real estate acquired through foreclosure	$	1,299			268
See accompanying notes to consolidated financial statements.

 

8

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

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

At September 30, 2019, statutory business trusts (“Trusts”) created or acquired by the Company had outstanding trust preferred securities with an aggregate par value of $36.0 million. The principal assets of the Trusts are $37.1 million of the Company's subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $1.1 million of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

On July 15, 2019, the Company announced the execution of an agreement and plan of merger and reorganization, by and between the Company and Carolina Trust BancShares, Inc. (“Carolina Trust”), pursuant to which, subject to the terms and conditions set forth therein, Carolina Trust will merge with and into the Company, with the Company as the surviving corporation of the merger. Refer to Note 2 - Business Combinations for more information.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2018 as filed with the Securities and Exchange Commission (the “SEC”) on March 1, 2019. There have been no significant changes to the accounting policies as disclosed in the Company's Form 10-K, except as reflected in Recently Adopted Accounting Pronouncements of this Note 1 – Summary of Significant Accounting Policies.

Management's Estimates

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

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

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 reasonably possible that the allowance for loan losses and valuation of foreclosed real estate may change materially in the near term.

9

Earnings Per Share

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

All share, earnings per share, and per share data have been retroactively adjusted to reflect the stock splits for all periods presented in accordance with GAAP. 

Subsequent Events

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

On October 23, 2019, the Company's Board of Directors declared a $0.10 dividend per common share, payable on January 3, 2020 to stockholders of record on December 13, 2019.

Reclassification

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

Recently Adopted Accounting Pronouncements

In July 2019, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2019-07, Codification Updates to SEC Sections ("ASU 2019-07"). ASU 2019-07 updates various Topics of the Accounting Standards Codification ("ASC") to align the guidance in various SEC sections of the Codification with the requirements of certain SEC final rules. The amendments were effective upon issuance and did not have a material effect on the financial statements.

During the first quarter of 2019, the Company adopted ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 applies a right-of-use (“ROU”) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset and a liability to make lease payments. The Company has elected to apply the package of practical expedients permitting entities to not reassess: 1) whether any expired or existing contracts are or contain leases; 2) the lease classification for any expired or existing leases; and 3) initial direct costs for any existing leases. Additionally, as provided by ASU 2016-02, the Company has elected not to apply the recognition requirements of ASC 842 to short-term leases, defined as leases with a term of 12 months or less, and to recognize the lease payments in net income on short-term leases on a straight-line basis over the lease term.

The Company adopted the guidance using the modified retrospective approach on January 1, 2019 and elected the practical expedients for transition including the transition option provided in ASU 2018-11, Leases (Topic 842) Targeted Improvements, which allowed us to initially apply the new leases standard at the adoption date. Consequently, the reporting for the comparative periods presented continued to be in accordance with ASC Topic 840, Leases. Therefore, the 2018 financial results and disclosures have not been adjusted.

10

  

The Company implemented internal controls as well as lease accounting software to facilitate the preparation of financial information. The Company is largely accounting for existing operating leases consistent with prior guidance except for the incremental balance sheet recognition for leases. There was no cumulative effect adjustment to retained earnings as of January 1, 2019. On January 1, 2019, the Company recorded a ROU operating lease asset and corresponding operating lease liability of $18.4 million and $18.8 million, respectively, on the consolidated balance sheet. The new standard did not have a material impact on the Company's results of operations or cash flows.

During the first quarter of 2019, the Company adopted ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 amends the requirements of the Derivatives and Hedging Topic of the ASC to improve the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements. The Company adopted the guidance using the modified retrospective approach on January 1, 2019. The guidance did not have a material effect on the Company's financial statements, particularly as the Company has not recorded any hedge ineffectiveness since inception.

During the first quarter of 2019, the Company adopted ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Cost (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities (“ASU 2017-08”). ASU 2017-08 shortens the amortization period for the premium to the earliest call date. The Company adopted the guidance using the modified retrospective approach on January 1, 2019. The guidance did not have a material effect on the Company's consolidated financial statements.

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

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

In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”). ASU 2016-08 updates the new revenue standard by clarifying the principal versus agent implementation guidance, but does not change the core principle of the new standard. The updates to the principal versus agent guidance: (i) require an entity to determine whether it is a principal or an agent for each distinct good or service (or a distinct bundle of goods or services) to be provided to the customer; (ii) illustrate how an entity that is a principal might apply the control principle to goods, services, or rights to services, when another party is involved in providing goods or services to a customer and (iii) clarify that the purpose of certain specific control indicators is to support or assist in the assessment of whether an entity controls a good or service before it is transferred to the customer, provide more specific guidance on how the indicators should be considered, and clarify that their relevance will vary depending on the facts and circumstances. The Company's revenue is primarily comprised of net interest income on financial assets and financial liabilities, which is explicitly excluded from the scope of ASU 2014-09, and non-interest income. A description of the Company's revenue streams accounted for under ASC 606, Revenue from Contracts with Customers follows:

Deposit service charges: The Company earns fees from its deposit customers for transaction-based, account maintenance, and overdraft services. Transaction-based fees are recognized at the time the transaction is executed as that is the point in time the Company fulfills the customer's request. Overdraft fees are recognized at the point in time that the overdraft occurs. Service charges on deposits are withdrawn from the customer's account balance.

Debit card income: The Company earns interchange fees from debit cardholder transactions conducted through payment networks. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder.

  

11

  

The Company has evaluated ASU 2016-08 and 2014-09 and determined that this guidance did not have a material impact on the way the Company currently recognizes revenue or the way it recognizes expenses related to those revenue streams. The Company adopted ASU 2014-09 and its related amendments on its required effective date of January 1, 2018 utilizing the modified retrospective approach. Since there was no net income impact upon adoption of the new guidance, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Consistent with the modified retrospective approach, the Company did not adjust prior period amounts.

Recently Issued Accounting Pronouncements

In May 2019, the FASB issued ASU 2019-05, Financial Instruments – Credit Losses (Topic 326): Targeted Transition Relief (“ASU 2019-05”). ASU 2019-05 provides entities with an option to irrevocably elect the fair value option, applied on an instrument-by-instrument basis for eligible instruments, upon adoption of ASU 2016-13,  Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. Refer below for further information surrounding the Company's adoption of Topic 326.

In April 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments (“ASU 2019-04”).  ASU 2019-04 clarifies and improves areas of guidance related to the recently issued standards on credit losses, hedging, and recognition and measurement of financial instruments. The amendments related to credit losses and related to recognition and measurement of financial instruments will be effective for the Company for reporting periods beginning after December 15, 2019. Refer below for further information surrounding the Company's adoption of these standards. The amendments related to hedging were effective for the Company for interim and annual periods beginning after December 15, 2018. These amendments did not have a material effect on the Company's financial statements.

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”). ASU 2018-13 amends the Fair Value Measurement Topic of the Accounting Standards Codification. The amendments remove, modify, and add certain fair value disclosure requirements based on the concepts in the FASB Concepts Statement, Conceptual Framework for Financial Reporting – Chapter 8: Notes to Financial Statements. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted. An entity is permitted to early adopt any removed or modified disclosures upon issuance on this ASU and delay adoption of the additional disclosures until their effective date. The Company does not expect these amendments to have a material effect on its financial statements.

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

In June 2016, the FASB ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 requires an entity to utilize a new impairment model known as the current expected credit loss (“CECL”) model to estimate its lifetime “expected credit loss” and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The CECL model is expected to result in earlier recognition of credit losses. The CECL approach is not applicable to available-for-sale ("AFS") debt securities; however, ASU 2016-13 prescribes  recognition of credit losses on AFS debt securities as an allowance rather than reductions in the amortized cost of the securities. Improvements to estimated credit losses will be recognized immediately in earnings rather than as interest income over time. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and AFS debt securities. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. While early adoption was permitted beginning in the first quarter of 2019, we will adopt the standard in the first quarter of 2020.  

12

  

The Company's preliminary evaluation indicates the provisions of ASU 2016-13 are expected to impact the Company's consolidated financial statements, in particular the level of the reserve for credit losses over the contractual life of the loans. In addition, the guidance eliminates the current guidance for purchased credit impaired loans, and requires an increase in the allowance for loan losses and an increase in the recorded investment of purchased credit impaired loans for the nonaccretable difference. In addition to the allowance for loan losses, we will also record an allowance for credit losses on debt securities instead of applying the impairment model currently utilized. The amount of the adjustments will be impacted by each portfolio's composition and credit quality at the adoption date as well as economic conditions and forecasts at that time. While the guidance changes the measurement of the allowance, it does not change the credit risk of the Company's lending and securities portfolios or the ultimate losses in those portfolios.

The Company has been working with an outside consultant and is continuing to assess the impact that this new guidance will have on its consolidated financial statements. The Company is continuing its implementation efforts through its cross-functional implementation team. The team has assigned roles and responsibilities, key tasks to complete, and a timeline to be followed. The implementation team meets periodically to discuss the latest developments and ensure progress is being made. The team also keeps current on evolving interpretations and industry practices related to ASU 2016-13 via webcasts, publications, and conferences. The team has finalized the methodologies that will be utilized and is finalizing the documentation, controls, processes and policies as it performs parallel runs. A full end-to-end parallel run will be completed during the fourth quarter of 2019 for the period ended September 30, 2019. The cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period will depend upon the nature and characteristics of the Company’s loan portfolio at the adoption date, the macroeconomic conditions and forecasts at that date, and other management judgments. The magnitude of any such adjustment has not yet been reasonably estimated.

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

NOTE 2 – BUSINESS COMBINATIONS

Pending Acquisition of Carolina Trust BancShares, Inc.

On July 15, 2019, the Company announced the execution of an agreement and plan of merger and reorganization, by and between the Company and Carolina Trust BancShares, Inc. (“Carolina Trust”), pursuant to which, subject to the terms and conditions set forth therein, Carolina Trust will merge with and into the Company, with the Company as the surviving corporation of the merger. The agreement provides that as soon as practicable following the merger, Carolina Trust's wholly-owned subsidiary, Carolina Trust Bank, will merge with and into the Bank, with the Bank as the surviving entity. The Company anticipates closing the merger on December 31, 2019.

Pursuant to the merger agreement, each share of Carolina Trust common stock will be converted into the right to receive 0.3000 shares of the Company's common stock, or $10.57 in cash for each share of the Company's common stock outstanding, subject to election and proration such that the aggregate consideration will consist of 90% Company common stock and 10% cash. Cash will also be paid in lieu of fractional shares. The aggregate merger consideration equals $100.1 million as of July 12, 2019, based on closing price of a share of the Company's common stock as of that date.

13

NOTE 3 – SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of securities available-for-sale at September 30, 2019 and December 31, 2018 follows: 

	September 30, 2019									December 31, 2018
			Gross		Gross							Gross		Gross
	Amortized		Unrealized		Unrealized			Fair		Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value		Cost		Gains		Losses			Value
	(In thousands)
Securities available-for-sale:
Municipal securities	$	171,693		9,390		—			181,083		212,215		2,768		(1,269	)		213,714
US government agencies		10,000		88		—			10,088		24,772		505		—			25,277
Collateralized loan obligations		256,868		174		(1,092	)		255,950		231,172		119		(592	)		230,699
Corporate securities		6,933		59		—			6,992		6,915		69		(24	)		6,960
Mortgage-backed securities:
Agency		164,612		3,756		(281	)		168,087		199,518		427		(2,425	)		197,520
Non-agency		160,321		2,699		(49	)		162,971		158,803		423		(1,695	)		157,531
Total mortgage-backed securities		324,933		6,455		(330	)		331,058		358,321		850		(4,120	)		355,051
Trust preferred securities		11,077		1,623		(1,774	)		10,926		11,066		1,713		(1,679	)		11,100
Total	$	781,504		17,789		(3,196	)		796,097		844,461		6,024		(7,684)			842,801

The Company had no held-to-maturity securities as of September 30, 2019 or December 31, 2018.  

The amortized cost and fair value of debt securities by contractual maturity at September 30, 2019 follows:

	At September 30, 2019
	Amortized		Fair
	Cost		Value
	(In thousands)
Securities available-for-sale:
Less than one year	$	255		256
One to five years		6,856		6,956
Six to ten years		104,272		106,320
After ten years		670,121		682,565
Total	$	781,504		796,097

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

14

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

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Proceeds	$	15,376			31,324			151,389			116,624
Realized gains	$	768			8			4,155			77
Realized losses		(12	)		(857	)		(264	)		(2,369	)
Total investment securities gains (losses), net	$	756			(849	)		3,891			(2,292	)

 

At September 30, 2019, the Company had pledged securities with a market value of $73.2 million for Federal Home Loan Bank (“FHLB”) advances. At December 31, 2018, the Company had pledged securities with a market value of $84.3 million for FHLB advances.

At September 30, 2019, the Company had pledged $125.3 million of securities to secure public agency funds. At December 31, 2018, the Company had pledged $165.5 million of securities to secure public agency funds.

The following tables summarize gross unrealized losses on investment securities and the fair market value of the related securities at September 30, 2019 and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

	At September 30, 2019
	Less than 12 Months							12 Months or Greater							Total
	Amortized		Fair		Unrealized			Amortized		Fair		Unrealized			Amortized		Fair		Unrealized
	Cost		Value		Losses			Cost		Value		Losses			Cost		Value		Losses
	(In thousands)
Available-for-sale:
Municipal securities	$	3,016		3,016		—			—		—		—			3,016		3,016		—
US government agencies		—		—		—			—		—		—			—		—		—
Collateralized loan obligations		98,124		97,884		(240	)		86,973		86,121		(852	)		185,097		184,005		(1,092	)
Corporate securities		—		—		—			—		—		—			—		—		—
Mortgage-backed securities:
Agency		1,374		1,373		(1	)		37,380		37,100		(280	)		38,754		38,473		(281	)
Non-agency		12,040		12,023		(17	)		2,152		2,120		(32	)		14,192		14,143		(49	)
Total mortgage-backed securities		13,414		13,396		(18	)		39,532		39,220		(312	)		52,946		52,616		(330	)
Trust preferred securities		—		—		—			8,114		6,340		(1,774	)		8,114		6,340		(1,774	)
Total	$	114,554		114,296		(258	)		134,619		131,681		(2,938	)		249,173		245,977		(3,196	)

15

	At December 31, 2018
	Less than 12 Months							12 Months or Greater							Total
	Amortized		Fair		Unrealized			Amortized		Fair		Unrealized			Amortized		Fair		Unrealized
	Cost		Value		Losses			Cost		Value		Losses			Cost		Value		Losses
	(In thousands)
Available-for-sale:
Municipal securities	$	12,395		12,331		(64	)		55,189		53,984		(1,205	)		67,584		66,315		(1,269	)
US government agencies		—		—		—			—		—		—			—		—		—
Collateralized loan obligations		146,913		146,344		(569	)		5,000		4,977		(23	)		151,913		151,321		(592	)
Corporate securities		2,980		2,956		(24	)		—		—		—			2,980		2,956		(24	)
Mortgage-backed securities:
Agency		14,615		14,450		(165	)		120,325		118,065		(2,260	)		134,940		132,515		(2,425	)
Non-agency		71,376		70,709		(667	)		43,138		42,110		(1,028	)		114,514		112,819		(1,695	)
Total mortgage-backed securities		85,991		85,159		(832	)		163,463		160,175		(3,288	)		249,454		245,334		(4,120	)
Trust preferred securities		—		—		—			8,214		6,535		(1,679	)		8,214		6,535		(1,679	)
Total	$	248,279		246,790		(1,489	)		231,866		225,671		(6,195	)		480,145		472,461		(7,684	)

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

At September 30, 2019 and December 31, 2018, the Company had 69 and 214, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company's investments were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows testing as needed, and determined that no OTTI expense was necessary during 2019 or 2018.

NOTE 4 – DERIVATIVES

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

16

The derivative positions of the Company at September 30, 2019 and December 31, 2018 are as follows: 

	At September 30,				At December 31,
	2019				2018
	Fair		Notional		Fair		Notional
	Value		Value		Value		Value
	(In thousands)
Derivative assets:
Cash flow hedges:
Interest rate swaps	$	—		—		1,232		45,000
Non-hedging derivatives:
Interest rate swaps		186		35,000		1,198		50,000
Mortgage loan interest rate lock commitments		1,653		122,840		1,199		76,571
Mortgage loan forward sales commitments		421		23,271		403		13,241
Mortgage-backed securities forward sales commitments		43		87,000		—		—
Total derivative assets	$	2,303		268,111		4,032		184,812
Derivative liabilities:
Cash flow hedges:
Interest rate swaps	$	1,102		45,000		—		—
Non-hedging derivatives:
Interest rate swaps		3,850		50,000		937		50,000
Mortgage-backed securities forward sales commitments		—		—		295		52,000
Total derivative liabilities	$	4,952		95,000		1,232		102,000

Non-Designated Hedges

Derivative Loan Commitments and Forward Sales Commitments

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

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

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

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

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

17

 

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

Interest Rate Swaps

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

Cash Flow Hedges of Interest Rate Risk

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

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

Risk Management Objective of Using Derivatives

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

NOTE 5 – LOANS RECEIVABLE, NET

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

18

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.

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

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

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

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

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

19

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. Syndicated loans are grouped within commercial business loans below.

The Bank originates leases, primarily on equipment utilized for business purposes, with terms that 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 September 30, 2019 and December 31, 2018, there were approximately $16.9 million and $23.1 million in lease receivables outstanding. Lease receivables are grouped within commercial business loans below.

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

Loans receivable, net at September 30, 2019 and December 31, 2018 are summarized by category as follows:

	At September 30,					At December 31,
	2019					2018
			% of Total					% of Total
All Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	721,841		26.52	%		732,717		29.03	%
Home equity		75,107		2.76	%		83,770		3.32	%
Commercial real estate		1,138,879		41.84	%		1,034,117		40.96	%
Construction and development		370,833		13.62	%		290,494		11.51	%
Consumer loans		23,459		0.86	%		23,845		0.94	%
Commercial business loans		392,062		14.40	%		359,393		14.24	%
Total gross loans receivable		2,722,181		100.00	%		2,524,336		100.00	%
Less:
Allowance for loan losses		16,125					14,463
Total loans receivable, net	$	2,706,056					2,509,873

20

Loans receivable, net at September 30, 2019 and December 31, 2018 for purchased non-credit impaired loans and nonacquired loans are summarized by category as follows:

	At September 30,					At December 31,
	2019					2018
Purchased Non-Credit Impaired Loans			% of Total					% of Total
(ASC 310-20) and Nonacquired Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	714,342		26.61	%		723,641		29.24	%
Home equity		75,087		2.80	%		83,717		3.38	%
Commercial real estate		1,117,804		41.65	%		1,004,420		40.59	%
Construction and development		368,110		13.72	%		287,673		11.63	%
Consumer loans		23,436		0.87	%		23,792		0.96	%
Commercial business loans		385,274		14.35	%		351,194		14.20	%
Total gross loans receivable		2,684,053		100.00	%		2,474,437		100.00	%
Less:
Allowance for loan losses		16,089					14,463
Total loans receivable, net	$	2,667,964					2,459,974

Loans receivable, net at September 30, 2019 and December 31, 2018 for purchased credit impaired loans are summarized by category below. 

	At September 30,					At December 31,
	2019					2018
Purchased Credit Impaired			% of Total					% of Total
Loans (ASC 310-30):	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	7,499		19.67	%		9,077		18.19	%
Home equity		20		0.06	%		53		0.11	%
Commercial real estate		21,075		55.27	%		29,696		59.51	%
Construction and development		2,723		7.14	%		2,821		5.65	%
Consumer loans		23		0.06	%		53		0.11	%
Commercial business loans		6,788		17.80	%		8,199		16.43	%
Total gross loans receivable		38,128		100.00	%		49,899		100.00	%
Less:
Allowance for loan losses		36					—
Total loans receivable, net	$	38,092					49,899

Included in the loan totals, net of purchase discount, were $548.8 million and $686.4 million in loans acquired through acquisitions at September 30, 2019 and December 31, 2018, respectively. At September 30, 2019 and December 31, 2018, the purchase discount on acquired non-credit impaired loans was $8.0 million and $10.9 million, respectively. No allowance for loan losses related to the acquired loans was recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

  

21

  

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

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

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

At September 30, 2019, the outstanding balance and recorded investment of PCI loans was $49.0 million and $38.1 million, respectively. At December 31, 2018, the outstanding balance and recorded investment of PCI loans was $63.7 million and $49.9 million, respectively.

The following table presents changes in the value of PCI loans receivable for the three and nine months ended September 30, 2019 and 2018: 

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Balance at beginning of period	$	43,592			64,518			49,899			78,415
Net reductions for payments, foreclosures, and accretion		(5,464	)		(6,785	)		(11,771	)		(20,682	)
Balance at end of period	$	38,128			57,733			38,128			57,733

The following table presents changes in the value of the accretable yield for PCI loans for the three and nine months ended September 30, 2019 and 2018: 

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Accretable yield, beginning of period	$	19,317			14,670			19,908			12,536
Accretion and interest income		(2,479	)		(1,138	)		(5,054	)		(3,694	)
Reclassification from nonaccretable balance, net(a)		345			433			1,057			3,836
Other changes, net(b)		(420	)		180			852			1,467
Accretable yield, end of period	$	16,763			14,145			16,763			14,145

(a) Reclassifications from the nonaccretable balance in the three and nine months ended September 30, 2019 were driven by improvement in credit quality.

(b) Other changes, net include the impact of changes in expectations of cash flows, which may vary from period to period due to the impact of modifications and changes to prepayment assumptions, as well as the impact of changes in interest rates on variable rate loans.

22

  

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

	At September 30,				At December 31,
	2019				2018
	(Dollars in thousands)
Variable rate loans	$	1,071,384	39.36	%		942,348	37.33	%
Fixed rate loans		1,650,797	60.64	%		1,581,988	62.67	%
Total loans outstanding	$	2,722,181	100.00	%		2,524,336	100.00	%

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

	For the Three Months Ended September 30, 2019
	Loans Secured by Real Estate
	One-to-						Commercial			Construction
	four			Home			real			and						Commercial
	family			equity			estate			development			Consumer			business			Unallocated			Total
Allowance for loan losses:	(In thousands)
Balance, beginning of period	$	3,585			236			5,538			2,061			378			3,599			470			15,867
Provision for loan losses - non PCI loans		66			(8	)		536			361			106			(65	)		(222	)		774
Provision for loan losses - PCI loans		(14	)		—			(84	)		—			(1	)		(55	)		—			(154	)
Charge-offs		(83	)		—			(336	)		(1	)		(117	)		—			—			(537	)
Recoveries		12			—			8			94			43			18			—			175
Balance, end of period	$	3,566			228			5,662			2,515			409			3,497			248			16,125
	For the Three Months Ended September 30, 2018
	Loans Secured by Real Estate
	One-to-						Commercial			Construction
	four			Home			real			and						Commercial
	family			equity			estate			development			Consumer			business			Unallocated			Total
	(In thousands)
Balance, beginning of period	$	3,110			202			4,339			2,082			117			2,543			594			12,987
Provision for loan losses - non PCI loans		402			15			352			4			255			(13	)		(265	)		750
Charge-offs		(79	)		—			—			(23	)		(117	)		(20	)		—			(239	)
Recoveries		3			1			22			—			12			79			—			117
Balance, end of period	$	3,436			218			4,713			2,063			267			2,589			329			13,615

 

23

	For the Nine Months Ended September 30, 2019
	Loans Secured by Real Estate
	One-to-						Commercial			Construction
	four			Home			real			and						Commercial
	family			equity			estate			development			Consumer			business			Unallocated			Total
Allowance for loan losses	(In thousands)
Balance, beginning of period	$	3,540			203			5,097			1,969			352			2,940			362			14,463
Provision for loan losses - non PCI loans		101			96			901			325			135			520			(114	)		1,964
Provision for loan losses - PCI loans		6			—			1			—			—			29			—			36
Charge-offs		(231	)		(78	)		(368	)		(17	)		(217	)		(62	)		—			(973	)
Recoveries		150			7			31			238			139			70			—			635
Balance, end of period	$	3,566			228			5,662			2,515			409			3,497			248			16,125
	For the Nine Months Ended September 30, 2018
	Loans Secured by Real Estate
	One-to-						Commercial			Construction
	four			Home			real			and						Commercial
	family			equity			estate			development			Consumer			business			Unallocated			Total
	(In thousands)
Balance, beginning of period	$	2,719			168			3,986			1,201			79			2,840			485			11,478
Provision for loan losses - non PCI loans		928			41			744			(152	)		373			(469	)		(156	)		1,309
Charge-offs		(226	)		—			(86	)		(24	)		(255	)		(136	)		—			(727	)
Recoveries		15			9			69			1,038			70			354			—			1,555
Balance, end of period	$	3,436			218			4,713			2,063			267			2,589			329			13,615

  

24

  

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

	Loans Secured by Real Estate
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
	family		equity		estate		development		Consumer		business		Unallocated		Total
	(In thousands)
At September 30, 2019:
Allowance for loan losses ending balances:
Individually evaluated for impairment	$	134		—		108		438		—		79		—		759
Collectively evaluated for impairment		3,426		228		5,553		2,077		409		3,389		248		15,330
Purchased credit impaired		6		—		1		—		—		29		—		36
Total allowance for loan losses	$	3,566		228		5,662		2,515		409		3,497		248		16,125
Loans receivable ending balances:
Individually evaluated for impairment	$	5,260		17		12,283		2,328		30		2,788		—		22,706
Collectively evaluated for impairment		709,082		75,070		1,105,521		365,782		23,406		382,486		—		2,661,347
Purchased credit impaired		7,499		20		21,075		2,723		23		6,788		—		38,128
Total loans receivable	$	721,841		75,107		1,138,879		370,833		23,459		392,062		—		2,722,181
At December 31, 2018:
Allowance for loan losses ending balances:
Individually evaluated for impairment	$	176		—		145		515		—		24		—		860
Collectively evaluated for impairment		3,364		203		4,952		1,454		352		2,916		362		13,603
Total allowance for loan losses	$	3,540		203		5,097		1,969		352		2,940		362		14,463
Loans receivable ending balances:
Individually evaluated for impairment	$	4,687		249		5,105		1,866		31		2,853		—		14,791
Collectively evaluated for impairment		718,953		83,468		999,316		285,807		23,761		348,341		—		2,459,646
Purchased credit impaired		9,077		53		29,696		2,821		53		8,199		—		49,899
Total loans receivable	$	732,717		83,770		1,034,117		290,494		23,845		359,393		—		2,524,336

25

  

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of September 30, 2019 and December 31, 2018. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

	At September 30, 2019						At December 31, 2018
			Unpaid							Unpaid
	Recorded		Principal		Related			Recorded		Principal		Related
	Investment		Balance		Allowance			Investment		Balance		Allowance
	(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family	$	4,527		4,625		—			3,083		3,241		—
Home equity		17		17		—			249		249		—
Commercial real estate		10,293		10,368		—			2,679		2,694		—
Construction and development		695		695		—			323		323		—
Consumer loans		30		60		—			31		31		—
Commercial business loans		2,462		2,462		—			2,697		2,698		—
		18,024		18,227		—			9,062		9,236		—
With an allowance recorded:
Loans secured by real estate:
One-to-four family		733		715		134			1,604		1,665		176
Home equity		—		—		—			—		—		—
Commercial real estate		1,990		2,181		108			2,426		2,426		145
Construction and development		1,633		1,633		438			1,543		1,543		515
Consumer loans		—		—		—			—		—		—
Commercial business loans		326		341		79			156		156		24
		4,682		4,870		759			5,729		5,790		860
Total:
Loans secured by real estate:
One-to-four family		5,260		5,340		134			4,687		4,906		176
Home equity		17		17		—			249		249		—
Commercial real estate		12,283		12,549		108			5,105		5,120		145
Construction and development		2,328		2,328		438			1,866		1,866		515
Consumer loans		30		60		—			31		31		—
Commercial business loans		2,788		2,803		79			2,853		2,854		24
	$	22,706		23,097		759			14,791		15,026		860

 

26

  

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three and nine months ended September 30, 2019 and 2018.

	For the Three Months Ended September 30,								For the Nine Months Ended September 30,
	2019				2018				2019				2018
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
	(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family	$	4,869		33		2,115		25		4,548		74		2,220		27
Home equity		4		1		17		3		1		1		55		4
Commercial real estate		6,645		217		3,108		37		5,175		275		3,087		86
Construction and development		592		20		267		4		618		26		267		13
Consumer loans		58		8		20		1		51		11		21		1
Commercial business loans		2,635		34		155		104		2,493		99		426		118
		14,803		313		5,682		174		12,886		486		6,076		249
With an allowance recorded:
Loans secured by real estate:
One-to-four family		649		10		1,293		7		586		24		1,278		23
Home equity		—		—		—		—		—		—		—		—
Commercial real estate		2,084		11		1,702		16		2,224		57		1,679		55
Construction and development		1,430		5		1,447		—		1,219		5		1,137		(4	)
Consumer loans		—		—		—		—		—		—		—		—
Commercial business loans		340		—		160		2		145		—		160		7
		4,503		26		4,602		25		4,174		86		4,254		81
Total:
Loans secured by real estate:
One-to-four family		5,518		43		3,408		32		5,134		98		3,498		50
Home equity		4		1		17		3		1		1		55		4
Commercial real estate		8,729		228		4,810		53		7,399		332		4,766		141
Construction and development		2,022		25		1,714		4		1,837		31		1,404		9
		58		8		20		1		51		11		21		1
Commercial business loans		2,975		34		315		106		2,638		99		586		125
	$	19,306		339		10,284		199		17,060		572		10,330		330

  

27

  

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of September 30, 2019 and December 31, 2018.

	At September 30, 2019
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
All Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	639		434		4,418		71		131		125		5,818
60-89 days past due		1,992		—		102		99		28		302		2,523
90 days or more past due		3,723		17		3,700		755		29		678		8,902
Total past due		6,354		451		8,220		925		188		1,105		17,243
Current		715,487		74,656		1,130,659		369,908		23,271		390,957		2,704,938
Total loans receivable	$	721,841		75,107		1,138,879		370,833		23,459		392,062		2,722,181
	At September 30, 2019
Purchased Non-Credit	Real Estate Loans
Impaired Loans	One-to-				Commercial		Construction
(ASC 310-20) and	four		Home		real		and				Commercial
Nonacquired Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	639		434		4,418		71		127		125		5,814
60-89 days past due		1,931		—		102		98		28		302		2,461
90 days or more past due		3,376		17		3,501		53		29		678		7,654
Total past due		5,946		451		8,021		222		184		1,105		15,929
Current		708,396		74,636		1,109,783		367,888		23,252		384,169		2,668,124
Total loans receivable	$	714,342		75,087		1,117,804		368,110		23,436		385,274		2,684,053
	At September 30, 2019
	Real Estate Loans
	One-to-				Commercial		Construction
Purchased Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	—		—		—		—		4		—		4
60-89 days past due		61		—		—		1		—		—		62
90 days or more past due		347		—		199		702		—		—		1,248
Total past due		408		—		199		703		4		—		1,314
Current		7,091		20		20,876		2,020		19		6,788		36,814
Total loans receivable	$	7,499		20		21,075		2,723		23		6,788		38,128

 

28

  

	At December 31, 2018
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
All Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	503		723		1,780		180		296		793		4,275
60-89 days past due		1,677		213		120		588		31		632		3,261
90 days or more past due		4,133		373		3,054		105		117		602		8,384
Total past due		6,313		1,309		4,954		873		444		2,027		15,920
Current		726,404		82,461		1,029,163		289,621		23,401		357,366		2,508,416
Total loans receivable	$	732,717		83,770		1,034,117		290,494		23,845		359,393		2,524,336
	At December 31, 2018
Purchased Non-Credit	Real Estate Loans
Impaired Loans	One-to-				Commercial		Construction
(ASC 310-20) and	four		Home		real		and				Commercial
Nonpurchased Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	378		720		1,037		172		296		793		3,396
60-89 days past due		1,313		213		120		559		31		632		2,868
90 days or more past due		3,686		373		2,895		106		117		602		7,779
Total past due		5,377		1,306		4,052		837		444		2,027		14,043
Current		718,264		82,411		1,000,368		286,836		23,348		349,167		2,460,394
Total loans receivable	$	723,641		83,717		1,004,420		287,673		23,792		351,194		2,474,437
	At December 31, 2018
	Real Estate Loans
	One-to-				Commercial		Construction
Purchased Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	126		3		743		7		—		—		879
60-89 days past due		364		—		—		30		—		—		394
90 days or more past due		447		—		158		—		—		—		605
Total past due		937		3		901		37		—		—		1,878
Current		8,140		50		28,795		2,784		53		8,199		48,021
Total loans receivable	$	9,077		53		29,696		2,821		53		8,199		49,899

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

29

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at September 30, 2019 and December 31, 2018.

	At September 30,		At December 31,
	2019		2018
	(In thousands)
Loans secured by real estate:
One-to-four family	$	5,527		4,471
Home equity		17		454
Commercial real estate		10,113		3,663
Construction and development		1,872		1,675
Consumer loans		32		107
Commercial business loans		1,471		1,351
	$	19,032		11,721

There were no non-PCI loans past due 90 days and still accruing at September 30, 2019 and one non-PCI loan past due 90 days and still accruing for $20,000 at December 31, 2018.

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

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

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

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

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

The Company uses the following definitions in the tables below:

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

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

  

30

  

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of September 30, 2019 and December 31, 2018.

	At September 30, 2019
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
Total Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	716,591		74,965		1,102,382		366,360		23,288		387,315		2,670,901
Special Mention		127		125		23,222		1,863		92		1,394		26,823
Substandard		5,123		17		13,275		2,610		79		3,353		24,457
Total loans receivable	$	721,841		75,107		1,138,879		370,833		23,459		392,062		2,722,181
Performing	$	715,967		75,090		1,128,567		368,259		23,427		390,591		2,701,901
Nonperforming:
90 days past due still accruing		347		—		199		702		—		—		1,248
Nonaccrual		5,527				10,113		1,872		32		1,471		19,032
Total nonperforming		5,874		17		10,312		2,574		32		1,471		20,280
Total loans receivable	$	721,841		75,107		1,138,879		370,833		23,459		392,062		2,722,181
	At September 30, 2019
Purchased Non-Credit	Real Estate Loans
Impaired Loans	One-to-				Commercial		Construction
(ASC 310-20) and	four		Home		real		and				Commercial
Nonacquired Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	709,789		74,945		1,086,024		364,375		23,269		381,039		2,639,441
Special Mention		—		125		21,045		1,863		92		1,299		24,424
Substandard		4,553		17		10,735		1,872		75		2,936		20,188
Total loans receivable	$	714,342		75,087		1,117,804		368,110		23,436		385,274		2,684,053
Performing	$	708,815		75,070		1,107,691		366,238		23,404		383,803		2,665,021
Nonperforming:
90 days past due still accruing		—		—		—		—		—		—		—
Nonaccrual		5,527		17		10,113		1,872		32		1,471		19,032
Total nonperforming		5,527		17		10,113		1,872		32		1,471		19,032
Total loans receivable	$	714,342		75,087		1,117,804		368,110		23,436		385,274		2,684,053

 

31

  

	At September 30, 2019
	Real Estate Loans
	One-to-				Commercial		Construction
Purchased Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	6,802		20		16,358		1,985		19		6,276		31,460
Special Mention		127		—		2,177		—		—		95		2,399
Substandard		570		—		2,540		738		4		417		4,269
Total loans receivable	$	7,499		20		21,075		2,723		23		6,788		38,128
Performing	$	7,152		20		20,876		2,021		23		6,788		36,880
Nonperforming:
90 days past due still accruing		347		—		199		702		—		—		1,248
Nonaccrual		—		—		—		—		—		—		—
Total nonperforming		347		—		199		702		—		—		1,248
Total loans receivable	$	7,499		20		21,075		2,723		23		6,788		38,128
	At December 31, 2018
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
Total Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	727,921		83,382		1,016,064		287,559		23,613		353,742		2,492,281
Special Mention		417		—		9,914		534		103		2,166		13,134
Substandard		4,379		388		8,139		2,401		129		3,485		18,921
Total loans receivable	$	732,717		83,770		1,034,117		290,494		23,845		359,393		2,524,336
Performing	$	727,799		83,316		1,030,296		288,819		23,718		358,042		2,511,990
Nonperforming:
90 days past due still accruing		447		—		158		—		20		—		625
Nonaccrual		4,471		454		3,663		1,675		107		1,351		11,721
Total nonperforming		4,918		454		3,821		1,675		127		1,351		12,346
Total loans receivable	$	732,717		83,770		1,034,117		290,494		23,845		359,393		2,524,336

 

32

  

	At December 31, 2018
Purchased Non-Credit	Real Estate Loans
Impaired Loans	One-to-				Commercial		Construction
(ASC 310-20) and	four		Home		real		and				Commercial
Nonpurchased Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	720,177		83,336		995,319		285,927		23,571		346,487		2,454,817
Special Mention		—		—		5,524		71		103		1,379		7,077
Substandard		3,464		381		3,577		1,675		118		3,328		12,543
Total loans receivable	$	723,641		83,717		1,004,420		287,673		23,792		351,194		2,474,437
Performing	$	719,170		83,263		1,000,757		285,998		23,665		349,843		2,462,696
Nonperforming:
90 days past due still accruing		—		—		—		—		20		—		20
Nonaccrual		4,471		454		3,663		1,675		107		1,351		11,721
Total nonperforming		4,471		454		3,663		1,675		127		1,351		11,741
Total loans receivable	$	723,641		83,717		1,004,420		287,673		23,792		351,194		2,474,437

	At December 31, 2018
	Real Estate Loans
	One-to-				Commercial		Construction
Purchased Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	7,745		45		20,745		1,632		42		7,255		37,464
Special Mention		418		—		4,390		463		—		787		6,058
Substandard		914		8		4,561		726		11		157		6,377
Total loans receivable	$	9,077		53		29,696		2,821		53		8,199		49,899
Performing	$	8,630		53		29,538		2,821		53		8,199		49,294
Nonperforming:
90 days past due still accruing		447		—		158		—		—		—		605
Nonaccrual		—		—		—		—		—		—		—
Total nonperforming		447		—		158		—		—		—		605
Total loans receivable	$	9,077		53		29,696		2,821		53		8,199		49,899

 

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

33

Troubled Debt Restructurings

At September 30, 2019, there were $7.5 million in loans designated as troubled debt restructurings of which $3.1 million were accruing. At September 30, 2018, there were $6.2 million in loans designated as troubled debt restructurings of which $4.1 million were accruing. At December 31, 2018, there were $6.4 million in loans designated as troubled debt restructurings of which $3.3 million were accruing.

There were no loans identified as troubled debt restructurings during the three months ended September 30, 2019 and September 30, 2018.

There was one one-to-four family loan and four commercial real estate loans designated as a troubled debt restructuring during the nine months ended September 30, 2019. All loans were designated as a troubled debt restructuring due to a payment structure change. The pre-modification and post-modification recorded investment were $2.7 million.

There was one commercial real estate loan and one construction and development loan designated as a troubled debt restructuring during the nine months ended September 30, 2018. All loans were designated as a troubled debt restructuring due to an interest rate change. The pre-modification and post-modification recorded inestment were $1.7 million. 

No loans restructured in the twelve months prior to September 30, 2019 went into default during the three months ended September 30, 2019. Four commercial real estate loans restructured in the twelve months prior to September 30, 2019 totaling $2.1 million in principal went into default during the nine months ended September 30, 2019. No loans restructured in the twelve months prior to September 30, 2018 went into default during the three and nine months ended September 30, 2018.

NOTE 6 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in real estate acquired through foreclosure for the periods ended September 30, 2019 and 2018:

	For the Three Months Ended						For the Nine Months Ended
	September 30,						September 30,
	2019			2018			2019			2018
	(In thousands)
Balance at beginning of period	$	1,218			1,726			1,534			3,106
Additions		660			177			1,274			268
Sales and paydowns		(46	)		(302	)		(976	)		(1,647	)
Write downs		—			—			—			(126	)
Balance at end of period	$	1,832			1,601			1,832			1,601

34

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

	At September 30,		At December 31,
	2019		2018
	(In thousands)
Real estate owned:
One-to-four family	$	198		204
Commercial real estate		853		—
Construction and development		781		1,330
Total real estate owned	$	1,832		1,534

As of September 30, 2019, the Company had approximately $10.5 million of loans in the process of foreclosure. At December 31, 2018, the Company had approximately $4.5 million of loans in the process of foreclosure.

NOTE 7 – DEPOSITS

Deposits outstanding by type of account at September 30, 2019 and December 31, 2018 are summarized as follows:

	At September 30,		At December 31,
	2019		2018
	(In thousands)
Noninterest-bearing demand accounts	$	611,959		547,022
Interest-bearing demand accounts		587,963		566,527
Savings accounts		180,827		192,322
Money market accounts		428,867		431,246
Certificates of deposit:
Less than $250,000		948,218		875,749
$250,000 or more		85,380		105,327
Total certificates of deposit		1,033,598		981,076
Total deposits	$	2,843,214		2,718,193

The aggregate amount of brokered certificates of deposit was $156.7 million and $174.1 million at September 30, 2019 and December 31, 2018, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $250,000. The aggregate amount of institutional certificates of deposit was $44.9 million and $39.4 million at September 30, 2019 and December 31, 2018, respectively.

NOTE 8 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

Current accounting literature requires disclosures about the fair value of all financial instruments whether or not recognized in the balance sheet, for which it is practicable to estimate the value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument.

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

35

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

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

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

Level 2 Observable inputs other than Level 1 quoted prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices in markets that are not active, or model-based valuation techniques for which all significant assumptions are derived principally from or corroborated by observable market data. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined by using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. U.S. Government sponsored agency securities, mortgage-backed securities issued by U.S. Government sponsored enterprises and agencies, obligations of states and municipalities, collateralized mortgage obligations issued by U.S. Government sponsored enterprises, and mortgage loans held-for-sale are generally included in this category. Certain private equity investments that invest in publicly traded companies are also considered Level 2 assets.

Level 3 Unobservable inputs that are supported by little, if any, market activity for the asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow models and similar techniques, and may also include the use of market prices of assets or liabilities that are not directly comparable to the subject asset or liability. These methods of valuation may result in a significant portion of the fair value being derived from unobservable assumptions that reflect The Company's own estimates for assumptions that market participants would use in pricing the asset or liability. This category primarily includes collateral-dependent impaired loans, other real estate, certain equity investments, and certain private equity investments.

 

36

Assets and liabilities measured at fair value on a recurring basis are as follows as of September 30, 2019 and December 31, 2018:

	Quoted market		Significant other		Significant other
	price in active		observable inputs		unobservable inputs
	markets (Level 1)		(Level 2)		(Level 3)
	(In thousands)
September 30, 2019
Available-for-sale investment securities:
Municipal securities	$	—		181,083		—
US government agencies		—		10,088		—
Collateralized loan obligations		—		255,950		—
Corporate securities		—		6,992		—
Mortgage-backed securities:
Agency		—		168,087		—
Non-agency		—		162,971		—
Trust preferred securities		—		10,926		—
Loans held for sale		—		36,882		—
Derivative assets:
Non-hedging derivatives:
Interest rate swaps		186		—		—
Mortgage loan interest rate lock commitments		—		1,653		—
Mortgage loan forward sales commitments		—		421		—
Mortgage-backed securities forward sales commitments		—		43		—
Derivative liabilities:
Cash flow hedges
Interest rate swaps		1,102		—		—
Non-hedging derivatives:
Interest rate swaps		3,850		—		—
December 31, 2018
Available-for-sale investment securities:
Municipal securities	$	—		213,714		—
US government agencies		—		25,277		—
Collateralized loan obligations		—		230,699		—
Corporate securities		—		6,960		—
Mortgage-backed securities:
Agency		—		197,520		—
Non-agency		—		157,531		—
Trust preferred securities		—		11,100		—
Loans held for sale		—		16,972		—
Derivative assets:
Cash flow hedges:
Interest rate swaps		1,232		—		—
Non-hedging derivatives:
Interest rate swaps		1,198		—		—
Mortgage loan interest rate lock commitments		—		1,199		—
Mortgage loan forward sales commitments		—		403		—
Derivative liabilities:
Non-hedging derivatives:
Interest rate swaps		937		—		—
Mortgage-backed securities forward sales commitments		—		295		—

37

Securities Available-for-Sale

Fair values for investment securities available-for-sale are measured on a recurring basis upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity. At September 30, 2019 and December 31, 2018 the Company's investment securities available-for-sale are recurring Level 2.

Mortgage Loans Held for Sale

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

Derivative Assets and Liabilities

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

  

38

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

Assets measured at fair value on a nonrecurring basis are as follows as of September 30, 2019 and December 31, 2018:

 

	Quoted market price		Significant other		Significant other
	in active markets		observable inputs		unobservable inputs
	(Level 1)		(Level 2)		(Level 3)
	(In thousands)
September 30, 2019
Impaired loans:
Loans secured by real estate:
One-to-four family	$	—		—		5,126
Home equity		—		—		17
Commercial real estate		—		—		12,175
Construction and development		—		—		1,890
Consumer loans		—		—		30
Commercial business loans		—		—		2,709
Real estate owned:
One-to-four family		—		—		198
Commercial real estate		—		—		853
Construction and development		—		—		781
Mortgage servicing rights		—		—		29,350
December 31, 2018
Impaired loans:
Loans secured by real estate:
One-to-four family	$	—		—		4,511
Home equity		—		—		249
Commercial real estate		—		—		4,960
Construction and development		—		—		1,351
Consumer loans		—		—		31
Commercial business loans		—		—		2,829
Real estate owned:
One-to-four family		—		—		204
Construction and development		—		—		1,330
Mortgage servicing rights		—		—		40,880

  

39

For Level 3 assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2019 and December 31, 2018, the significant unobservable inputs used in the fair value measurements were as follows:

	September 30, 2019 and December 31, 2018
		Significant	Significant Unobservable
	Valuation Technique	Observable Inputs	Inputs
Impaired loans	Appraisal value	Appraisals and or sales of comparable properties	Appraisals discounted  10% to 20% for sales commissions and other holding costs
Real estate owned	Appraisal value/ Comparison sales	Appraisals and or sales of comparable properties	Appraisals discounted  10% to 20% for sales commissions and other holding costs
Mortgage servicing rights	Discounted cash flows	Comparable sales	Weighted average discount rates
			averaging 10% - 12% in 2019
			Weighted average discount rates
			averaging 12% - 13% in 2018
			Weighted average prepayment rates
			averaging 14% - 16%  in 2019
			Weighted average prepayment rates
			averaging 6% - 7% in 2018
			Net servicing fee of 0.25% in each period presented
			Weighted average delinquency rates
			averaging 1.79% in 2019
			Weighted average delinquency rates
			averaging 2.34% in 2018

Impaired Loans

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

Other Real Estate Owned (“OREO”)

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

Mortgage Servicing Rights

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

The Company recorded a $1.8 million temporary impairment of mortgage servicing rights in the three months ended September 30, 2019. The Company recorded a $3.1 million temporary impairment of mortgage servicing rights in the nine months ended September 30, 2019. Impairment was recorded in the 2017, 2018 and 2019 tranches. The Company does not hedge the mortgage servicing rights positions and the impact of falling long-term interest rates increased prepayment speed assumptions reducing the value of the MSR asset.

  

40

The carrying amount and estimated fair value of the Company's financial instruments at September 30, 2019 and December 31, 2018 are as follows:

 

		At September 30, 2019
		Carrying	Fair Value
		Amount	Total		Level 1		Level 2		Level 3
		(In thousands)
Financial assets:
Cash and due from banks	$	25,519		25,519		25,519		—		—
Interest-bearing cash		51,358		51,358		51,358		—		—
Securities available-for-sale		796,097		796,097		—		796,097		—
Federal Home Loan Bank stock		21,707		21,707		—		—		21,707
Other investments		3,520		3,520		—		—		3,520
Derivative assets		2,303		2,303		186		2,117		—
Loans held for sale		36,882		36,882		—		36,882		—
Loans receivable, net		2,706,056		2,703,641		—		—		2,703,641
Accrued interest receivable		13,029		13,029		—		13,029		—
Real estate acquired through foreclosure		1,832		1,832		—		—		1,832
Mortgage servicing rights		26,528		29,350		—		—		29,350
Financial liabilities:
Deposits		2,843,214		2,849,215		—		2,849,215		—
Short-term borrowed funds		417,000		416,972		—		416,972		—
Long-term debt		42,570		43,715		—		43,715		—
Derivative liabilities		4,952		4,952		4,952		—		—
Drafts outstanding		6,518		6,518		—		6,518		—
Advances from borrowers for insurance and taxes		6,923		6,923		—		6,923		—
Accrued interest payable		2,009		2,009		—		2,009		—
Dividends payable to stockholders		2,003		2,003		—		2,003		—

  

41

	At December 31, 2018
	Carrying		Fair Value
	Amount		Total		Level 1		Level 2		Level 3
	(In thousands)
Financial assets:
Cash and due from banks	$	28,857		28,857		28,857		—		—
Interest-bearing cash		33,276		33,276		33,276		—		—
Securities available-for-sale		842,801		842,801		—		842,801		—
Federal Home Loan Bank stock		21,696		21,696		—		—		21,696
Other investments		3,450		3,450		—		—		3,450
Derivative assets		4,032		4,032		2,430		1,602		—
Loans held for sale		16,972		16,972		—		16,972		—
Loans receivable, net		2,509,873		2,506,384		—		—		2,506,384
Accrued interest receivable		13,494		13,494		—		13,494		—
Real estate acquired through foreclosure		1,534		1,534		—		—		1,534
Mortgage servicing rights		32,933		40,880		—		—		40,880
Financial liabilities:
Deposits		2,718,193		2,721,885		—		2,721,885		—
Short-term borrowed funds		405,500		405,532		—		405,532		—
Long-term debt		59,436		61,853		—		61,853		—
Derivative liabilities		1,232		1,232		937		295		—
Drafts outstanding		8,129		8,129		—		8,129		—
Advances from borrowers for insurance and taxes		4,100		4,100		—		4,100		—
Accrued interest payable		1,591		1,591		—		1,591		—
Dividends payable to stockholders		1,576		1,576		—		1,576		—

		At September 30, 2019		At December 31, 2018
		Notional	Estimated	Notional	Estimated
		Amount	Fair Value	Amount	Fair Value
		(In thousands)
Off-Balance Sheet Financial Instruments:
Commitments to extend credit	$	462,466	—	379,170	—
Standby letters of credit		22,041	—	13,797	—

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

Cash and due from banks

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

Interest-bearing cash

The carrying amount of these financial instruments approximates fair value.

FHLB stock and other investments

The carrying amount of these financial instruments approximates fair value.
 

42

Loans receivable

During the first quarter of 2018, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which were applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. The entry price notion previously applied by the Company used a discounted cash flows technique to calculate the present value of expected future cash flows for a financial instrument. The exit price notion uses the same approach, but also incorporates other factors, such as enhanced credit risk, illiquidity risk and market factors that sometimes exist in exit prices in dislocated markets. The technique used prior to adopting the amendments included in the standard, but with added emphasis on both illiquidity risk and credit risk not captured by the previously applied entry price notion. The fair value of the Company's loan portfolio has always included a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company's loan portfolio is initially fair valued using a segmented approach.  The results are then adjusted to account for credit risk as described above. However, under the new guidance, the Company believes a further credit risk discount must be applied through the use of a discounted cash flow model to compensate for illiquidity risk, based on certain assumptions included within the discounted cash flow model, primarily the use of discount rates that better capture inherent credit risk over the lifetime of a loan. This consideration of enhanced credit risk provides an estimated exit price for the Company's loan portfolio. For variable rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral.

Accrued interest receivable

The carrying value approximates the fair value.

Deposits

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

Short-term borrowed funds

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within90 days approximate their fair values. Estimated fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Long-term debt

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

Drafts outstanding, advances from borrowers for insurance and taxes and dividends payable to stockholders

The carrying value approximates the fair value.

Accrued interest payable

The fair value approximates the carrying value.

Commitments to extend credit

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

Off-balance sheet financial instruments

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

43

NOTE 9 – EARNINGS PER SHARE

Basic earnings per common share are calculated by dividing net income by the weighted average number of common shares outstanding during the period. Basic earnings per common share exclude the effect of nonvested restricted stock. Diluted earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding plus the weighted average number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. Diluted earnings per common share include the effects of outstanding stock options and restricted stock issued by the Company, if dilutive. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercises and vesting were used to acquire shares of common stock at the average market price during the reporting period. 

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

The following is a summary of the reconciliation of average shares outstanding for the three and nine months ended September 30, 2019 and 2018:

	For the Three Months Ended September 30,
	2019				2018
	Basic		Diluted		Basic		Diluted
Weighted average shares outstanding		22,149,567		22,149,567		22,678,681		22,678,681
Effect of dilutive securities		—		186,816		—		220,302
Weighted average shares outstanding		22,149,567		22,336,383		22,678,681		22,898,983

	For the Nine Months Ended September 30,
	2019				2018
	Basic		Diluted		Basic		Diluted
Weighted average shares outstanding		22,177,483		22,177,483		21,616,485		21,616,485
Effect of dilutive securities		—		187,710		—		226,284
Weighted average shares outstanding		22,177,483		22,365,193		21,616,485		21,842,769

The following is a summary of the reconciliation of shares issued and outstanding and unvested restricted stock awards as of September 30, 2019 and 2018 used to calculate book value per share:  

	As of September 30,
	2019			2018
Issued and outstanding shares		22,249,424			22,570,445
Less nonvested restricted stock awards		(115,933	)		(135,045	)
Period end dilutive shares		22,133,491			22,435,400

44

NOTE 10 – LEASES

The Company has entered into agreements to lease certain office facilities, including buildings and land, and equipment under non-cancellable operating lease agreements. Our leases have remaining lease terms of 1 year to 40 years, which include options to extend or terminate the lease. These options to extend or terminate the lease are included in the lease term when it is reasonably certain that the options will be exercised.

In addition to the package of practical expedients, the Company has also elected the practical expedient which allows lessees to make an accounting policy election by underlying class of asset to not separate nonlease components from the associated lease component, and instead account for them all together as part of the applicable lease component.

Operating lease expense was $0.7 million for the three months ended September 30, 2019, and $2.0 million for the nine months ended September 30, 2019. Cash paid for amounts included in the measurement of operating lease liabilities was $0.6 million for the three months ended September 30, 2019, and $1.9 million for the nine months ended September 30, 2019. We do not apply the recognition requirements of ASC 842 to short-term leases and recognize the lease payments on a straight-line basis over the lease term. The rate implicit in the lease is not readily determinable for the Company's leases. Accordingly, the incremental borrowing rate, giving consideration to the FHLB borrowing rate, is based on the information available at commencement date and is used to determine the present value of lease payments.

Supplemental balance sheet information related to operating leases follows: 

	At September 30, 2019
Right of use operating lease asset (in millions)	$	17.6
Right of use operating lease liability (in millions)	$	17.9
Weighted average remaining lease term (years)		15.1
Weighted average discount rate		3.4	%

Future minimum lease payments (in thousands), by year and in the aggregate, under non-cancellable operating leases with initial or remaining terms in excess of one year as of September 30, 2019 are as follows:

	At September 30, 2019
Year 1	$	2,497
Year 2		2,170
Year 3		2,004
Year 4		1,930
Year 5		1,622
After Year 5		13,275
Total undiscounted payments		23,498
Less: imputed interest		(5,593	)
Present value of lease payments (ROU operating lease liability)	$	17,905

45

NOTE 11 – SUPPLEMENTAL SEGMENT INFORMATION

The Company has three reportable segments: community banking, wholesale mortgage banking (“mortgage banking”) and other. The community banking segment provides traditional banking services offered through CresCom Bank. The mortgage banking segment provides mortgage loan origination and servicing offered through Crescent Mortgage. The other segment provides managerial and operational support to the other business segments through Carolina Services and Carolina Financial.

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

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

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

The following tables present selected financial information for the Company's reportable business segments for the three and nine months ended September 30, 2019 and 2018: 

	Community		Mortgage
For the Three Months Ended September 30, 2019	Banking		Banking			Other			Eliminations			Total
	(In thousands)
Interest income	$	45,478		438			14			(116	)		45,814
Interest expense		9,103		142			530			(144	)		9,631
Net interest income (expense)		36,375		296			(516	)		28			36,183
Provision for loan losses		720		(100	)		—			—			620
Noninterest income from external customers		5,306		7,389			21			—			12,716
Intersegment noninterest income		242		—			—			(242	)		—
Noninterest expense		19,487		7,107			313			—			26,907
Intersegment noninterest expense		—		240			2			(242	)		—
Income (loss) before income taxes		21,716		438			(810	)		28			21,372
Income tax expense (benefit)		4,852		113			(228	)		7			4,744
Net income (loss)	$	16,864		325			(582	)		21			16,628

 

46

	Community		Mortgage
For the Three Months Ended September 30, 2018	Banking		Banking		Other			Eliminations			Total
	(In thousands)
Interest income	$	40,588		472		14			(89	)		40,985
Interest expense		6,582		113		520			(113	)		7,102
Net interest income (expense)		34,006		359		(506	)		24			33,883
Provision for loan losses		750		—		—			—			750
Noninterest income from external customers		5,060		5,240		—			—			10,300
Intersegment noninterest income		242		36		—			(278	)		—
Noninterest expense		19,041		4,674		287			—			24,002
Intersegment noninterest expense		—		242		—			(242	)		—
Income (loss) before income taxes		19,517		719		(793	)		(12	)		19,431
Income tax expense (benefit)		4,254		164		(187	)		(4	)		4,227
Net income (loss)	$	15,263		555		(606	)		(8	)		15,204

	Community		Mortgage
For the Nine Months Ended September 30, 2019	Banking		Banking			Other			Eliminations			Total
	(In thousands)
Interest income	$	131,735		1,296			45			(346	)		132,730
Interest expense		27,162		422			1,638			(429	)		28,793
Net interest income (expense)		104,573		874			(1,593	)		83			103,937
Provision for loan losses		2,120		(120	)		—			—			2,000
Noninterest income from external customers		15,162		18,606			51			—			33,819
Intersegment noninterest income		724		18			—			(742	)		—
Noninterest expense		57,498		18,079			956			—			76,533
Intersegment noninterest expense		—		720			4			(724	)		—
Income (loss) before income taxes		60,841		819			(2,502	)		65			59,223
Income tax expense (benefit)		13,391		196			(626	)		15			12,976
Net income (loss)	$	47,450		623			(1,876	)		50			46,247

	Community		Mortgage
For the Nine Months Ended September 30, 2018	Banking		Banking		Other			Eliminations			Total
	(In thousands)
Interest income	$	116,905		1,361		41			(169	)		118,138
Interest expense		17,732		244		1,488			(244	)		19,220
Net interest income (expense)		99,173		1,117		(1,447	)		75			98,918
Provision for loan losses		1,284		25		—			—			1,309
Noninterest income from external customers		15,690		15,599		88			—			31,377
Intersegment noninterest income		724		64		—			(788	)		—
Noninterest expense		71,318		13,809		845			—			85,972
Intersegment noninterest expense		—		725		—			(725	)		—
Income (loss) before income taxes		42,985		2,221		(2,204	)		12			43,014
Income tax expense (benefit)		8,810		505		(532	)		5			8,788
Net income (loss)	$	34,175		1,716		(1,672	)		7			34,226

 

47

  

The following tables present selected financial information for the Company's reportable business segments for September 30, 2019 and December 31, 2018:

	Community		Mortgage
At September 30, 2019	Banking		Banking		Other		Eliminations			Total
	(In thousands)
Assets	$	3,977,642		77,997		645,379		(721,130	)		3,979,888
Loans receivable, net		2,699,843		14,667		—		(8,454	)		2,706,056
Loans held for sale		7,919		28,963		—		—			36,882
Deposits		2,853,207		—		—		(9,993	)		2,843,214
Borrowed funds		427,000		8,043		32,570		(8,043	)		459,570

	Community		Mortgage
At December 31, 2018	Banking		Banking		Other		Eliminations			Total
	(In thousands)
Assets	$	3,786,360		84,335		610,167		(690,114	)		3,790,748
Loans receivable, net		2,494,421		30,879		—		(15,427	)		2,509,873
Loans held for sale		1,450		15,522		—		—			16,972
Deposits		2,724,920		—		—		(6,727	)		2,718,193
Borrowed funds		432,500		14,951		32,436		(14,951	)		464,936

48

 

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

The following discussion reviews our results of operations for the three and nine months ended September 30, 2019 as compared to the three and nine months ended September 30, 2018 and assesses our financial condition as of September 30, 2019 as compared to December 31, 2018. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2018 included in our Form 10-K for that period. Results for the three and nine months ended September 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019 or any future period.

Cautionary Warning Regarding Forward-Looking Statements

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

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

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

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

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

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

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

• changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, 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;

 

49

• 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;

• discontinuation of a published LIBOR rate after 2021 and the impact to our assets and liabilities;

• the impact of 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 (“PCAOB”) and the FASB;

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

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

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

• our liquidity and working capital requirements;

• competitive pressures among depository and other financial institutions;

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

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

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

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

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

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

• management compensation and the methodology for its determination;

• our ability to compete in our industry and innovation by our competitors;

• increased cybersecurity risk, including potential business disruptions or financial losses;

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

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

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

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements prove to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q and our other reports filed pursuant to the Securities Exchange Act of 1934. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

50

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 (“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 uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings.

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

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

Pending Acquisition of Carolina Trust BancShares, Inc.

On July 15, 2019, the Company announced the execution of an agreement and plan of merger and reorganization, by and between the Company and Carolina Trust BancShares, Inc. (“Carolina Trust”), pursuant to which, subject to the terms and conditions set forth therein, Carolina Trust will merge with and into the Company, with the Company as the surviving corporation of the merger. The agreement provides that as soon as practicable following the merger, Carolina Trust's wholly-owned subsidiary, Carolina Trust Bank, will merge with and into the Bank, with the Bank as the surviving entity. The Company anticipates closing the merger December 31, 2019. Pursuant to the merger agreement, each share of Carolina Trust common stock will be converted into the right to receive 0.3000 shares of the Company's common stock, or $10.57 in cash for each share of the Company's common stock outstanding, subject to election and proration such that the aggregate consideration will consist of 90% Carolina Financial stock and 10% cash. Cash will also be paid in lieu of fractional shares. The aggregate merger consideration equals $100.1 million as of July 12, 2019, based on closing price of a share of the Company's common stock as of that date.

Executive Summary of Operating Results

The following is a summary of the Company's financial highlights and significant events in the third quarter of 2019:  

• Net income for Q3 2019 increased 9.3% to $16.6 million, or $0.74 per diluted share, from $15.2 million, or $0.66 per diluted share for Q3 2018.

• Operating earnings for Q3 2019, which exclude certain non-operating income and expenses, increased 20.8% to $18.6 million, or $0.83 per diluted share, from $15.4 million, or $0.67 per diluted share, for Q3 2018.

• Operating earnings for Q3 2019 have been adjusted to eliminate the following significant items:

o The fair value loss on interest rate swaps of $1.0 million due to the continued impact of falling long-term interest rates during the quarter on the valuation of longer-duration derivatives that do not meet hedge accounting requirements. 

51

 

o The gain on sale of securities of approximately $756,000.

o Merger-related expenses of approximately $484,000.

o The loss on early extinguishment of debt of approximately $70,000.

o The temporary impairment of our mortgage servicing rights (MSR) of $1.8 million due to increased prepayment speed assumptions in the portfolio driven by the continued impact of falling interest rates.

• Performance ratios for Q3 2019 compared to Q3 2018:

o Return on average assets was 1.71% compared to 1.66%.

o Operating return on average assets was 1.91% compared to 1.68%.

o Return on average tangible equity was 14.08% compared to 14.68%.

o Operating return on average tangible equity was 15.72% compared to 14.85%.

• Loans receivable, gross grew $70.9 million from June 30, 2019, or at an annualized rate of 10.7%, and grew $197.8 million, or at an annualized rate of 10.5% since December 31, 2018.

• Total deposits increased $37.1 million from June 30, 2019 and increased $125.0 million since December 31, 2018.

• On December 3, 2018, the Company announced that the Board of Directors had approved a plan to repurchase up to $25 million in shares of the Company’s common stock through open market and privately negotiated transactions over the next three years. The Company began stock repurchases on December 4, 2018. During the third quarter of 2019, the Company repurchased approximately 47,000 shares at an average price of $34.23. Cumulatively since December 4, 2018, the Company repurchased approximately 381,000 shares at an average price of $31.94.

 

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 but not limited to, core deposits, tangible book value, operating earnings, allowance for loan losses to non-acquired loans, net interest margin-core and yield on loans receivable-core to evaluate and compare the Company's operating results from period to period in a meaningful manner.

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.

  

52

  

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

	At or for the Three		At or for the Nine
	Months Ended		Months Ended
	September 30, 2019	September 30, 2018	September 30, 2019	September 30, 2018
Performance Ratios (annualized):
Return on average stockholders' equity	10.82%	10.87%	10.31%	8.91%
Return on average assets	1.71%	1.66%	1.60%	1.27%
Return on average tangible equity (Non-GAAP)	14.08%	14.68%	13.56%	12.46%
Average earning assets to average total assets	90.13%	89.59%	89.90%	89.57%
Average loans receivable to average deposits	93.04%	87.82%	93.00%	88.74%
Average stockholders' equity to average assets	15.79%	15.27%	15.47%	14.21%
Net interest margin-tax equivalent (1)	4.13%	4.15%	4.04%	4.15%
Net charge-offs (recoveries) to average loans receivable	0.05%	0.02%	0.02%	(0.05)%
Nonperforming assets to period end loans receivable	0.77%	0.49%	0.77%	0.49%
Nonperforming assets to total assets	0.52%	0.32%	0.52%	0.32%
Nonperforming loans to total loans	0.70%	0.43%	0.70%	0.43%
Allowance for loan losses as a percentage of loans receivable (end of period)	0.59%	0.55%	0.59%	0.55%
Allowance for loan losses as a percentage of non-acquired loans receivable (Non-GAAP)	0.74%	0.80%	0.74%	0.80%
Allowance for loan losses as a percentage of nonperforming loans	84.73%	129.26%	84.73%	129.26%

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

53

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

	For the Three Months Ended
		September 30,		June 30,		March 31,		December 31,		September 30,
		2019		2019		2019		2018		2018
	(In thousands, except share data)
As Reported:
Income before income taxes	$	21,372		19,356		18,495		19,425		19,431
Tax expense		4,744		4,282		3,950		3,981		4,227
Net income	$	16,628		15,074		14,545		15,444		15,204
Net interest margin - core:
Net interest margin-tax equivalent (1)	$	36,539		34,661		33,899		35,349		34,298
Purchased loan accretion and early payoff charges and deferred fees		(3,209	)	(1,521	)	(1,617	)	(3,283	)	(2,831	)
Net interest margin - core (2) (Non-GAAP)	$	33,330		33,140		32,282		32,066		31,467
Loans receivable interest income - core:
Loans receivable interest income	$	38,291		36,325		84,813		34,969		33,357
Purchased loan accretion and early payoff charges and deferred fees		(3,209	)	(1,521	)	(1,617	)	(3,283	)	(2,831	)
Loans receivable interest income - core (2) (Non-GAAP)	$	35,082		34,804		33,196		31,686		30,526
Average equity	$	614,550		598,196		580,300		569,528		559,401
Average tangible equity (Non-GAAP)		472,349		455,270		436,630		425,105		414,205
Average assets		3,891,019		3,878,269		3,826,116		3,700,795		3,663,915
Average loans receivable		2,639,921		2,610,394		2,535,192		2,428,603		2,402,075
Average interest earning assets		3,507,155		3,483,713		3,432,818		3,322,894		3,282,426
Return on average assets		1.71	%	1.55	%	1.52	%	1.67	%	1.66	%
Return on average equity		10.82	%	10.08	%	10.03	%	10.85	%	10.87	%
Return on average tangible equity (Non-GAAP)		14.08	%	13.24	%	13.32	%	14.53	%	14.68	%
Tangible equity to tangible assets (Non-GAAP)		12.50	%	12.36	%	12.05	%	11.83	%	11.72	%
Net interest margin-tax equivalent (1)		4.13	%	3.99	%	4.00	%	4.23	%	4.15	%
Net interest margin-core (2) (Non-GAAP)		3.77	%	3.82	%	3.81	%	3.84	%	3.80	%
Yield on loans receivable-core (2) (Non-GAAP)		5.27	%	5.35	%	5.31	%	5.18	%	5.04	%
Weighted average common shares outstanding:
Basic		22,149,567		22,189,508		22,193,861		22,416,190		22,678,681
Diluted		22,336,383		22,372,273		22,381,809		22,587,466		22,898,983
Earnings per common share:
Basic	$	0.75		0.68		0.66		0.69		0.67
Diluted	$	0.74		0.67		0.65		0.68		0.66

Continued

54

	For the Three Months Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
	2019			2019			2019			2018			2018
					(In thousands, except share data)
Operating Earnings and Performance Ratios:
Income before income taxes	$	21,372			19,356			18,495			19,425			19,431
(Gain)/loss on sale of securities		(756	)		(1,941	)		(1,194	)		(346	)		849
Fair value adjustments on interest rate swaps		996			2,164			1,371			2,222			(628	)
Merger related expenses		484			—			—			—			—
Loss on extinguishment of debt		70			31			—			—			—
Impairment of mortgage servicing rights		1,800			1,300			—			—			—
Operating earnings before income taxes		23,966			20,910			18,672			21,301			19,652
Tax expense (3)		5,400			4,653			4,001			4,379			4,279
Operating earnings (Non-GAAP)	$	18,556			16,257			14,671			16,922			15,373
Average equity	$	614,550			598,196			580,300			569,528			559,401
Less average intangible assets		(142,201	)		(142,926	)		(143,670	)		(144,423	)		(145,196	)
Average tangible common equity (Non-GAAP)	$	472,349			455,270			436,630			425,105			414,205
Average assets	$	3,891,019			3,878,269			3,826,116			3,700,795			3,663,915
Less average intangible assets		(142,201	)		(142,926	)		(143,670	)		(144,423	)		(145,196	)
Average tangible assets (Non-GAAP)	$	3,748,818			3,735,343			3,682,446			3,556,372			3,518,719
Operating return on average assets (Non-GAAP)		1.91	%		1.68	%		1.53	%		1.83	%		1.68	%
Operating return on average stockholders' equity (Non-GAAP)		12.08	%		10.87	%		10.11	%		11.88	%		10.99	%
Operating return on average tangible assets (Non-GAAP)		1.98	%		1.74	%		1.59	%		1.90	%		1.75	%
Operating return on average tangible equity (Non-GAAP)		15.72	%		14.28	%		13.44	%		15.92	%		14.85	%
Weighted average common shares outstanding:
Basic		22,149,567			22,189,508			22,193,861			22,416,190			22,678,681
Diluted		22,336,383			22,372,273			22,381,809			22,587,466			22,898,983
Operating earnings per common share:
Basic (Non-GAAP)	$	0.84			0.73			0.66			0.75			0.68
Diluted (Non-GAAP)	$	0.83			0.73			0.66			0.75			0.67

Continued

55

		At the Month Ended
		September 30,		June 30,		March 31,		December 31,		September 30,
		2019		2019		2019		2018		2018
		(In thousands, except share data)
Core deposits:
Noninterest-bearing demand accounts	$	611,959		616,823		575,990		547,022		567,394
Interest-bearing demand accounts		587,963		561,094		581,424		566,527		579,522
Savings accounts		180,827		184,764		188,725		192,322		190,946
Money market accounts		428,867		437,716		458,575		431,246		453,957
Total core deposits (Non-GAAP)		1,809,616		1,800,397		1,804,714		1,737,117		1,791,819
Certificates of deposit:
Less than $250,000		948,218		921,309		923,709		875,749		863,290
$250,000 or more		85,380		84,403		88,647		105,327		104,514
Total certificates of deposit		1,033,598		1,005,712		1,012,356		981,076		967,804
Total deposits	$	2,843,214		2,806,109		2,817,070		2,718,193		2,759,623
Tangible book value per share:
Total stockholders' equity	$	621,595		605,579		589,150		575,285		564,027
Less intangible assets		(141,849	)	(142,570	)	(143,305	)	(144,054	)	(144,817	)
Tangible common equity (Non-GAAP)	$	479,746		463,009		445,845		431,231		419,210
Issued and outstanding shares		22,249,424		22,284,981		22,296,372		22,387,009		22,570,445
Less nonvested restricted stock awards		(115,933	)	(109,728	)	(111,578	)	(117,966	)	(135,045	)
Period end dilutive shares		22,133,491		22,175,253		22,184,794		22,269,043		22,435,400
Total stockholders' equity	$	621,595		605,579		589,150		575,285		564,027
Divided by period end dilutive shares		22,133,491		22,175,253		22,184,794		22,269,043		22,435,400
Common book value per share	$	28.08		27.31		26.56		25.83		25.14
Tangible common equity (Non-GAAP)	$	479,746		463,009		445,845		431,231		419,210
Divided by period end dilutive shares		22,133,491		22,175,253		22,184,794		22,269,043		22,435,400
Tangible common book value per share (Non-GAAP)	$	21.68		20.88		20.10		19.36		18.69

	At the Month Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
	2019			2019			2019			2018			2018
Acquired and non-acquired loans:
Acquired loans receivable	$	548,754			601,193			644,461			686,401			749,442
Non-acquired gross loans receivable		2,173,427			2,050,043			1,946,149			1,837,935			1,708,022
Total gross loans receivable	$	2,722,181			2,651,236			2,590,610			2,524,336			2,457,464
% Acquired		20.16	%		22.68	%		24.88	%		27.19	%		30.50	%
Non-acquired loans	$	2,173,427			2,050,043			1,946,149			1,837,935			1,708,022
Allowance for loan losses		16,125			15,867			15,021			14,463			13,615
Allowance for loan losses to non-acquired loans (Non-GAAP)		0.74	%		0.77	%		0.77	%		0.79	%		0.80	%
Total gross loans receivable	$	2,722,181			2,651,236			2,590,610			2,524,336			2,457,464
Allowance for loan losses		16,125			15,867			15,021			14,463			13,615
Allowance for loan losses to total gross loans receivable		0.59	%		0.60	%		0.58	%		0.57	%		0.55	%

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

(2) Net interest margin-core and yield on loans - core excludes the impact of purchase accounting accretion, loan payoff charges and related deferred fees recognized related to early loan repayments.

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

56

Critical Accounting Policies

There have been no significant changes to our critical accounting policies from those disclosed in our 2018 Annual Report on Form 10-K, except as disclosed in Note 1 - Summary of Significant Accounting Policies in the accompanying financial statements. Refer to the notes to our consolidated financial statements in our 2018 Annual Report on Form 10-K for a full disclosure of all critical accounting policies.

Results of Operations

Summary

The Company reported an increase in net income for the three months ended September 30, 2019 to $16.6 million, or $0.74 per diluted share, as compared to $15.2 million, or $0.66 per diluted share, for the three months ended September 30, 2018. Included in net income for Q3 2019 was a recovery of interest income of approximately $1.2 million related to a payoff of a purchased credit impaired loan. Excluding the recovery, accretion income from acquired loans was $1.7 million for Q3 2019, as compared to $2.2 million for Q3 2018. The Company reported an increase in net income for the nine months ended September 30, 2019 to $46.2 million, or $2.07  per diluted share, as compared to $34.2 million, or $1.57 per diluted share, for the nine months ended September 30, 2018. Included in net income for the nine months ended 2019 and 2018 was purchased loan accretion of $5.9 million and $7.0 million, respectively. Provision for loan losses during the nine months ended September 30, 2019 and 2018 was $2.0 million and $1.3 million, respectively. Merger-related expenses for the nine months ended September 30, 2019 and September 30, 2018 were $0.5 million and $15.2 million, respectively.

Net Interest Income and Margin

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

Net interest income increased to $36.2 million for the three months ended September 30, 2019 from $33.9 million for the three months ended September 30, 2018. Net interest income increased to $103.9 million for the nine months ended September 30, 2019 from $98.9 million for the nine months ended September 30, 2018. The increase in net interest income is further explained in the following section. 

57

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. 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 are amortized into interest income on loans.

	For The Three Months Ended September 30,
	2019								2018
				Interest		Average						Interest		Average
	Average			Earned/		Yield/			Average			Earned/		Yield/
	Balance			Paid		Rate			Balance			Paid		Rate
	(Dollars in thousands)
Interest-earning assets:
Loans held for sale	$	29,733			313		4.18	%		23,692			266		4.45	%
Loans receivable, net (1)		2,639,921			38,291		5.75	%		2,402,075			33,357		5.51	%
Interest-bearing cash		18,788			101		2.13	%		21,419			107		1.98	%
Securities available for sale		796,651			6,745		3.39	%		815,612			6,912		3.39	%
Federal Home Loan Bank stock		18,556			331		7.08	%		16,181			313		7.67	%
Other investments		3,505			33		3.74	%		3,447			30		3.45	%
Total interest-earning assets		3,507,154			45,814		5.18	%		3,282,426			40,985		4.95	%
Noninterest-earning assets		383,864								381,489
Total assets	$	3,891,018								3,663,915
Interest-bearing liabilities:
Demand accounts		579,696			678		0.46	%		573,875			601		0.42	%
Money market accounts		430,137			1,146		1.06	%		459,141			890		0.77	%
Savings accounts		181,245			254		0.56	%		193,010			191		0.39	%
Certificates of deposit		1,029,125			5,047		1.95	%		927,395			3,347		1.43	%
Short-term borrowed funds		339,961			1,931		2.25	%		292,217			1,529		2.08	%
Long-term debt		43,852			575		5.20	%		46,261			544		4.67	%
Total interest-bearing liabilities		2,604,016			9,631		1.47	%		2,491,899			7,102		1.13	%
Noninterest-bearing deposits		617,150								581,925
Other liabilities		55,302								30,689
Stockholders' equity		614,550								559,401
Total liabilities and stockholders' equity	$	3,891,018								3,663,914
Net interest spread							3.71	%							3.82	%
Net interest margin		4.09	%							4.10	%
Net interest margin (tax-equivalent) (2)		4.13	%							4.15	%
Net interest income				$	36,183								33,883

(1) Average balances of loans receivable, net include nonaccrual loans.

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

Our net interest margin was 4.09%, or 4.13% on a tax-equivalent basis, for the three months ended September 30, 2019 compared to 4.10%, or 4.15% on a tax equivalent basis, for the three months ended September 30, 2018. Q3 2019 included accretion income from acquired loans of  $2.9 million (33 bps to NIM) and early payoff fees of $276,000 (3 bps to NIM) compared to Q3 2018 accretion income from acquired loans of $2.2 million (27 bps to NIM) and early payoff fees of $620,000 (8 bps to NIM). Excluding accretion income from acquired loans and early payoff fees, Q3 net interest margin-core (Non-GAAP) was 3.77% compared to 3.80% in Q3 2018.   

58

Our net interest spread, which is not on a tax-equivalent basis, was  3.71% for the three months ended September 30, 2019 as compared to 3.82% for the same period in 2018. 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 11 basis point decrease in net interest spread is a result of the 23 basis point increase in yield on interest-earning assets net of a 34 basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing because of the increases in the prime rate as well as higher accretion income from acquired loans partially offset by the impact of lower fees on early payoffs. The increase in rates paid on interest-bearing liabilities is primarily due to repricing because of the increase in the prime rate in addition to increased competition in our markets for deposits to fund strong loan growth. 

	For The Nine Months Ended September 30,
	2019								2018
				Interest		Average						Interest		Average
	Average			Earned/		Yield/			Average			Earned/		Yield/
	Balance			Paid		Rate			Balance			Paid		Rate
	(Dollars in thousands)
Interest-earning assets:
Loans held for sale	$	21,856			722		4.41	%		22,832			726		4.25	%
Loans receivable, net (1)		2,595,553			109,430		5.64	%		2,375,461			97,311		5.48	%
Interest-bearing cash		20,399			345		2.26	%		22,889			285		1.66	%
Securities available for sale		813,528			21,209		3.48	%		785,782			18,979		3.22	%
Federal Home Loan Bank stock		20,048			923		6.16	%		18,303			751		5.49	%
Other investments		3,479			101		3.88	%		3,967			86		2.90	%
Total interest-earning assets		3,474,863			132,730		5.11	%		3,229,234			118,138		4.89	%
Noninterest-earning assets		390,487								376,198
Total assets	$	3,865,350								3,605,432
Interest-bearing liabilities:
Demand accounts		568,828			1,878		0.44	%		555,802			1,446		0.35	%
Money market accounts		438,804			3,571		1.09	%		462,250			2,263		0.65	%
Savings accounts		185,169			802		0.58	%		203,815			451		0.30	%
Certificates of deposit		1,003,593			13,972		1.86	%		896,569			8,759		1.31	%
Short-term borrowed funds		370,549			6,676		2.41	%		328,388			4,488		1.83	%
Long-term debt		51,218			1,893		4.94	%		61,569			1,813		3.94	%
Total interest-bearing liabilities		2,618,161			28,793		1.47	%		2,508,393			19,220		1.02	%
Noninterest-bearing deposits		594,514								558,453
Other liabilities		54,871								26,318
Stockholders' equity		597,804								512,268
Total liabilities and stockholders' equity	$	3,865,350								3,605,432
Net interest spread							3.64	%							3.87	%
Net interest margin		4.00	%							4.10	%
Net interest margin (tax-equivalent) (2)		4.04	%							4.15	%
Net interest income				$	103,937								98,918

(1) Average balances of loans receivable, net include nonaccrual loans.

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

59

Our net interest margin was 4.00%, or 4.04% on a tax-equivalent basis, for the nine months ended September 30, 2019 compared to 4.10%, or 4.15% on a tax equivalent basis, for the nine months ended September 30, 2018. The yield on loans receivable during the nine months ended September 30, 2019 and 2018 reflects accretion income from acquired loans of $5.9 million (23 bps to NIM) and $7.0 million (29 bps to NIM), respectively. Also reflected in the yield are early payoff fees of $422,000 (2 bps to NIM) and $1.2 million (5 bps to NIM) for the nine months ended September 30, 2019 and 2018, respectively. Excluding accretion income from acquired loans and early payoff fees, net interest margin-core (Non-GAAP) was $3.80% compared to 3.81% for the nine months ended September 30, 2019 and 2018, respectively. 

Our net interest spread, which is not on a tax-equivalent basis, was  3.64% for the nine months ended September 30, 2019 as compared to 3.87% for the same period in 2018. 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 23 basis point decrease in net interest spread is a result of the 22 basis point increase in yield on interest-earning assets net of a 45 basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing because of the increases in the prime rate partially offset by the impact of lower accretion income from acquired loans and lower fees on early payoffs. The increase in rates paid on interest-bearing liabilities is primarily due to repricing because of the increase in the prime rate in addition to increased competition in our markets for deposits to fund strong loan growth. 

Provision for Loan Losses

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

Following is a summary of the activity in the allowance for loan losses during the periods ended September 30, 2019 and 2018.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
	(Dollars in thousands)
Balance, beginning of period	$	15,867			12,987			14,463			11,478
Provision for loan losses		620			750			2,000			1,309
Loan charge-offs		(537	)		(239	)		(973	)		(727	)
Loan recoveries		175			117			635			1,555
Balance, end of period	$	16,125			13,615			16,125			13,615

The Company experienced net charge-offs of $362,000 and net charge-offs of $122,000 for three months ended September 30, 2019 and 2018. The Company experienced net charge-offs of $338,000 for the nine months ended September 30, 2019 and net recoveries of $828,000 for the nine months ended September 30, 2018. Nonperforming assets to total assets increased to 0.52% as of September 30, 2019 compared to 0.35% as of December 31, 2018. The increase in the NPA ratio was primarily due to one fully collateralized lending relationship totaling $5.6 million. Provision for loan losses of $2.0 million was recorded during the first nine months of 2019 compared to provision for loan losses of $1.3 million during the first nine months of 2018. The increase was primarily due to loan growth and reduced recoveries in 2019.   

60

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

Noninterest Income and Expense

Noninterest income provides us with additional revenues that are significant sources of income. In Q3 2019 and Q3 2018, noninterest income comprised 21.7% and 20.8%, respectively, of total interest and noninterest income. The major components of noninterest income for the Company are listed below:

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Noninterest income:
Mortgage banking income	$	6,063			3,685			13,799			11,701
Deposit service charges		1,742			2,084			5,088			6,096
Net loss on extinguishment of debt		(70	)		—			(101	)		—
Net gain (loss) on sale of securities		756			(849	)		3,891			(2,292	)
Fair value adjustments on interest rate swaps		(996	)		628			(4,531	)		1,883
Net increase in cash value life insurance		400			378			1,196			1,153
Mortgage loan servicing income		2,490			2,313			7,694			6,428
Debit card income, net		1,148			1,086			3,339			3,562
Other		1,183			975			3,444			2,846
Total noninterest income	$	12,716			10,300			33,819			31,377

61

Noninterest income increased $2.4 million to $12.7 million for the three months ended September 30, 2019 from $10.3 million for the three months ended September 30, 2018. Noninterest income increased by $2.4 million for the nine months ended September 30, 2019 to $33.8 million from $31.4 million for the nine months ended September 30, 2018. The increase in noninterest income for the three and nine months ended September 30, 2019 primarily relates to the gain on sale of securities and mortgage banking income partially offset by fair value adjustments on interest rate swaps and lower deposit service charges.

Mortgage loan servicing income increased $0.2 million for the three months ended September 30, 2019 compared to the three months ended September 30, 2018. Mortgage loan servicing income increased $1.3 million for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. The increase in mortgage loan servicing income was primarily driven by an increase in loans serviced for the comparative periods.

The following table provides a break out of mortgage banking: 

	Loan Originations				Mortgage Banking Income				Margin
	For the Three Months Ended September 30,
	2019		2018		2019		2018		2019			2018
Additional segment information:	(Dollars in thousands)
Community banking	$	33,233		27,563		968		541		2.91	%		1.96	%
Wholesale mortgage banking		232,874		190,142		5,095		3,144		2.19	%		1.65	%
Total	$	266,107		217,705		6,063		3,685		2.28	%		1.69	%
	Loan Originations				Mortgage Banking Income				Margin
	For the Nine Months Ended September 30,
	2019		2018		2019		2018		2019			2018
Additional segment information:	(Dollars in thousands)
Community banking	$	82,979		91,786		2,292		1,843		2.76	%		2.01	%
Wholesale mortgage banking		562,371		576,205		11,507		9,858		2.05	%		1.71	%
Total	$	645,350		667,991		13,799		11,701		2.14	%		1.75	%

62

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

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
	(In thousands)
Noninterest expense:
Salaries and employee benefits	$	13,634			13,451			40,264			40,660
Occupancy and equipment		4,286			4,113			12,523			11,860
Marketing and public relations		432			312			1,306			1,011
FDIC insurance		—			285			502			805
Recovery of mortgage loan repurchase losses		(100	)		(150	)		(300	)		(450	)
Legal expense		159			94			372			327
Other real estate expense (income), net		36			(13	)		330			(2	)
Mortgage subservicing expense		702			640			2,176			1,772
Amortization of mortgage servicing rights		1,572			1,099			4,151			2,967
Impairment of mortgage servicing rights		1,800			—			3,100			—
Amortization of core deposit intangible		720			778			2,204			2,375
Merger-related expenses		484			—			484			15,216
Other		3,182			3,393			9,421			9,431
Total noninterest expense	$	26,907			24,002			76,533			85,972

Noninterest expense increased to $26.9 million for the three months ended September 30, 2019 from $24.0 million for the three months ended September 30, 2018. The increase in noninterest expense is primarily the result of a temporary impairment of mortgage servicing rights recorded in the third quarter of 2019 as well as an increase in the amortization of mortgage servicing rights and merger related expenses partially offset by lower other non-interest expense and an FDIC insurance credit.

Noninterest expense decreased to $76.5 million for the nine months ended September 30, 2019 from $86.0 million for the nine months ended September 30, 2018. The decrease in noninterest expense is primarily the result of merger-related expenses recognized for the nine months ending September 30, 2018 of $15.2 million related to the acquisition of First South Bancorp, Inc.. Excluding the impact of merger related expenses, noninterest expenses increased $5.8 million due to the MSR impairment of $3.1 million, an increase in occupancy and equipment expense and an increase in the amortization of mortgage servicing rights.  

Income Tax Expense

Our effective tax rate was 22.2% for the three months ended September 30, 2019, compared to 21.7% for the three months ended September 30, 2018. Our effective tax rate was 21.9% for the nine months ended September 30, 2019, compared to 20.4% for the nine months ended September 30, 2018. The Company incurred approximately $484,000 merger-related expenses for the nine months ending September 30, 2019 compared to $15.2 million of merger-related expenses for the nine months ended September 30, 2018. The Company's tax rates also reflect tax benefits related to excess stock-based compensation.

63

Balance Sheet Review
 
Securities

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

At September 30, 2019, our securities portfolio, excluding FHLB stock and other investments, was $796.1 million or approximately 20.0% of our assets. Our available-for-sale securities portfolio included municipal securities, US agency securities, collateralized loan obligations, corporate securities, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $796.1 million and an amortized cost of $781.5 million resulting in a net unrealized gain of $14.6 million.

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

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 September 30, 2019 and December 2018 were $2.7 billion and $2.5 billion, respectively.

Our loan portfolio consists primarily of loans secured by real estate . As of September 30, 2019, our loan portfolio included $2.3 billion, or 84.7%, of gross loans secured by real estate. As of December 31, 2018, our loan portfolio included $2.1 billion, or 84.8%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, gross loans receivable increased $197.8 million since December 31, 2018. The growth in loan balances was primarily the result of strong organic growth in commercial lending.

64

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

	At September 30,					At December 31,
	2019					2018
			% of Total					% of Total
All Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	721,841		26.52	%		732,717		29.03	%
Home equity		75,107		2.76	%		83,770		3.32	%
Commercial real estate		1,138,879		41.84	%		1,034,117		40.96	%
Construction and development		370,833		13.62	%		290,494		11.51	%
Consumer loans		23,459		0.86	%		23,845		0.94	%
Commercial business loans		392,062		14.40	%		359,393		14.24	%
Total gross loans receivable		2,722,181		100.00	%		2,524,336		100.00	%
Less:
Allowance for loan losses		16,125					14,463
Total loans receivable, net	$	2,706,056					2,509,873

 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.

65

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

	At September 30, 2019
			After one
	One year or		but within		After five
	less		five years		years		Total
			(In thousands)
Loans secured by real estate:
One-to-four family	$	22,471		144,449		554,921		721,841
Home equity		11,902		17,261		45,944		75,107
Commercial real estate		139,253		762,154		237,472		1,138,879
Construction and development		97,770		235,219		37,844		370,833
Consumer loans		2,022		8,314		13,123		23,459
Commercial business loans		39,435		261,145		91,482		392,062
Total gross loans receivable	$	312,853		1,428,542		980,786		2,722,181
Loans maturing - after one year
Variable rate loans							$	865,979
Fixed rate loans								1,543,349
							$	2,409,328

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 September 30, 2019 and December 31, 2018, the Company had $1.2 million and $0.6 million, respectively, of PCI loans that were 90 days past due and 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.

66

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

	At September 30,		At December 31,
	2019		2018
	(In thousands)
Loans receivable:
90 days and still accruing	$	—		20
Nonaccrual loans-renegotiated loans		4,386		3,086
Nonaccrual loans-other		14,646		8,635
Real estate acquired through foreclosure, net		1,832		1,534
Total non-performing assets	$	20,864		13,275
Problem assets not included in non-performing assets:
Accruing renegotiated loans outstanding	$	3,065		3,327

At September 30, 2019, nonperforming assets (non-PCI) were $20.9 million, or 0.52% of total assets. Comparatively, nonperforming assets (non-PCI) were $13.3 million, or 0.35% of total assets, at December 31, 2018. Nonperforming loans were 0.70% and 0.47% of gross loans receivable at September 30, 2019 and December 31, 2018, respectively.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $3.1 million at September 30, 2019, compared to $3.3 million at December 31, 2018. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower's ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at September 30, 2019 and December 31, 2018 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.

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

 Allowance for Loan Losses

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

67

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.

The allowance for loan losses was $16.1 million, or 0.74% of non-acquired loans, at September 30, 2019, compared to $14.5 million, or 0.79% of total non-acquired loans, at December 31, 2018. Loans acquired in business combinations were $548.7 million and $686.4 million at September 30, 2019 and December 31, 2018, 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 September 30, 2019 and December 31, 2018, acquired non-credit impaired loans had a purchase discount remaining of $8.0 million and $10.9 million, respectively.

68

The table below shows a reconciliation of acquired and non-acquired loans and allowance for loan losses to non-acquired loans (dollars in thousands):

	At the Month Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
	2019			2019			2019			2018			2018
Acquired and non-acquired loans:
Acquired loans receivable	$	548,754			601,193			644,461			686,401			749,442
Non-acquired gross loans receivable		2,173,427			2,050,043			1,946,149			1,837,935			1,708,022
Total gross loans receivable	$	2,722,181			2,651,236			2,590,610			2,524,336			2,457,464
% Acquired		20.16	%		22.68	%		24.88	%		27.19	%		30.50	%
Non-acquired loans	$	2,173,427			2,050,043			1,946,149			1,837,935			1,708,022
Allowance for loan losses		16,125			15,867			15,021			14,463			13,615
Allowance for loan losses to non-acquired loans (Non-GAAP)		0.74	%		0.77	%		0.77	%		0.79	%		0.80	%
Total gross loans receivable	$	2,722,181			2,651,236			2,590,610			2,524,336			2,457,464
Allowance for loan losses		16,125			15,867			15,021			14,463			13,615
Allowance for loan losses to total gross loans receivable		0.59	%		0.60	%		0.58	%		0.57	%		0.55	%

69

The Company experienced net charge-offs of $362,000 and net charge-offs of $122,000 for three months ended September 30, 2019 and 2018. The Company experienced net charge-offs of $338,000 for the nine months ended September 30, 2019 and net recoveries of $828,000 for the nine months ended September 30, 2018. Asset quality has remained relatively consistent since December 31, 2018, with nonperforming assets to total assets of  0.52% as of September 30, 2019 as compared to 0.35% as of December 31, 2018. The increase in the NPA ratio was primarily due to one fully collateralized lending relationship.

The following table summarizes the activity related to our allowance for loan losses for the three and nine months ended September 30, 2019 and 2018.  

	For the Three Months						For the Nine Months
	Ended September 30						Ended September 30
	2019			2018			2019			2018
	(Dollars in thousands)
Balance, beginning of period	$	15,867			12,987			14,463			11,478
Provision for loan losses		620			750			2,000			1,309
Loan charge-offs:
Loans secured by real estate:
One-to-four family		(83	)		(79	)		(231	)		(226	)
Home equity		—			—			(78	)		—
Commercial real estate		(336	)		—			(368	)		(86	)
Construction and development		(1	)		(23	)		(17	)		(24	)
Consumer loans		(117	)		(117	)		(217	)		(255	)
Commercial business loans		—			(20	)		(62	)		(136	)
Total loan charge-offs		(537	)		(239	)		(973	)		(727	)
Loan recoveries:
Loans secured by real estate:
One-to-four family		12			3			150			15
Home equity		—			1			7			9
Commercial real estate		8			22			31			69
Construction and development		94			—			238			1,038
Consumer loans		43			12			139			70
Commercial business loans		18			79			70			354
Total loan recoveries		175			117			635			1,555
Net loan (charge-offs) recoveries		(362	)		(122	)		(338	)		828
Balance, end of period	$	16,125			13,615			16,125			13,615
Allowance for loan losses as a percentage of loans receivable (end of period)		0.59	%		0.55	%		0.59	%		0.55	%
Net charge-offs (recoveries) to average loans receivable (annualized)		0.05	%		0.02	%		0.02	%		(0.05	)%

70

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 third party 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 11 - 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 third party market, as part of our mortgage banking activities, for which we receive service fee income. These rights are known as mortgage servicing rights, or MSRs, where the owner of the MSR acts on behalf of the mortgage loan owner and has the contractual right to receive a stream of cash flows in exchange for performing specified mortgage servicing functions. These duties typically include, but are not limited to, performing loan administration, collection, and default activities, including the collection and remittance of loan payments, responding to customer inquiries, accounting for principal and interest, holding custodial (impound) funds for the payment of property taxes and insurance premiums, counseling delinquent mortgagors, modifying loans and supervising foreclosures and property dispositions. We subservice the duties and responsibilities obligated to the owner of the MSR to a third party provider for which we pay a fee.

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

The Company was servicing $3.6 billion loans for others at September 30, 2019 and $4.0 billion at December 31, 2018. Mortgage servicing rights asset had a balance of $26.5 million and $32.9 million at September 30, 2019 and December 31, 2018, respectively. The midpoint economic estimated fair value range of the mortgage servicing rights was $29.4 million and $40.9 million at September 30, 2019 and December 31, 2018, respectively. Amortization expense related to the mortgage servicing rights was $1.6 million and $1.1 million during the three months ended September 30, 2019 and 2018, respectively. Amortization expense related to the mortgage servicing rights was $4.2 million and $3.0 million during the nine months ended September 30, 2019 and 2018, respectively. Amortization expense was increased as a result of falling mortgage interest rates which resulted in increased prepayment expectations.

71

Below is a roll-forward of activity in the balance of the servicing assets for the three and nine months ended September 30, 2019 and 2018 along with the activity in the related valuation allowance.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
	(In thousands)
MSR beginning balance	$	29,640			23,626			32,933			21,003
Amount capitalized		260			1,637			846			4,989
Purchased servicing		—			8,831			—			9,970
Amount amortized		(1,572	)		(1,099	)		(4,151	)		(2,967	)
MSR impairment		(1,800	)		—			(3,100	)		—
MSR ending balance	$	26,528			32,995			26,528			32,995

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2019		2018		2019		2018
	(In thousands)
MSR valuation allowance beginning balance	$	1,300		—		—		—
Increase (reduction)		1,800		—		3,100		—
MSR valuation allowance ending balance	$	3,100				3,100		—

                The Company recorded a $1.8 million temporary impairment of mortgage servicing rights in the third quarter of 2019.  The valuation allowance on mortgage servicing rights was $3.1 million at September 30, 2019. The Company does not hedge the mortgage servicing rights positions and the impact of falling long-term interest rates increased prepayment speed assumptions reducing the value of the MSR asset.

                The following table presents a rollforward of the serviced loan principal and the associated MSR asset balance for the nine months ended September 30, 2019. The table presents the percentage of the serviced loan principal that has been repaid in relation to the amortization expense recognized on the MSR asset during the nine months ended September 30, 2019. 

		For the Nine Months
		Ended September 30, 2019
		Principal serviced					MSR asset
	(In millions)
Beginning balance	$	3,964.7				$	32.9
Amount capitalized		92.5					0.8
Amount of repayments/amortization		(413.0	)	(10)	%		(4.1	)	(12)	%
Ending balance	$	3,644.2					29.6
MSR valuation allowance							(3.1	)
MSR ending balance						$	26.5

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

72

The following table summarizes the activity for the reserve for mortgage repurchase losses for the three and nine months ended September 30, 2019 and 2018. 

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2019			2018			2019			2018
				(In thousands)
Beginning balance	$	1,092			1,592			1,292			1,892
Recovery of mortgage loan repurchase losses		(100	)		(150	)		(300	)		(450	)
Ending balance	$	992			1,442			992			1,442

                For the three months ended September 30, 2019 and 2018, the Company recorded a recovery of mortgage repurchase losses of $100,000 and $150,000, respectively. For the nine months ended September 30, 2019 and 2018, the Company recorded a recovery of mortgage repurchase losses of $300,000 and $450,000, respectively. The reduction in the reserve for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. As a result of the Company's analysis of its reserve for mortgage loan repurchase losses, the reserve was reduced accordingly.

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management's desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At September 30, 2019, deposits totaled $2.8 billion, an increase of $125.0 million from deposits of $2.7 billion at December 31, 2018. The increase in deposits since December 31, 2018 relates to continued efforts to fund our balance sheet growth with core deposits through business development.

73

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

	For the Nine Months
	Ended September 30,
	2019				2018
	Average		Average		Average		Average
	Balance		Rate		Balance		Rate
	(Dollars in thousands)
Interest-bearing demand accounts	$	568,828		0.44%		555,802		0.35%
Money market accounts		438,804		1.09%		462,250		0.65%
Savings accounts		185,169		0.58%		203,815		0.30%
Certificates of deposit less than $100,000		523,062		1.84%		439,849		1.20%
Certificates of deposit of $100,000 or more		480,531		1.88%		456,720		1.38%
Total interest-bearing average deposits		2,196,394				2,118,436
Noninterest-bearing deposits		594,514				558,453
Total average deposits	$	2,790,908				2,676,889

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

	At September 30, 2019
	(In thousands)
Three months or less	$	124,131
Over three through six months		106,488
Over six through twelve months		147,900
Over twelve months		137,353
Total certificates of deposits	$	515,872

Borrowings

The followings table outlines our various sources of short-term borrowed funds during the three and nine months ended September 30, 2019 and 2018 and the amounts outstanding at the end of each period, the maximum amount for each component during the periods, the average amounts for each period, and the average interest rate that we paid for each borrowings source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the periods shown. Stated period end rates are contractual rates. The average for the period rates reflect the impact of purchase accounting.

74

					Maximum		Average for the
			Contractual		Month		Period including
	Ending		Period End		End		Fair Value Amortization
	Balance		Rate		Balance		Balance		Rate
At or for the three months ended September 30, 2019	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	417,000		1.72% - 2.32%		417,000		339,961		2.25	%
Long-term borrowed funds
Long-term FHLB advances, due 2020		10,000		1.76% - 1.76%		10,000		11,304		1.57	%
Subordinated debentures, due 2032 through 2037		32,570		4.31% - 6.00%		32,570		32,548		6.46	%
					Maximum		Average for the
			Contractual		Month		Period including
	Ending		Period End		End		Fair Value Amortization
	Balance		Rate		Balance		Balance		Rate
At or for the three months ended September 30, 2018	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	320,500		1.05% - 2.32%		408,500		292,217		2.02	%
Long-term borrowed funds
Long-term FHLB advances, due 2019 through 2021		12,000		1.72% - 2.35%		35,000		13,891		1.79	%
Subordinated debentures, due 2032 through 2037		32,391		4.07% - 5.50%		32,391		32,370		6.37	%
					Maximum		Average for the
			Contractual		Month		Period including
	Ending		Period End		End		Fair Value Amortization
	Balance		Rate		Balance		Balance		Rate
At or for the nine months ended September 30, 2019	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	417,000		1.05% - 2.68%		430,500		370,549		2.41	%
Long-term borrowed funds
Long-term FHLB advances, due 2020		10,000		1.72% - 2.70%		27,000		18,714		1.83	%
Subordinated debentures, due 2032 through 2037		32,570		4.31% - 6.00%		32,570		32,504		6.73	%

75

					Maximum		Average for the
			Contractual		Month		Period including
	Ending		Period End		End		Fair Value Amortization
	Balance		Rate		Balance		Balance		Rate
At or for the nine months ended September 30, 2018	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	320,500		1.04% - 2.71%		408,500		328,388		1.81	%
Long-term borrowed funds
Long-term FHLB advances, due 2019 through 2021		12,000		1.72% - 2.35%		42,500		29,244		1.64	%
Subordinated debentures, due 2032 through 2037		32,391		4.07% - 5.50%		32,391		32,325		6.15	%

76

Liquidity

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

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

Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, third lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At September 30, 2019, the Company had FHLB advances of $427.0 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $344.4 million.

Lines of credit with the FRB are based on collateral pledged. At September 30, 2019, the Company had lines available with the FRB for $135.0 million. At September 30, 2019, the Company had no FRB advances outstanding.

Capital Resources
 

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

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

The required minimum ratios are as follows:

• Common equity Tier 1 capital ratio (common equity Tier 1 capital to total risk-weighted assets) of 4.5%;

• Tier 1 Capital Ratio (Tier 1 capital to total risk-weighted assets) of 6%;

• Total capital ratio (total capital to total risk-weighted assets) of 8%; and

• Leverage ratio (Tier 1 capital to average total consolidated assets) of 4%

77

The new capital guidelines also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity Tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. The phase-in of the capital conservation buffer requirement began on January 1, 2016 and became fully phased in as of January 1, 2019.

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

On June 11, 2018, the Company 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 $63.1 million.

On December 3, 2018, the Company announced that the Board of Directors had approved a plan to repurchase up to $25,000,000 in shares of the Company's common stock through open market and privately negotiated transactions over the next three years. The Company began stock repurchases on December 4, 2018. During the third quarter, the Company repurchased 46,807 shares at an average price of $34.23. Cumulatively since December 4, 2018 through September 30, 2019, the Company repurchased 380,943 shares at an average price of $31.94.

The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at September 30, 2019 and December 31, 2018 are as follows: 

																To Be Well
						Minimum Capital					Minimum Capital					Capitalized Under
						Required - Basel III					Required - Basel III					Prompt Corrective
	Actual					Phase-In Schedule					Fully Phased-In					Action Regulations
	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
September 30, 2019
Carolina Financial Corporation
CET1 capital (to risk weighted assets)	$	469,609		15.97	%		205,833		7.000	%		205,833		7.000	%		N/A		N/A
Tier 1 capital (to risk weighted assets)		501,063		17.04	%		249,940		8.500	%		249,940		8.500	%		N/A		N/A
Total capital (to risk weighted assets)		517,188		17.59	%		308,749		10.500	%		308,749		10.500	%		N/A		N/A
Tier 1 capital (to total average assets)		501,063		13.40	%		149,561		4.000	%		149,561		4.000	%		N/A		N/A
CresCom Bank
CET1 capital (to risk weighted assets)		495,507		16.86	%		205,750		7.000	%		205,750		7.000	%		191,054		6.50	%
Tier 1 capital (to risk weighted assets)		495,507		16.86	%		249,839		8.500	%		249,839		8.500	%		235,143		8.00	%
Total capital (to risk weighted assets)		511,632		17.41	%		308,625		10.500	%		308,625		10.500	%		293,929		10.00	%
Tier 1 capital (to total average assets)		495,507		13.26	%		149,518		4.000	%		149,518		4.000	%		186,897		5.00	%
December 31, 2018
Carolina Financial Corporation
CET1 capital (to risk weighted assets)	$	431,568		15.19	%		181,094		6.375	%		198,848		7.000	%		N/A		N/A
Tier 1 capital (to risk weighted assets)		462,888		16.29	%		223,704		7.875	%		241,459		8.500	%		N/A		N/A
Total capital (to risk weighted assets)		477,351		16.80	%		280,518		9.875	%		298,273		10.500	%		N/A		N/A
Tier 1 capital (to total average assets)		462,888		13.01	%		142,270		4.000	%		142,270		4.000	%		N/A		N/A
CresCom Bank
CET1 capital (to risk weighted assets)		454,181		16.00	%		180,948		6.375	%		198,688		7.000	%		184,496		6.50	%
Tier 1 capital (to risk weighted assets)		454,181		16.00	%		223,524		7.875	%		241,264		8.500	%		227,072		8.00	%
Total capital (to risk weighted assets)		468,644		16.51	%		280,292		9.875	%		298,032		10.500	%		283,840		10.00	%
Tier 1 capital (to total average assets)		454,181		12.76	%		142,392		4.000	%		142,392		4.000	%		177,990		5.00	%

78

The following table provides the amount of dividends and dividend payout ratios (dividends declared divided by net income) for the three and nine months ended September 30, 2019 and 2018.  

	For the Three Months					For the Nine Months
	Ended September 30,					Ended September 30,
		2019		2018			2019		2018
		(Dollars in thousands)
Dividends declared	$	2,003		1,580			5,795		3,987
Dividend payout ratios		12.05	%	10.39	%		12.53	%	11.65	%

Off Balance Sheet Arrangements

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

At September 30, 2019, we had issued commitments to extend credit of approximately $484.5 million through various types of lending arrangements. There were 68 standby letters of credit included in the commitments for $22.0 million. Total variable rate commitments were $375.9 million and fixed rate commitments were $108.6 million.

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

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

Market Risk Management and Interest Rate Risk

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

79

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

As of September 30, 2019, the following table summarizes the forecasted impact on net interest income using a base case scenario given downward movements in interest rates of 100 and 200 basis points and upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements. Therefore, management's assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market condition.

		Annualized Hypothetical
Interest Rate Scenario		Percentage Change in
Change	Prime Rate	Net Interest Income
(2.00)%	3.00%	(5.60)%
(1.00)%	4.00%	(2.60)%
0.00%	5.00%	0.00%
1.00%	6.00%	1.10%
2.00%	7.00%	2.00%
3.00%	8.00%	2.80%

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

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

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

80

Accounting, Reporting, and Regulatory Matters

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

Effect of Inflation and Changing Prices

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

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

81

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

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

Item 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control over Financial Reporting

There has been no change in the Company's internal control over financial reporting during the three months ended September 30, 2019, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

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

Item 1A. RISK FACTORS.

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for fiscal year ended December 31, 2018, as well as cautionary statements contained in this Form 10-Q, including those under the caption “Cautionary Note Regarding Any Forward-Looking Statements” set forth in Part I, Item 2 of this Form 10-Q, risks and matters described elsewhere in this Form 10-Q and in our other filings with the SEC.

82

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

(a) Not applicable

(b) Not applicable

(c) Issuer purchases of Registered Equity Securities:

On December 3, 2018, the Company announced that the Board of Directors had approved a plan to repurchase up to $25,000,000 in shares of the Company's common stock through open market and privately negotiated transactions over the next three years. The Company began stock repurchases on December 4, 2018. During the second quarter, the Company repurchased 46,807  shares at an average price of $34.23. Cumulatively since December 4, 2018 through September 30, 2019, the Company repurchased 380,943 shares at an average price of $31.94.

The following table reflects share repurchase activity during the three months ended September 30, 2019:

					(c) Total Number of Shares		(d) Maximum Number (or
					Purchased as Part of		Approximate Dollar Value) of
	(a) Total Number of		(b) Average Price		Publicly Announced Plans		Shares that may yet be Purchased
Period	Shares Purchased		Paid per Share		or Programs		Under the Plans or Programs
July 1 - July 31		18,093		34.52		18,093		13,809,714
August 1 - August 31		23,742		34.00		23,742		13,002,486
September 1 - September 30		4,972		34.30		4,972		12,831,946
		46,807				46,807

Item 3. DEFAULTS UPON SENIOR SECURITIES.

Not applicable

Item 4. MINE SAFETY DISCLOSURES. 

Not applicable  

Item 5. OTHER INFORMATION.

Not applicable 

Item 6. EXHIBITS.

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

83

SIGNATURES

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

	CAROLINA FINANCIAL CORPORATION
	Registrant
Date: November 8, 2019	/s/ Jerold L. Rexroad
	Jerold L. Rexroad
	President and Chief Executive Officer
	(Principal Executive Officer)
Date: November 8, 2019	/s/ William A. Gehman III
	William A. Gehman III
	Executive Vice President and Chief Financial Officer
	(Principal Financial and Accounting Officer)

84

INDEX TO EXHIBITS

Exhibit
Number	Description
2.1	Agreement and Plan of Merger and Reorganization by and between Carolina Financial Corporation and Carolina Trust BancShares, Inc. dated July 15, 2019.(1)
2.2	Agreement and Plan of Merger and Reorganization by and between Carolina Financial Corporation and First South Bancorp, Inc. dated June 9, 2017. (2)
4.1	Restated Certificate of Incorporation.(3)
4.2	Amendment to the Restated Certificate of Incorporation (incorporated by reference to Exhibit A of the Company's Definitive Proxy Statement on Schedule 14A filed on June 30, 2016).
4.3	Amendment to Restated certificate of Incorporation (incorporated by reference to Exhibit A of the Company's Definitive Proxy Statement on Schedule 14A filed on March 29, 2018).
4.4	Amended and Restated Bylaws.(4)
4.5	Specimen Common Stock Certificate.(5)
4.6	See Exhibits 4.1, 4.2, and 4.3 for provisions of the Restated Certificate of Incorporation and Amended and Restated Bylaws which define the rights of the stockholders.
31.1	Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2	Rule 13a-14(a) Certification of the Principal Financial Officer.
32	Section 1350 Certifications.
101	The following materials from the Quarterly Report on Form 10-Q of Carolina Financial Corporation as of and for the quarter ended September 30, 2019, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders' Equity, (v) Consolidated Statement of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.
(1)	Incorporated by reference to Exhibit 2.1 of the Company's Current Report on Form 8-K filed on July 18, 2019.
(2)	Incorporated by reference to Exhibit 2.1 of the Company's Current Report on Form 8-K filed on June 15, 2017.
(3)	Incorporated by reference to Exhibit 3.1 of the Company's Registration Statement on Form S-3 filed on August 31, 2015.
(4)	Incorporated by reference to Exhibit 3.1 of the Company's Current Report on Form 8-K filed on May 5, 2016.
(5)	Incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form 10 filed on February 26, 2014.

85