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ACFC > SEC Filings for ACFC > Form 10-K on 1-Apr-2013All Recent SEC Filings

Show all filings for ATLANTIC COAST FINANCIAL CORP | Request a Trial to NEW EDGAR Online Pro

Form 10-K for ATLANTIC COAST FINANCIAL CORP


1-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General Description of Business

The principal business of Atlantic Coast Financial Corporation and Atlantic Coast Bank consists of attracting retail deposits from the general public and investing those funds primarily in held-for-sale loans secured by first mortgages on owner-occupied, one- to four-family residences originated through our warehouse lending customers, and, to a lesser extent, first mortgages on owner occupied, one- to four-family residences, home equity loans and automobile and other consumer loans originated for retention in our loan portfolio. In addition we have been increasing our focus on small business lending through our SBA lending programs, as well as commercial business and owner occupied commercial real estate loans to small businesses. Loans are obtained principally through retail staff and, brokers. The Company sells the guaranteed portion of loans originated through small business lending, rather than hold the loans in portfolio. We also originate multi-family residential loans and commercial construction and residential construction loans, but no longer emphasize the origination of such loans unless they are connected with SBA lending. We also invest in investment securities, primarily those issued by U.S. government-sponsored agencies or entities, including Fannie Mae, Freddie Mac and Ginnie Mae.

Revenues are derived principally from interest on loans and other interest-earning assets, such as investment securities. To a lesser extent, revenue is generated from service charges, gains on the sale of loans and other income.

The Company offers a variety of deposit accounts having a wide range of interest rates and terms, which generally include savings accounts, money market accounts, demand deposit accounts and time deposit accounts with terms ranging from 90 days to five years. In accordance with the Consent Order (see Recent Events) interest rates paid on deposit are limited and subject to national rates published weekly by the FDIC. Deposits are primarily solicited in the Bank's market area of southeastern Georgia and the Jacksonville metropolitan area when necessary to fund loan demand.

Recent Events

On February 25, 2013, the Company and the Bank entered into an Agreement and Plan of Merger with Bond Street Holdings, Inc. and its bank subsidiary, Florida Community Bank, N.A. Pursuant to the Merger Agreement, the Company will be merged with and into Bond Street and the Bank will then merge with and into Florida Community Bank.

Under the terms of the Merger Agreement, each share of the Company's common stock issued and outstanding immediately prior to the completion of the Merger will be converted into the right to receive $5.00 in cash. Of this amount, (i) $3.00 per share in cash will be payable to shareholders following the closing of the Merger; (ii) $2.00 per share in cash will be held in an escrow account and will be available to cover losses from shareholder claims, net of payments received under insurance policies covering such losses, for one year following the closing of the Merger or until the final resolution of such claims, if later. Any remaining cash will be payable to shareholders of the Company.

The Merger Agreement and the transactions contemplated thereby are subject to the approval of the shareholders of the Company, regulatory approvals and other customary closing conditions. Closing of the Merger is expected to occur by the end of the second quarter of 2013.

Effective August 10, 2012, the Bank's Board of Directors consented to the issuance of the Order by the OCC. Among other things, the Order calls for the Bank to achieve and maintain Tier 1 capital of 9.00% of adjusted total assets and Total risk based capital of 13.00% of risk weighted assets by December 31, 2012. The Bank was not incompliance with the Order at December 31, 2012 with respect to the capital requirements. As of that date, Tier 1 leverage ratio, Tier 1 risk-based capital ratio and Total risk-based capital ratio were 5.13%, 8.62%, and 9.79%, respectively. As a result of entering into the Order to achieve and maintain specific capital levels, the Bank's capital classification under the PCA rules has been lowered to adequately capitalized. The Company's Board of Directors and management remain committed to meeting the capital requirements of the Order at the earliest possible time through the completion of the Merger described above, or if not approved, then through continuation of its strategic alternatives process. The Order does not affect the Bank's ability to continue to conduct its banking business with customers in a normal fashion. See Part I. Item 1. Business - Supervision and Regulation contained in this report for further description of the provisions contained in the Order.

The Company is regulated by the FRB and remains under the provisions of the OTS Supervisory Agreement dated December 10, 2010.

Critical Accounting Policies

Certain accounting policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances, including, but without limitation, changes in interest rates, performance of the economy, financial condition of borrowers and laws and regulations. Management believes that its critical accounting policies include determining the allowance for loan losses, determining fair value of securities available-for-sale, other real estate owned and accounting for deferred income taxes. These accounting policies are discussed in detail in Note 1 of the Notes to the Consolidated Financial Statements contained in this report.

Allowance for Loan Losses

An allowance for loan losses is maintained to reflect probable incurred losses in the loan portfolio. The allowance is based on ongoing assessments of the estimated losses incurred in the loan portfolio and is established as these losses are recognized through a provision for loan losses charged to earnings. Generally, loan losses are charged against the allowance when management believes the uncollectibity of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Due to the decline in real estate values in our markets since 2008 and the weak United States economy in general, we believe it is likely that collateral for non-performing one- to four-family residential and home equity loans, will not be sufficient to fully repay such loans. Therefore the Company charges one- to four-family residential and home equity loans down by the expected loss amount at the time they become non-performing, which is generally 90 days past due. This process accelerates the recognition of charge-offs on one- to four-family residential and home equity loans but has no impact on the impairment evaluation process.

The reasonableness of the allowance is reviewed and established by management, within the context of applicable accounting and regulatory guidelines, based upon its evaluation of then-existing economic and business conditions affecting the Bank's key lending areas. Senior credit officers monitor the conditions discussed above continuously and reviews are conducted monthly with the Bank's senior management and Board of Directors.

Management's methodology for assessing the reasonableness of the allowance consists of several key elements, which include a general loss component for unimpaired loans by type of loan and specific allowances for identified impaired loans.

The general loss component is calculated by applying loss factors, adjusted for other qualitative factors to outstanding unimpaired loan balances. Loss factors are based on the Bank's recent loss experience. Qualitative factors consider current market conditions that may impact real estate values within the Bank's primary lending areas, and on other significant factors that, in management's judgment, may affect the ability to collect loans in the portfolio as of the evaluation date. Other significant qualitative factors that exist as of the balance sheet date that are considered in determining the adequacy of the allowance include the following:

Current delinquency levels and trends;

Non-performing asset levels and trends and related charge-off history;

Economic trends - local and national;

Changes in loan policy;

Expertise of management and staff of the Bank;

Volumes and terms of loans; and

Concentrations of credit.

The impact of the general loss component on the allowance began increasing during 2008 and has remained at an elevated level through the end of 2012. The increase reflected the deterioration of market conditions since 2008, and the increase in the recent loan loss experience that has resulted from management's proactive approach to charging off losses on impaired one- to four-family and home equity loans in the period the impairment is identified.

Management also evaluates the allowance for loan losses based on a review of certain large balance individual loans. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows management expects to receive on impaired loans that may be susceptible to significant change and risks. For all specifically reviewed loans where it is probable that the Bank will be unable to collect all amounts due according to the terms of the loan agreement, impairment is determined by computing a fair value based on either discounted cash flows using the loan's initial interest rate or the fair value of the collateral if the loan is collateral dependent. No specific allowance is recorded unless fair value is less than carrying value. Large groups of smaller balance homogeneous loans, such as individual consumer and residential loans are collectively evaluated for impairment and are excluded from the specific impairment evaluation; for these loans, the allowance for loan losses is calculated in accordance with the general allowance for loan losses policy described above. Accordingly, individual consumer and residential loans are not separately identified for impairment disclosures, unless the loan has been modified as a troubled debt restructuring as discussed below.

Loans for which the terms have been modified as a result of the borrower's financial difficulties are classified as TDRs. TDRs are measured for impairment based upon the present value of estimated future cash flows using the loan's interest rate at inception of the loan or the appraised value of the collateral if the loan is collateral dependent. Impairment of homogeneous loans, such as one- to four-family residential loans, that have been modified as TDRs is calculated in the aggregate based on the present value of estimated future cash flows. Loans modified as TDRs with market rates of interest are classified as impaired loans in the year of restructure and until the loan has performed for 12 months in accordance with the modified terms.

The allowance for loan losses was $10.9 million, or 2.5% of total loans outstanding, and $15.5 million, or 3.0% of total loans outstanding at December 31, 2012 and 2011, respectively. The provision for loan losses for each quarter of 2012, 2011 and 2010, and the total for the respective years is as follows:

                                    2012        2011       2010
                                      (Dollars in Millions)

First quarter                     $    3.5     $  2.8     $  3.7
Second quarter                         3.7        3.0        7.5
Third quarter                          3.5        4.4        3.1
Fourth quarter                         1.8        5.2        6.9
Total provision for loan losses   $   12.5     $ 15.4     $ 21.2

As this information illustrates the amount of the allowance for loan losses and related provision expense can vary over long-term and short-term periods. Changes in economic conditions, the composition of the loan portfolio and individual borrower conditions can dramatically impact the required level of allowance for loan losses, particularly for larger individually evaluated loan relationships, in relatively short periods of time. The allowance for loan losses allocated to individually evaluated loan relationships was $2.2 million and $6.0 million at December 31, 2012 and 2011, respectively, a decrease of $3.8 million. Given the rapidly changing and uncertain real estate market coupled with changes in borrowers' financial condition, changes in collateral values, and the overall economic uncertainty, management anticipates there will continue to be significant changes in individual specific loss allocations in future periods as these factors are difficult to predict and can vary widely as more information becomes available or as projected events change.

Fair Value of Securities Available-for-Sale

Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in other comprehensive income, net of tax. The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at the determination date.

When OTTI is determined to have occurred, the amount of the OTTI recognized in earnings depends on whether we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI recognized in earnings is equal to the entire difference between its amortized cost basis and its fair value at the balance sheet date. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized as a charge to earnings. The amount of the OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. The Company recorded no OTTI for the year ended December 31, 2012.

Other Real Estate Owned

Assets acquired through or in lieu of loan foreclosure are initially recorded at fair value, less estimated selling costs, at the date of foreclosure, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Costs relating to improvement of property are capitalized, whereas costs relating to the holding of property are expensed.

Deferred Income Taxes

After converting to a federally chartered savings association, Atlantic Coast Bank became a taxable organization. Income tax expense, or benefit, is the total of the current year income tax due, or refundable, and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary difference between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates and operating loss carryforwards. The Company's principal deferred tax assets result from the allowance for loan losses and operating loss carry forwards. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Internal Revenue Code and applicable regulations are subject to interpretation with respect to the determination of the tax basis of assets and liabilities for credit unions that convert charters and become a taxable organization. Since Atlantic Coast Bank's transition to a federally chartered savings bank, the Company has recorded income tax expense based upon management's interpretation of the applicable tax regulations. Positions taken by the Company in preparing our federal and state tax returns are subject to the review of taxing authorities, and the review by taxing authorities of the positions taken by management could result in a material adjustment to the financial statements.

All available evidence, both positive and negative, is considered when determining whether or not a valuation allowance is necessary to reduce the carrying amount to a balance that is considered more likely than not to be realized. The determination of the realizability of deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of such evidence. Positive evidence considered includes the probability of achieving forecasted taxable income and the ability to implement tax planning strategies to accelerate taxable income recognition. Negative evidence includes the Company's cumulative losses. Following the initial establishment of a valuation allowance, if the Company is unable to generate sufficient pre-tax income in future periods or otherwise fails to meet forecasted operating results, an additional valuation allowance may be required. Any valuation allowance is required to be recorded during the period identified. As of December 31, 2012, the Company had a valuation allowance of $27.7 million for the net deferred tax asset.

Business Strategy

Overview

Our primary objective is to operate a community-oriented financial institution, serving customers in our primary market areas while providing stockholders a solid long-term return on capital. Accomplishing this objective will require financial strength based on a strong capital position, and the implementation of business strategies designed to return the Company to profitability consistent with safety and soundness considerations. To strengthen the Company's capital position the Company has entered into the Merger Agreement discussed above. In the event the Merger is not approved or completed, the Company will continue to explore all strategic alternatives to raise capital. Operating strategies are focused on credit management and reducing the cost of non-performing assets, increasing revenues from mortgage banking, principally through the Bank's warehouse lending activity, and small business lending activities that maximize profits but with lower capital requirements. In addition, the Company seeks to increase non-maturity deposits to improve our cost of funds and to reduce our cost structure. As stated in the Consent Order, before the Bank can make significant changes to its current products, services, asset composition and size, funding sources, and other business activities it must get non-objection from the OCC unless it has been given written non-objection to its strategic and capital plan. See Part I. Item 1. Business - Supervision and Regulation contained in this report for further description of the provisions contained in the Order. The following are the key elements of our business strategy:

Strengthening Our Capital Position. Following the Company's conversion from a mutual holding company to a stock company, the Company's Board of Directors began considering strategies to raise capital. In late 2011, the Company began a review of strategic alternatives, engaging Stifel, Nicolaus and Company, Incorporated to assist the Board in exploring alternatives to enhance stockholder value, including various alternatives including a recapitalization in the form of a rights offering as well as an outright merger transaction. In evaluating its options, the Board of Directors considered the relative risks involved with the alternatives, along with the Company's goal of maximizing the return to stockholders. These risks include the prospects of approval by regulators for successful completion of each alternative, the effectiveness of each option in gaining full compliance with the Order issued by the OCC under which the Bank operates, the Bank's continued exposure to credit, market, economic, and interest rate risks, as well as ongoing earnings pressure from the Company's asset quality and wholesale debt. Considering all the factors the Board of Directors entered into the Merger Agreement on February 25, 2013. Completion of the Merger, which is subject to approval by our regulators and stockholders, is expected to close by June 30, 2013. In the event the Merger is not completed the Board of Directors will continue to explore all other strategic alternatives to raise capital. There can be no assurances that the Company will complete the Merger, or if necessary, otherwise raise additional capital.

Continuing Our Proactive Approach To Reducing Non-performing Assets By Aggressive Resolution And Disposition Initiatives. As a result of the decline in our local economy beginning in 2008, the Bank experienced a substantial increase in our non-performing assets. At December 31, 2012, our non-performing assets were $33.0 million as compared to $9.6 million at December 31, 2007. Management has instituted a proactive strategy to aggressively reduce non-performing assets through accelerated charge-offs, loan work out programs, enhanced collection practices, the use of distressed asset sales and improved risk management.

An aggressive charge-off policy. Beginning in 2009, management began to implement an aggressive charge-off strategy for one- to four-family residential mortgage loans and home equity loans by taking partial or full charge-offs in the period that such loans became non-accruing, generally when loans are 90 days or more past due.

Loan work out programs. We remain committed to working with responsible borrowers to renegotiate residential loan terms. The Bank had $20.0 million in troubled debt restructurings at December 31, 2012, compared to $8.6 million at December 31, 2008. Troubled debt restructurings avoid the expense of foreclosure proceedings and holding and disposition expenses of selling foreclosed property, and provide us increased interest income.

Enhanced collection practices. Beginning in 2009, due to the elevated delinquency of our one- to four-family residential mortgage loans and the increasing complexity of working out these types of loans, management engaged the services of a national third party servicer for certain loans. Initially, one- to four-family residential mortgage loans, and any associated home equity loans that were 60 days past due, were assigned to the third party servicer for collection. Subsequently, the Bank assigned other one- to four-family residential mortgage loans to the third party servicer irrespective of delinquency status, if it was determined the loan may have higher than normal collection risk. At December 31, 2012, the outstanding balance of loans assigned to the third party servicer was $63.5 million. In addition in 2012, the Company increased resources internally to focus on workouts of non-performing one- to four-family residential loans which has led to decreased levels of non-performing loans and improved recoveries.

Non-performing asset sales. In order to reduce the expenses of the foreclosure process, including the sale of foreclosed property, the Bank has sold certain non-performing loans through national loan sales of distressed assets, which may mitigate future losses. From 2008 to December 31, 2012, the Bank sold $10.7 million of loans through distressed asset sales resulting in a loss on such sales of $4.1 million. The Bank may continue distressed asset sales in the future to dispose of non-performing assets when management believes it will result in the least overall loss to the Company. Also as a part of the Bank's work out program the Bank continues to accept short sales of residential property by borrowers where such properties are sold at a loss and the proceeds of such sales are paid to us when this action represents the least costly resolution for the Company.

Credit risk management. The Bank is also enhancing credit administration by improving internal risk management processes. In 2010, an independent risk committee of our board of directors was established to evaluate and monitor system, market and credit risk. In 2012, in connection with a requirement by the Order, the Bank established a broad problem asset resolution program and developed enhanced asset workout plans for each criticized asset.

Increasing Revenue By Expanding Our Warehouse Lending Operations And Increasing Our Emphasis On Commercial Lending To Small Businesses. Historically, Atlantic Coast Bank has emphasized the origination of one- to four-family residential mortgage loans in northeastern Florida and southeastern Georgia. At December 31, 2012, our one- to four-family residential loan portfolio was $193.1 million, or 45.3%, of our loan portfolio. During late 2008, the Bank began to originate mortgage loans for sale in the secondary market on a limited scale. As a result of our internal evaluation, management has begun to shift our business model to a process where customers requesting a mortgage loan will be referred to a third party in exchange for a fee for closed mortgages and sell such mortgages purchased through warehouse lending arrangements. In addition, the Bank intends to continue to increase production in its small business lending initiative.

Warehouse lending strategy. In the latter part of 2009, the Bank began a program for warehouse lending where we finance mortgages originated by third parties and hold a lien position for a short duration (usually less than 30 days) while earning interest (and often a fee) until a sale is completed to an investor. Management expects to modestly expand this aspect of mortgage banking in the future.

Commercial lending strategy. Management also plans to increase commercial business lending and owner-occupied commercial real estate lending with an emphasis on small businesses, subject to regulatory capital requirements. The Bank intends to participate in government programs relating to commercial business loans such as the SBA and the U.S. Department of Agriculture (USDA). The Bank began to implement this strategy in September 2010, by hiring an executive to lead the small business lending along with an experienced SBA lending team. The SBA loan pipeline grew from $3.9 million at the beginning of 2011 to $14.8 million at December 31, 2012. The Company generally sells the guaranteed portion of SBA loans to investors at attractive premiums. Our focus on owner-occupied commercial real estate loans will be to professional service businesses. The Bank intends to target principal balances of up to $1.5 million in our commercial business and owner-occupied commercial real estate lending, while not originating or purchasing higher risk loans such as commercial real estate development projects, multi-family loans and land acquisition and development loans.

Strengthening Our Retail Franchise By Growing Noninterest-bearing Deposits and Reducing Our Overall Cost of Deposits. We believe a successful retail franchise results from a strong core customer base that a focuses on noninterest-bearing deposits within an overall deposit strategy that offers interest rates that are competitive to its markets, but in line with the overall interest rate environment. Therefore, we remain committed to generating lower-cost and more . . .

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