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

Show all filings for BANK OF THE CAROLINAS CORP | Request a Trial to NEW EDGAR Online Pro

Form 10-K for BANK OF THE CAROLINAS CORP


1-Apr-2013

Annual Report


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

The following presents management's discussion and analysis of our financial condition and results of operations. The discussion is intended to assist in understanding our consolidated financial condition and results of operations, and it should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. All share and per share data have been adjusted to give retroactive effect to stock splits and stock dividends.

Bank of the Carolinas Corporation (the "Company") is a North Carolina-chartered bank holding company that was incorporated on May 30, 2006, for the sole purpose of serving as the parent bank holding company for Bank of the Carolinas (the "Bank"). The Bank is an FDIC-insured, North Carolina-chartered bank that began operations on December 7, 1998.

Because the Company has no operations and conducts no business on its own other than owning the Bank, the discussion contained in these footnotes concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and its subsidiary are collectively referred to herein as the Company unless otherwise noted.

Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The notes to our audited financial statements for the years ended December 31, 2012, 2011, and 2010 contain a summary of our significant accounting policies. We believe our policies with respect to methodology for the determination of our allowance for loan losses, and our asset impairment judgments, such as the recoverability of other real estate values, involve a higher degree of complexity and require us to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, we consider the policies related to those areas critical.

The allowance for loan losses represents our best estimate of probable losses that are inherent in the loan portfolio at the balance sheet date. The allowance is based on generally accepted accounting principles, which require that losses be accrued when they are probable of occurring and estimable and require that losses be accrued based on the differences between the value of collateral, the present value of future cash flows or values that are observable in the secondary market, and the loan balance.

The allowance for loan losses is created by direct charges to income. Losses on loans are charged against the allowance in the period in which those loans, in our opinion, become uncollectible. Recoveries during the period are credited to the allowance. The factors that influence our judgment in determining the amount charged against operating income include analyzing historical loan and lease losses, current trends in delinquencies and charge-offs, current assessment of problem loan administration, the results of regulatory examinations, and changes in the size, composition and risk assessment of the loan and lease portfolio. Also included in our estimates for loan losses are considerations with respect to the impact of current economic events, the outcomes of which are uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas and industries in which we conduct business.

The factors that are enumerated above form the basis for a model which we utilize in calculating the appropriate level of our allowance for loan losses at the balance sheet date. This model has three main components. First, losses are estimated on loans we have individually identified and determined to be "impaired". A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. The loss allowance applicable to impaired loans is the difference, if any, between the loan balances outstanding and the value of the impaired loans as determined by either
1) an estimate of the cash flows that we expect to receive from those borrowers discounted at the loan's effective rate, or 2) in the case of collateral-dependent loans, the fair value of the collateral securing those loans less estimated costs to sell.

Second, for all other loans, we divide the loan portfolio into groups or pools based on similarity of risk characteristics. Historical loss rates, which are weighted toward current experience, are then applied to determine an appropriate allowance for each pool or group.


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Finally, an adjustment is applied, if appropriate, to give effect to qualitative or environmental factors that could cause estimated credit losses within the existing loan portfolio to differ from the historical loss experience.

We review our allowance on a quarterly basis and believe that it is adequate to cover inherent loan losses on the loans outstanding as of each reporting date. However, the appropriateness of the allowance using our procedures and methods is dependent upon the accuracy of various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not, in any particular period, sustain loan losses that are significantly different from the amounts reserved for those loans, or that subsequent evaluations of the loan portfolio and our allowance, in light of conditions and factors then prevailing, will not require material changes in the allowance for loan losses or future charges to earnings. In addition, various regulatory agencies, as an integral part of their routine examination process, periodically review our allowance. Those agencies may require that we make additions to the allowance based on their judgments about information available to them at the time of their examinations.

In 2011, the Company modified its methodology for determining the allowance for loan losses. Prior to these changes, the loan loss methodology calculated historical loss rates using a three-year loss history with a quarter lag and a weighted average. During the first quarter of 2011, the Company began using a three-year average annual loss rate. At the end of 2011, the loan loss methodology was modified further to include the current quarter-end, which eliminated the quarter lag used previously. As a result of these changes, there was a net decrease to the Company's allowance for loan losses of approximately $80,000 in 2011.

Accounting for intangible assets is as prescribed by generally accepted accounting principles. We account for recognized intangible assets based on their estimated useful lives. Intangible assets with finite useful lives are amortized, while intangible assets with an indefinite useful life are not amortized. Goodwill is not amortized, but is subject to fair value impairment tests on at least an annual basis. If we determine that impairment has occurred based on our evaluation, the impairment charge is recognized at that time.

Accrued taxes represent the estimated amount payable to or receivable from taxing jurisdictions, either currently or in the future, and are reported, on a net basis, as a component of either "other assets" or "other liabilities" in the consolidated balance sheets. The calculation of the Company's income tax expense is complex and requires the use of many estimates and judgments in its determination.

Management's determination of the realization of the net deferred tax asset is based upon management's judgment of various future events and uncertainties, including the timing and amount of future income and the implementation of various tax plans to maximize realization of the deferred tax asset. As of December 31, 2012, a $14.4 million valuation allowance has been established primarily due to the possibility that all of the deferred tax asset associated with the allowance for loan losses may not be realized. See Note 10 Income Taxes in the notes to the audited consolidated financial statements for further disclosure on this matter.

From time to time, management bases the estimates of related tax liabilities on its belief that future events will validate management's current assumptions regarding the ultimate outcome of tax-related exposures. While the Company has obtained the opinion of advisors that the anticipated tax treatment of these transactions should prevail and has assessed the relative merits and risks of the appropriate tax treatment, examination of the Company's income tax returns, changes in tax law and regulatory guidance may impact the treatment of these transactions and resulting provisions for income taxes.

Overview

The past few years have been difficult ones for the financial services industry in general. Bank failures have been numerous, particularly among community banks in some southeastern states, primarily brought about by the severe downturn in real estate markets. Our operating results have been adversely affected by the weakness in the economy in general and real estate in particular. Our net loss available to common shareholders was $5.5 million for 2012, $29.2 million for 2011, and $3.6 million for 2010. The losses in all years were driven by substantial increases in loan loss provisions due to deterioration in our loan portfolio, significant losses and net operating expenses associated with foreclosed real estate, as well as lost interest revenue caused by elevated levels of nonperforming assets.


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In addition to the effect on our operating results noted above, the economic environment has led to a decline of $37.5 million in our loan portfolio during 2012. Given the prominence of real estate loans in our lending activities, it has been and continues to be a challenge to generate quality credit in sufficient volume to outpace payments.

We strive to serve the financial needs of small to medium-sized businesses and individuals in our market area, offering an array of financial products emphasizing superior customer service.

Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, made up almost 89% of our loan portfolio at December 31, 2012, with the remainder of our loans consisting of commercial and industrial loans and loans to individuals. We also offer certain loan products through associations with various mortgage lending companies. Through these associations, we originate 1-4 family residential mortgages, at both fixed and variable rates. We earn fees for originating these loans and transferring the loan package to the mortgage lending companies.

The deposit services we offer include small business and personal checking accounts, savings accounts, money market checking accounts and certificates of deposit. The Company concentrates on providing customer service to build its customer deposit base.

Additional funding includes certificates of deposit acquired through deposit brokers, advances from the Federal Home Loan Bank, term repurchase agreements from two money center financial institutions and federal funds lines of credit from correspondent banks.

Over 90% of our revenue (net interest income plus noninterest income) was comprised of net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Therefore, the levels of interest rates and our ability to effectively manage the effect that changes in interest rates have on net interest income can have a significant impact on revenue and results of operations. Results of operations may also be materially affected by our provision for loan losses, which has been much higher during the past three years than our long-term trend. Service charges and fee income generated from customer services represented less than 10% of revenue in each of the past two years and represents an area of potential revenue growth. Noninterest expense is the third major driver of operating results along with net interest income and the provision for loan losses. Total noninterest expenses absorbed over 114% of our revenue in 2012 and 141% in 2011. Noninterest expenses include compensation and employee benefits, occupancy and equipment expenses, FDIC insurance premiums, expenses related to foreclosed real estate, professional services, expenditures for data processing services and various other costs of doing business.

In addition, due to the establishment of the valuation allowance against the deferred tax asset, there was no tax expense or benefit in 2012. Results for 2011 were significantly impacted by a provision for income taxes of $4.5 million that was made to establish a deferred income tax valuation allowance to reduce the carrying value of the Company's net deferred tax asset to zero, thereby increasing a loss before income taxes of $23.7 million to a net loss of $28.3 million. For the year 2010, the Company's income tax provision represented tax benefits of approximately 38% of income before income taxes.

Regulatory Action

Consent Order with FDIC and North Carolina Commissioner of Banks. The Bank entered into a Stipulation to the Issuance of a Consent Order (the "Stipulation") with the Federal Deposit Insurance Corporation (the "FDIC") and the North Carolina Office of the Commissioner of Banks (the "Commissioner") and the FDIC and the Commissioner issued the related Consent Order (the "Order"), effective April 27, 2011. The description of the Stipulation and the Order set forth below is qualified in its entirety by reference to the Stipulation and the Order, copies of which are included as exhibits 10.14 and 10.15 to this Form 10-K, and incorporated herein by reference.

Management. The Order requires that the Bank have and retain qualified management, including a chief executive officer, senior lending officer, and chief operating officer with qualifications and experience commensurate with their assigned duties and responsibilities within 60 days from the effective date of the Order. Within 30 days of the effective date of the Order, the board of directors was required to retain a bank consultant to develop a written analysis and assessment of the Bank's management needs. Following receipt of the consultant's management report, the Bank was required to formulate a written management plan that incorporated the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a time frame for completing each action.


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Capital Requirements. While the Order is in effect, the Bank must maintain a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%. If the Bank's capital ratios are below these levels as of the date of any call report or regulatory examination, the Bank must, within 30 days from receipt of a written notice of capital deficiency from its regulators, present a plan to increase capital to meet the requirements of the Order.

Allowance for Loan and Lease Losses and Call Report. Upon issuance of the Order, the Bank was required to make a provision to replenish the allowance for loan and lease losses ("ALLL"). Within 30 days of the effective date of the Order, the Bank was required to review its call reports filed with its regulators on or after December 31, 2010, and amend those reports if necessary to accurately reflect the financial condition of the Bank. Within 60 days of the effective date of the Order, the Bank was required to submit a comprehensive policy for determining the adequacy of the ALLL.

Concentrations of Credit. Within 60 days of the issuance of the Order, the Bank was required to perform a risk segmentation analysis with respect to its concentrations of credit and develop a written plan for systematically reducing and monitoring the Bank's commercial real estate and acquisition, construction, and development loans to an amount commensurate with the Bank's business strategy, management expertise, size, and location.

Charge-Offs, Credits. The Order requires that the Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified "loss" and 50% of those assets classified "doubtful." If an asset is classified "doubtful," the Bank may alternatively charge off the amount that is considered uncollectible in accordance with the Bank's written analysis of loan or lease impairment. The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, "loss" or "doubtful" and is uncollected. The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified "substandard." These limitations do not apply if the Bank's failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.

Asset Growth. While the Order is in effect, the Bank must notify its regulators at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition. The Bank's asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from its regulators.

Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of its regulators. In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior regulatory approval.

Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution's market area. An "adequately capitalized" institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.

Written Plans and Other Material Terms. Under the terms of the Order, the Bank was required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:

- Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management

- Plan to reduce assets of $500,000 or greater classified "doubtful" and "substandard"

- Revised lending and collection policy to provide effective guidance and control over the Bank's lending and credit administration functions

- Effective internal loan review and grading system

- Policy for managing the Bank's other real estate


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- Business/strategic plan covering the overall operation of the Bank

- Plan and comprehensive budget for all categories of income and expense for the year 2011

- Policy and procedures for managing interest rate risk

- Assessment of the Bank's information technology function

Under the Order, the Bank's board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank's activities. The Bank was also required to establish a board committee to monitor and coordinate compliance with the Order.

The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

Written Agreement with the Federal Reserve Bank of Richmond. The Company entered into a written agreement (the "Agreement") with the Federal Reserve Bank of Richmond, on August 26, 2011. The description of the Agreement set forth below is qualified in its entirety by reference to the Agreement, a copy of which is included as exhibit 10.16 to this Form 10-K, and is incorporated herein by reference.

Source of Strength. The Agreement requires that the Company take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to its wholly-owned subsidiary, Bank of the Carolinas (the "Bank"), and ensure that the Bank complies with the requirements of the consent order entered into between the North Carolina Commissioner of Banks, the FDIC and the Bank.

Dividends, Distributions, and other Payments. The Agreement prohibits the Company's payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation. It also prohibits the Company from directly or indirectly taking any dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank of Richmond.

Under the terms of the Agreement, the Company and the Bank may not make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.

Debt and Stock Redemption. The Agreement requires that the Company and any non-bank subsidiary of the Company not, directly or indirectly, incur, increase or guarantee any debt without the prior written approval of the Federal Reserve Bank. The Agreement also requires that the Company not, directly or indirectly, purchase or redeem any shares of its capital stock without the prior written approval of the Federal Reserve Bank of Richmond.

Capital Plan, Cash Flow Projections and Progress Reports. The Agreement requires that the Company file an acceptable capital plan and certain cash flow projections with the Federal Reserve Bank of Richmond. It also requires that the Company file a written progress report within 30 days after the end of each calendar quarter while the Agreement remains in effect.

The Order will remain in effect until modified or terminated by the Federal Reserve Bank of Richmond.

Financial Condition at December 31, 2012 and December 31, 2011

Total assets at December 31, 2012, decreased by $48.6 million or 10.0% to $437.4 million compared to $486.0 million at December 31, 2011. We had earning assets of $398.5 million at December 31, 2012 consisting of $262.4 million in accruing loans, $106.9 million in investment securities and $29.2 million in temporary investments. Stockholders' equity was $9.1 million at December 31, 2012 compared to $14.6 million at December 31, 2011.

Loans. Total loans declined by $37.5 million or 12.2% during the twelve months of 2012, from $307.9 million on December 31, 2011 to $270.4 million at December 31, 2012. On December 31, 2012, real estate loans made up 89.3% of total loans while commercial non-real estate loans comprised another 10.7% of the portfolio. Total loans represented 61.8% and 63.4% of our total assets on December 31, 2012 and 2011, respectively.


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Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulation also influence interest rates. On average, our loan portfolio yielded 4.97% for the year ending December 31, 2012 as compared to an average yield of 5.10% during 2011.

The following table contains selected data relating to the composition of our loan portfolio by type of loan on the dates indicated.

Table I.

Analysis of Loan Portfolio (dollars in thousands)



                                                                                                  At December 31,
                                             2012                         2011                         2010                         2009                         2008
                                     Amount        Percent        Amount        Percent        Amount        Percent        Amount        Percent        Amount        Percent
Real estate loans:
Residential 1-4 family              $  72,595         26.85 %    $  78,631         25.54 %    $  78,750         21.51 %    $  76,767         19.62 %    $  68,876         16.99 %
Commercial real estate                110,527         40.88        126,849         41.20        161,839         44.20        161,904         41.38        154,463         38.10
Construction and development           28,976         10.72         33,081         10.74         35,310          9.64         41,580         10.63         60,476         14.92
Home equity                            29,462         10.89         29,727          9.65         31,465          8.59         30,775          7.87         29,656          7.32

Total real estate loans               241,560         89.34        268,288         87.13        307,364         83.94        311,026         79.50        313,471         77.33
Commercial business loans              22,992          8.50         34,271         11.13         51,581         14.09         75,762         19.36         84,282         20.79
Consumer loans:
Installment                             3,158          1.17          3,490          1.13          4,300          1.17          3,303          0.84          5,989          1.48
Other                                   2,664          0.99          1,858          0.61          2,908          0.80          1,174          0.30          1,660          0.40

Total loans                           270,374        100.00 %      307,907        100.00 %      366,153        100.00 %      391,265        100.00 %      405,402        100.00 %

Allowance for loan losses (6,890 ) (8,101 ) (6,863 ) (8,167 ) (6,308 )

Total loans, net $ 263,484 $ 299,806 $ 359,290 $ 383,098 $ 399,094

The following table reflects the scheduled maturities of commercial real estate loans, construction and development loans, and commercial business loans (dollars in thousands):

                                                         December 31, 2012
                                                     After 1 year
                                        1 year        but within        After
. . .
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