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ACFC > SEC Filings for ACFC > Form 10-K on 28-Mar-2012All Recent SEC Filings




Annual Report

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


The Bank's principal business consists of attracting deposits from the general public and the business community and making loans secured by various types of collateral, including real estate and other consumer assets. The Bank is significantly affected by prevailing economic conditions, particularly interest rates, as well as government policies and regulations concerning among other things, monetary and fiscal affairs, housing and financial institutions. Attracting and maintaining deposits is influenced by a number of factors, including interest rates paid on competing investments offered by other financial and non-financial institutions, account maturities, fee structures, and level of personal income and savings. Lending activities are affected by the demand for funds and thus are influenced by interest rates, the number and quality of lenders and regional economic growth. Sources of funds for lending activities of the Bank include deposits, borrowings, payments on loans, maturities of securities and income provided from operations.

Earnings are primarily dependent upon net interest income, which is the difference between interest income and interest expense and the provision for loan losses. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on such loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on such deposits and borrowings. Provision for loan losses results from actual incurred losses when loans are charged-off and the collateral is insufficient to recover unpaid amounts, as well as an allowance for estimated future losses from uncollected loans. Earnings are also affected by the Bank's service charges, gains and losses from sales of loans and securities, commission income, interchange fees, other income, non-interest expenses and income taxes. Non-interest expenses consist of compensation and benefit expenses, occupancy and equipment costs, data processing costs, FDIC insurance premiums, outside professional services, interchange fees, collection expenses and cost of repossessed assets, and other expenses. Earnings may also be negatively impacted by the Supervisory Agreements entered into by the Company and the Bank with the Office of Thrift Supervision (predecessor regulatory agency to the Office of the Comptroller of the Currency and the Federal Reserve). Please see "Supervision and Regulation - Regulatory Agreements with the Office of Thrift Supervision" and "Risk Factors" for more information.

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 other-than-temporary impairment of securities, other real estate owned and accounting for deferred income taxes. Accounting policies are discussed in detail in Note 1 of the Notes to Consolidated Financial Statements included in Item 8.

Allowance for Loan Losses

An allowance for loan losses ("allowance") 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 declining real estate values in our markets and the weak United States economy in general, it is increasingly likely that impairment reserves on non-performing one-to-four family residential and home equity loans, will not be recoverable and represent a confirmed loss. As a consequence the Company recognizes the charge-off of impairment reserves on non-performing one-to-four family residential and home equity loans in the period the loan is classified as such. This process accelerates the recognition of charge-offs 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 quarterly 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 by type of loan and specific allowances for identified problem loans. The allowance also incorporates the results of measuring impaired loans.

The general loss component is calculated by applying loss factors to outstanding loan balances based on the internal risk evaluation of the loans or pools of loans. Changes to the risk evaluations relative to both performing and non-performing loans affect the amount of this component. Loss factors are based on the Bank's recent loss experience, 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 factors that exist as of the balance sheet date that may be considered in determining the adequacy of the allowance include credit quality trends (including trends in non-performing loans expected to result from existing conditions), collateral values, geographic foreclosure rates, new and existing home inventories, loan volumes and concentrations, specific industry conditions within portfolio segments and recent charge-off experience in particular segments of the portfolio. The impact of the general loss component on the allowance began increasing during 2008 and has continued to increase during each year through 2011. The increase reflected the deterioration of market conditions, and the increase in the recent loan loss experience that has resulted from management's proactive approach to charging off losses on impaired 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. 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.

Loans for which the terms have been modified as a result of the borrower's financial difficulties are considered troubled debt restructurings ("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 homogenous loans, such as one-to four-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 assessment of market rate of interest for homogenous TDR loans is done based on the weighted average rates of those loans compared to prevailing interest rates at the time of restructure.

The allowance for loan losses was $15.5 million at December 31, 2011, and $13.3 million at December 31, 2010. The allowance for loan losses as a percentage of total loans was 2.98% at December 31, 2011, and 2.37% as of December 31, 2010. The provision for loan losses for each quarter of 2011 and 2010, and the total for the respective years is as follows:

                                           2011        2010
                                            (In Millions)
                         First quarter    $   2.8     $  3.7
                         Second quarter       3.0        7.5
                         Third quarter        4.4        3.1
                         Fourth quarter       5.2        6.9
                         Total            $  15.4     $ 21.2

This data demonstrates the manner in which the allowance for loan losses and related provision expense can change over long-term and short-term periods. Changes in economic conditions, the nature and size 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 $6.0 million at December 31, 2011 and $3.9 million at December 31, 2010, an increase of $2.0 million. Given the rapidly changing and uncertain real estate market coupled with changes in borrowers' financial condition, weakening of collateral values, and the overall economic conditions, 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 (loss), 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 other-than-temporary impairment ("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 an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI is determined to have occurred, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If the Company intends to sell the security or it is more likely than not that it 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 the Company does not intend to sell the security and it is not more likely than not that it 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 an OTTI charge of $186,000 for the year ended December 31, 2011.

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 bank, Atlantic Coast Bank became a taxable organization. Income tax expense (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 carryforwards. 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. Atlantic Coast Financial Corporation records 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 of the deferred tax asset 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 in 2009, 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, offsetting the tax benefit for operating losses that would otherwise be recognized. Any valuation allowance is required to be recorded during the period identified. As of December 31, 2011, the Company had a valuation allowance of $25.6 million, or 100% of the net deferred tax asset.

Business Strategy

Overview. Our primary objective is to operate in our primary market areas as a retail community-oriented financial institution, serving customers following a traditional retail banking model 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 is exploring 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 warehouse lending and small business lending activities that maximize profits but with lower capital requirements, while reducing our expense base. In addition, a key element of the Company retail focus is to increase non-maturity deposits which leads to deeper customer relationships and improve our cost of funds. The following are the key elements of our business strategy:

Strengthening our capital position. Based on the Bank's non-compliance with the IMCR, current economic and market conditions, and the Company's recent operating results, the Company's Board of Directors began a review of strategic alternatives late in 2011, engaging Stifel, Nicolaus Weisel, Incorporated to assist the Board in exploring alternatives to enhance stockholder value, including consideration of a potential business combination in addition to a previously disclosed rights offering. As part of its review of strategic alternatives, the Company requested and has received approval from its primary regulator, the Federal Reserve, to pursue strategic alternatives that may lead to a transaction that requires stockholder approval. There can be no assurances that the Company will complete a business combination or raise additional capital. The Board of Directors is reviewing all possible strategic alternatives and the relative benefits of such alternatives to stockholders.

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, 2011, our non-performing assets were $49.6 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 $19.3 million in troubled debt restructurings at December 31, 2011, 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 loan that was 60 days past due, was 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, 2011, the outstanding balance of loans assigned to the third party servicer was $74.3 million.

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, 2011, the Bank sold $10.2 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. The Bank also has accepted 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.

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.

Increasing revenue by expanding our warehouse lending operations and an increasing 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, 2011, our one-to-four family residential loan portfolio was $241.5 million, or 46.9%, 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 intends to shift our business model to sell mortgage loans originated by our internal sales force and sell mortgages purchased through warehouse lending arrangements. In addition, the Bank intends 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 U.S. Small Business Administration ("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. As of December 31, 2011 the SBA loan pipeline grew from $3.9 million at the beginning of the year to $14.5 million at December 31, 2011. 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.

Expanding our retail franchise by growing our non-maturity deposit. We believe a strong core or non-maturity deposit base is key to a retail community bank's success because customer relationships are deepened. Therefore we remain committed to generating lower-cost and more stable non-maturity deposits in our market. The Bank attracts and retains transaction accounts by offering competitive products and rates, excellent customer service and a comprehensive marketing program. Our deposit marketing programs are focused on individuals, businesses and municipalities located in our market area. Our non-maturity deposits (consisting of demand, savings and money market accounts) increased $21.3 million to $310.7 million at December 31, 2011 from $289.4 million at December 31, 2010. At December 31, 2011, non-maturity deposits comprised 61.1% of our total deposits, compared to 54.8% of our total deposits at December 31, 2010. Non-maturity deposits are our least costly source of funds, which improves our interest rate spread and also contributes non-interest income from account related services.

Reducing our operating expense base. The Company has historically operated with a high cost structure as it has implemented growth and new business activities. In order to improve profitability we are focused on reducing operating costs which do not add value to our other business strategies by implementing a review of all major vendors and operating processes. These actions are expected to reduce the run rate of operating expenses, before credit costs, by approximately $3 million in 2012

Comparison of Financial Condition at December 31, 2011 and December 31, 2010

General.In order to maintain its well capitalized status, the Company strategically reduced its assets during 2011. Total assets decreased $38.4 million to $789.0 million at December 31, 2011 as compared to $827.4 million at December 31, 2010. Specifically net portfolio loans decreased by $44.0 million, investments in available-for-sale securities decreased by $22.3 million, bank owned life insurance decreased by $8.3 million and other real estate owned decreased by $4.1 million. These reductions were partially offset by an increase in cash and cash equivalents of $32.5 million and loans held for sale of $12.3 million. Non-maturity deposits (consisting of demand, savings and money market accounts) grew by a combined $21.3 million, while time deposits decreased by $41.4 million and Federal Home Loan Bank advances decreased by $15.0 million.

Following is a summarized comparative balance sheet as of December 31, 2011 and December 31, 2010:

                                         December 31,       December 31,          Increase (Decrease)
                                             2011               2010            Dollars        Percentage
                                                              (Dollars in Thousands)
Cash and cash equivalents               $       41,017     $        8,550     $    32,467            379.7 %
Securities available for sale                  126,821            149,090         (22,269 )          -14.9 %
Loans                                          521,233            563,096         (41,863 )           -7.4 %
Allowance for loan losses                       15,526             13,344           2,182             16.4 %
Loans, net                                     505,707            549,752         (44,045 )           -8.0 %
Loans held for sale                             61,619             49,318          12,301             24.9 %
 Other assets                                   53,803             70,732         (16,929 )          -23.9 %
Total assets                            $      788,967     $      827,442     $   (38,475 )           -4.6 %

Liabilities and Stockholders' equity
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