CresCom Bank
Annual Report 2009

Plain-text annual report

March 5, 2010 Dear Stockholders, Carolina Financial Corporation is pleased to report earnings of $7.2 million for fiscal 2009, as compared to $5.6 million for fiscal 2008, or $3.72 per common share diluted compared to $2.83 per common share diluted, respectively. Total assets at December 31, 2009 were stable at $1.1 billion when compared to December 31, 2008. Loans receivable, net decreased 11.1% to $690.2 million at December 31, 2009 from $776.6 million at December 31, 2008. Total deposits increased to $761.1 million as of December 31, 2009 from $717.4 million at December 31, 2008, an increase of 6.1%. Stockholders’ equity increased $9.5 million, primarily due to net income of $7.2 million and an increase in the market value of securities net of tax of $2.0 million. Net interest income for fiscal 2009 increased 6.4% to $31.7 million, compared to $29.8 million for fiscal 2008. Provision for loan losses of $10.5 million in 2009 compared to $6.4 million in 2008, increased as a result of an increase in non-performing assets. In addition, the company expensed $5.2 million in 2009 related to other real estate and mortgage loan repurchase losses related to mortgage operations as compared to $290,000 in 2008. Return on average assets during 2009 was 0.65% while return on average equity was 14.06%. As anticipated, levels of non-performing assets and credit losses increased further during the year as a result of the distressed residential real estate markets and economic recession. Non-performing assets at December 31, 2009 increased to $35.7 million compared to $21.0 million at December 31, 2008. While it is difficult to know the full extent of the economic downturn and the resulting impact on Carolina Financial Corporation’s credit quality, we expect further increases in non-performing assets, corresponding provisions and expenses and net charge-offs in 2010. Our wholesale mortgage operations experienced strong activity during 2009, making a significant contribution to our year-end earnings. An increase in refinance activity due to lower interest rates coupled with expanding our own sales efforts in new markets has provided positive results. We were faced with numerous challenges in 2009 including an increase in non-performing loans, higher loan loss provisions and a greater level of charge-offs as well as an FDIC special deposit insurance assessment. Additionally, total FDIC insurance including the special assessment was $2.2 million in 2009 compared to $617,000 in 2008, an increase of $1.6 million. Nevertheless, credit quality issues remain a major concern and will remain so until the economy meaningfully improves, housing values begin to stabilize and the unemployment situation recovers. We are glad to have your support as a significant part of our success, sharing our belief that a service- oriented banking institution can successfully compete against larger banking organizations. On behalf of our entire staff and Board of Directors, we thank you for your business, support and trust over the years. I hope to see you at our Annual Meeting of Shareholders in Charleston on April 28, 2010. Sincerely, John D. Russ President and Chief Executive Officer - 1 - [This Page Intentionally Left Blank] - 2 - CAROLINA FINANCIAL CORP ORATION TABLE OF CONTENTS Letter to Stockholders Summar y o f Select ed Financial Data Fi nancial Discussion Indepe ndent Auditor’s R eport Consolidated Financial Statements Consol idated Statements of Financial C onditi on Consol idated Statements of Operations Consol idated Statements of C hanges in Stockholders’ Equi t y and Comprehensive Income ( Loss) Consol idated Statements of C ash Flows Notes to Consolidated Financial Statements Caroli na Financial Corporation’s Officers and Directors Communit y FirstBank of Charleston’s Officers and Directors Crescent Bank’s Officers and Directors Crescent Mortgage Compan y’s Officers and Direct ors Caroli na Service Corporation’s Officers and Directors Corporat e In formation 1 4-5 6-19 20 21 22 23 24-2 5 26-5 0 51 52 53 54 55 56 - 3 - CAROLINA FINANCIAL CORP ORATION SUMMARY OF SELECTED FINANCIAL DATA Set forth below are selected consolidated financial and other data of the Company at and for the periods indicated. The information below is only a summary and should be read together with the accompanying Financial Discussion, which follows this data, and the consolidated financial statements presented herein. Operating Data: Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Noninterest expense Income before income taxes Income tax expense 2009 $ 56,736 25,019 31,717 10,460 21,257 27,938 37,673 11,522 4,353 Net income $ 7,169 For The Years Ended December 31, 2007 2008 (In Thousands) 2006 63,049 33,227 29,822 6,361 23,461 9,227 23,882 8,806 3,256 5,550 65,572 37,285 28,287 1,775 26,512 8,869 22,301 13,080 4,806 56,073 29,711 26,362 2,755 23,607 9,063 20,317 12,353 4,543 8,274 7,810 2005 33,107 15,113 17,994 1,315 16,679 10,049 17,364 9,364 3,378 5,986 Balance Sheet Data: Total assets Interest-bearing cash Securities available for sale Securities held to maturity Federal Home Loan Bank stock Loans held for sale Loans receivable, net Allowance for loan losses Deposits Short-term borrowed funds Long-term debt Stockholders' equity 2009 2008 At December 31, 2007 (In Thousands) 2006 2005 $ 1,078,757 17,759 104,401 125,633 12,456 71,233 690,163 13,032 761,108 43,787 203,638 56,138 1,138,994 16,285 120,988 113,689 11,874 28,283 776,621 11,300 717,389 148,090 218,465 46,591 977,139 4,241 157,456 - 10,147 25,030 738,705 10,083 692,100 85,603 137,965 49,535 804,435 8,311 58,091 - 5,689 30,449 661,465 8,406 622,456 15,117 110,465 40,659 661,449 3,715 45,806 - 5,036 54,357 517,621 5,734 479,154 45,363 85,465 31,883 - 4 - CAROLINA FINANCIAL CORP ORATION SUMMARY OF SELECTED FINANCIAL DATA 2009 2008 For The Years Ended December 31, 2007 (In Thousands) 2006 Selected Average Balances: Total assets Loans receivable, net Deposits Stockholders' equity Performance Ratios: Return on average equity Return on average assets Average earning assets to average total assets Average loans receivable, net to average deposits Average equity to average assets Net interest margin Net charge-offs to average loans receivable, net Non-performing assets to period end loans receivable, net Allowance for loan losses as a percentage $ 1,098,061 737,448 767,814 50,986 1,090,787 774,183 750,110 47,552 864,497 708,629 665,252 44,823 762,158 608,868 580,472 35,615 14.06% 0.65% 94.70% 96.05% 4.64% 3.05% 1.18% 5.17% 11.67% 0.51% 95.66% 103.21% 4.36% 2.86% 0.66% 2.71% 18.46% 0.96% 95.22% 106.52% 5.18% 3.44% 0.01% 2.18% 21.93% 1.02% 94.83% 104.89% 4.67% 3.65% 0.01% 0.19% 2005 554,675 422,194 397,714 28,098 21.30% 1.08% 94.10% 106.16% 5.07% 3.45% 0.00% 0.15% of gross loans receivable (end of period) 1.85% 1.44% 1.35% 1.25% 1.10% Per Share Data: Book value (end of period) Basic earnings Diluted earnings 2009 At or For The Years Ended December 31, 2008 2006 2007 2005 $ 29.35 3.75 3.72 24.36 2.95 2.83 27.55 4.61 4.23 22.70 4.51 4.10 18.75 3.53 3.19 Average common shares - basic Average common shares - diluted 1,912,449 1,924,720 1,883,101 1,960,362 1,794,659 1,954,392 1,729,964 1,902,818 1,693,736 1,876,142 - 5 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Financial Discussion Carolina Financial Corporation is not a publicly traded company subject to reporting and disclosure requirements of the Securities and Exchange Commission (“SEC”) as enumerated in Article 9 of Regulation S-X, Guide 3 or any other requirements for SEC registrants. The Company also does not have an actively traded market for its stock. The accompanying Financial Discussion is provided to assist the reader of these consolidated financial statements and is not intended to comply with disclosure requirements of the SEC as enumerated above. Discussion of Forward-Looking Statements The accompanying Financial Discussion contains certain "forward-looking statements" concerning risks and uncertainties about the financial condition and future operations of Carolina Financial Corporation (the “Company”) and its wholly-owned subsidiary banks, Community FirstBank of Charleston (“Community FirstBank”) and Crescent Bank, (together, the “Banks”), and its wholly-owned subsidiary service corporation, Carolina Services Corporation of Charleston (“Carolina Services”). Effective July 27, 2009, Carolina Financial Corporation contributed 100% of its wholly owned mortgage subsidiary Crescent Mortgage Company (“Crescent Mortgage”) to Community FirstBank. Crescent Mortgage continues to operate as a wholly owned subsidiary of Community FirstBank. These forward- looking statements, as defined by federal securities laws, relate to, among others, expectations of the business environment in which the Company operates, projections of future performance, including operating efficiencies, perceived opportunities in the market, potential future credit experience, and statements regarding the Company’s mission and vision. These forward-looking statements are based upon Management’s current expectations, and may, therefore involve risks and uncertainties. Management’s ability to predict results or the effect of future plans or strategies is inherently uncertain. The Company’s actual results, performance or achievements may differ materially from those suggested, expressed or implied by forward-looking statements due to a wide range of factors, including, but not limited to, the general business environment, general economic conditions nationally and within the State of South Carolina, interest rates, the South Carolina and national real estate markets, the demand for mortgage loans, the credit risk of lending activities, including changes in the levels of and trends of loan delinquencies and charge-offs, results of examinations by our banking regulators, competitive conditions between banks and non-bank financial service providers, regulatory changes, changes in federal and state tax matters and other risks. No assurance can be given that the results of any forward-looking statements will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. For these statements, we claim the protection of the safe harbor for forward- looking statements contained in the Private Securities Litigation Reform Act or other applicable legal provisions. Risk Factors The Company operates in a business environment that has inherent risks. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that items we currently deem to be immaterial may become material and adversely affect our business, financial condition and results of operations. Our business has been adversely affected by downturns in the local economies of our market areas and further downturns could significantly adversely impact our business. Our business is directly affected by market conditions, industry and finance trends, legislative and regulatory changes, and changes in governmental monetary and fiscal policies and inflation, all of which are beyond our control. Currently our markets are experiencing a prolonged recession and continue to reflect weakness in business and economic conditions that may result in (i) a decrease in the demand for loans and other products and services offered by the Company, (ii) a further decrease in the value of loan collateral, or (iii) a further increase in the number of customers and counterparties who become delinquent, file for bankruptcy protection under bankruptcy laws or default on their loans or other obligations. A further increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of nonperforming assets, net charge-offs, and provision for loan losses that could adversely impact our results of operations and financial condition. Further downturns in the real estate markets in our primary market area could significantly adversely impact our business. Our business activities and credit exposure are primarily concentrated in Charleston, Dorchester, and Horry counties in South Carolina. The real estate markets have experienced a significant decline in these markets and these real estate markets may experience further declines. As of December 31, 2009, substantially all of the Company’s loan portfolio is secured by real estate located in South Carolina. If real estate values continue to decline, the collateral for these loans will provide less security. As a result, the borrower’s ability to pay, or the Company’s ability to recover on defaulted loans by selling the underlying collateral, would be diminished. Higher FDIC insurance premiums adversely affect our earnings. The FDIC insures deposits for the Banks. The FDIC charges the insured financial institution premiums to maintain the Deposit Insurance Fund. Current economic conditions have increased the number and severity of bank failures and there are expectations for further bank failures. The FDIC issued guidelines that increased premiums paid by insured institutions based on certain risk criteria at the covered - 6 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION financial institution. As a result, the Company experienced an increase in FDIC premiums in 2009 over 2008 of approximately $1.6 million. Changes in interest rates could impact our financial condition and results of operations. The Company’s earnings are significantly dependent on net interest income. The primary source of income is net interest income, which is the difference between interest earned on interest-bearing assets and interest paid on interest-bearing liabilities. It is expected that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-bearing assets, or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” would negatively impact earnings. Concern of customers over deposit insurance may cause a decrease in deposits at the Company. With continued concerns about bank failures, customers are concerned about FDIC insurance coverage on their deposits and may withdraw deposits from the Company in an effort to ensure that the amount they have on deposit with the Company are fully insured. Decreases in deposits may adversely affect our funding costs and net income. The FDIC recently increased FDIC insurance limits on both individual and commercial accounts. Should the FDIC not maintain these increased limits, this could further increase customer concerns. The fiscal and monetary policy of the federal government and its agencies could have a material adverse effect on our earnings. The Federal Reserve Board regulates the supply of money and credit in the United States. Its policies determine in large part the cost of funds for lending and investing and the return earned on those loans and investments, both of which affect the net interest margin. They also can materially decrease the value of financial instruments that we hold, such as debt securities and mortgage servicing rights. Its policies also can adversely affect borrowers, potentially increasing the risk that they may fail to repay their loans. Changes in Federal Reserve Board policies are beyond our control and difficult to predict; consequently, the impact of these changes on our activities and results of operations is difficult to predict. Changes in bankruptcy regulations could adversely affect the Company’s business. As one component to stemming potential foreclosures, the current governmental administration is discussing “bankruptcy cram-downs”, whereby a judge, under certain guidelines, could unilaterally modify the terms of the contractual debt agreement between the borrower and the lender. If this or similar legislation becomes effective, the impact could significantly adversely impact the Company’s business. If the allowance for loan losses is not sufficient to cover actual loan losses, earnings will decrease. Every loan made by the Company carries a risk that it will not be repaid in accordance with its terms or that any collateral securing it will not be sufficient to assure payment. This risk is affected by, among other things, cash flows of borrowers, changes in the value of collateral, borrower credit histories, changes in economic and industry conditions and duration of the loan. Regulatory agencies, as an integral part of their examination process, review our loans and the allowance for loan losses. Although we believe that the allowance for loan losses is adequate to absorb probable losses in our loan portfolio, we cannot predict these losses or whether our allowance will be adequate or that regulators will not require us to increase this allowance. Any of these occurrences could materially and adversely affect our business, financial condition and profitability. Our funding sources may prove insufficient to replace deposits and support future growth. We rely on customer deposits, advances from the Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”), and other borrowings to fund operations. Although the Company has historically been able to replace maturing deposits and advances, if desired, no assurance can be given that we would be able to replace such funds in the future if the financial condition of the FHLB or programs sponsored by the FRB or other market conditions were to change. In addition, certain borrowing sources are on a secured basis. Due to changes applied by rating agencies on bonds, changes in collateral requirements or deteriorating loan quality, outstanding borrowings could be required to be repaid, incurring prepayment penalties. Our financial flexibility will be severely constrained if we are unable to maintain access to funding at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future operations, our revenues may not increase proportionally to cover these costs. In addition, the Company’s mortgage company funds mortgage loans held for sale through warehouse lines of credit and purchase and sale agreements. Due to recent economic conditions, sources of warehouse lending have decreased and could affect Crescent Mortgage’s ability to fund loans held for sale. - 7 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed. We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. Should we elect or be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common or preferred stock. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside of our control, and our financial performance. Accordingly, there is no assurance that we will have the ability to raise additional capital if needed or on terms acceptable to us. Failure to be able to raise additional capital could result in the Company not meeting our regulatory capital standards. If our investment in the Federal Home Loan Bank of Atlanta were impaired in the future, our earnings and stockholders’ equity would decrease. We own common stock of the Federal Home Loan Bank of Atlanta. We hold this stock to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the Federal Home Loan Bank’s advance program. There is no market for our Federal Home Loan Bank of Atlanta common stock. Recent published reports indicate that certain member banks of the Federal Home Loan Bank System may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the Federal Home Loan Bank of Atlanta, could be substantially diminished. Consequently, we believe that there is a risk that our investment in Federal Home Loan Bank of Atlanta common stock could be impaired at some time in the future. If this occurs, it would cause our earnings and stockholders’ equity to decrease. If the decline in value of any of our investment securities becomes other-than-temporary, we are required to write down the value of that security through a charge to earnings. We review our investment securities portfolio at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other-than-temporary, we are required to write down the value of that security through a charge to earnings. Changes in the expected future cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other-than-temporary, which would require a charge to earnings to write down these securities to fair value. The Company is subject to extensive governmental regulation, which could have an adverse impact on our operations. The banking industry is extensively regulated and supervised under both federal and state law. The Company is subject to the regulation and supervision of the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Company, and the South Carolina Board of Financial Institutions. These regulations are intended primarily to protect depositors, the public and the FDIC insurance fund, and not our shareholders. These regulations govern matters ranging from the maintenance of adequate capital to the general business operations and financial condition of the Company. Any changes in any federal and state law, as well as regulations and governmental policies, income tax laws and accounting principles, could affect the Company in substantial and unpredictable ways, including ways that could adversely affect its business, financial condition or results of operations. The Company is subject to liquidity risk. The inability of the Company to raise funds through deposits, borrowings, sale of securities or other sources could have a substantial negative impact on the Company’s liquidity. Factors that could detrimentally impact the Company’s access to liquidity include a decrease in the level of the Company’s business activity or adverse regulatory action against the Company. The Company’s ability to borrow could be impaired by such factors as a disruption in the financial markets or negative views and expectations of the prospects for the financial services industry. Although the Company’s current sources of funds are considered adequate for its current liquidity needs, there can be no assurance in this regard for the future. If additional debt is needed in the future, there can be no assurance that such debt would be available or, if available, would be on favorable terms. The ability of the Company to raise capital or borrow in the debt markets has been negatively affected by recent economic conditions. If additional financing sources are unavailable or not available on reasonable terms, the Company’s financial condition, results of operations and future prospects could be adversely affected. The Company’s 2009 earnings have been highly dependent upon the results of the mortgage operations. There are a number of items that could adversely affect the volumes and margin of the Company’s mortgage operations. These include, but are not limited to, the Federal Reserve mortgage-backed securities purchase program, aggressively low rates, the housing market recovery, the status and financial condition of FNMA and FHLMC, proposed changes in the FHA lending requirements, extensive regulatory changes and liquidity. Should these factors significantly impact production of mortgages, it is likely that the Company’s earnings would be adversely affected. - 8 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION The Company’s mortgage operations are subject to significant repurchase risk. The Company is exposed to significant repurchase risk on mortgage loan production related to potential reimbursements for loans sold to third parties for borrower fraud, underwriting and documentation issues, early defaults and prepayments of sold loans. If the Company experiences significant losses related to repurchase risk, it is possible that the reserve established for such exposure is not adequate. We believe that the reserve related to repurchase risk is adequate to absorb probable losses, however, we cannot predict these losses or whether our reserve will be adequate. Any of these occurrences could materially and adversely affect our business, financial condition and profitability. Hurricanes, earthquakes and other natural disasters may adversely affect loan portfolios and operations and increase the cost of doing business. The Company operates in markets that are susceptible to natural disasters. Large-scale natural disasters may significantly affect loan portfolios by damaging properties pledged as collateral, affecting the economies our borrowers live in, and by impairing the ability of the borrower to repay their loans. Overview Carolina Financial Corporation, a bank holding company, is a Delaware corporation that was incorporated in 1996 and began operations in 1997. We operate principally through Community FirstBank of Charleston and Crescent Bank, both South Carolina state-chartered banks. Our assets are approximately $1.1 billion at December 31, 2009. Our subsidiaries provide a full range of financial services designed to meet the financial needs of our customers, including: • Commercial and retail banking • Mortgage banking • Cash management, and • Retail investment services and asset management. Carolina Financial, through Community FirstBank and Crescent Bank, currently conducts business through 10 bank branches located in the following counties: Charleston (4), Dorchester (2), and Horry (4) in South Carolina. Effective July 27, 2009, Carolina Financial Corporation contributed 100% of its wholly owned mortgage subsidiary Crescent Mortgage Company (“Crescent Mortgage”) to Community FirstBank. Crescent Mortgage is located in Dekalb County, Georgia, and originates loans in 40 states. Comparison of Operating Results for the Years Ended December 31, 2009 and 2008 Net Income. Net income increased $1.6 million, or 29.2%, to $7.2 million, or $3.72 diluted earnings per share, during 2009 compared to $5.6 million, or $2.83 diluted earnings per share, during 2008. The net increase in net income primarily resulted from increases in net interest income of $1.9 million to $31.7 million during 2009 compared to $29.8 million during 2008 offset by an increase in provision for loan losses of $4.1 million to $10.5 million during 2009 compared to $6.4 million during 2008. Noninterest income increased by $18.7 million to $27.9 million during 2009 compared to $9.2 million during 2008. There was also an increase in noninterest expense of $13.8 million to $37.7 million during 2009 compared to $23.9 million during 2008. Income tax expense increased $1.1 million in 2009 over 2008. Net Interest Income. Net interest income increased $1.9 million, or 6.3%, to $31.7 million during 2009 from $29.8 million during 2008. This increase is primarily the result of an increase in the Company’s net interest margin to 3.05% in 2009 from 2.86% in 2008, an improvement of 19 basis points. The improvement in net interest margin during fiscal 2009 over fiscal 2008 is primarily the result of the mix of interest-bearing liabilities to lower-rate liabilities and the repricing of higher-rate liabilities, net of the reduction in yield earned on interest-earning assets. The rate paid on interest-bearing liabilities in 2009 was 2.51% as compared to 3.36% in 2008, a reduction of 85 basis points. During fiscal 2009, the Company focused on increasing checking and money market deposits and reducing brokered deposits and higher-rate certificates of deposits. The yield earned on interest-earning assets in 2009 was 5.46% as compared to 6.04% in 2008, a reduction of 58 basis points. Fiscal 2008 experienced a falling rate environment as evidenced by the reduction in the prime rate. During fiscal 2008 the prime rate dropped from 7.25% at the beginning of the year to 3.25% by December 31, 2008. During fiscal 2009, the prime rate remained at 3.25% all year. Accordingly, yields earned on interest-bearing assets and rates paid on interest-bearing liabilities that are tied to the prime rate or other variable index, reflected a reduction in the interest rates. Total interest income decreased $6.3 million, or 10.0%, to $56.7 million during 2009 from $63.0 million during 2008. Average loans receivable, net decreased $36.7 million, or 4.7 %, to $737.4 million during 2009 from $774.2 million during 2008. The yield earned on loans receivable, net decreased to 5.60% from 6.21% during 2009 and 2008, respectively. At December 31, 2009 and 2008, approximately 65% and 70%, respectively, of the loan portfolio consisted of adjustable rate loans and 35% and 30%, respectively, are fixed rate loans. - 9 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Additionally, the Company’s net interest income was adversely affected by the Company’s nonaccrual loans that increased to $27.1 million at the end of 2009 from $13.9 million at the end of 2008. Lost interest, interest not recorded in the accompanying consolidated statements of operations related to loans on nonaccrual, loans charged off during the period, and loans transferred to real estate acquired through foreclosure, totaled approximately $1.6 million and $1.2 for fiscal 2009 and 2008, respectively. The average balance of securities available for sale decreased $88.4 million, or 45.6%, to $105.3 million during 2009 from $193.6 million during 2008. The yield earned on securities available for sale decreased to 5.16% from 5.76% during 2009 and 2008, respectively. During 2009 and 2008, the Company transferred approximately $30.6 million and $112.3 million, respectively, of securities available for sale to securities held to maturity. The average balance of securities held to maturity increased $107.8 million, or 449.2%, to $131.8 million during 2009 from $24.0 million during 2008. The yield earned on securities held to maturity decreased to 5.57% from 6.31% during 2009 and 2008, respectively. Total interest expense decreased $8.2 million, or 24.7%, to $25.0 million during 2009 from $33.2 million during 2008. Average interest- bearing liabilities increased $8.6 million, or 0.9%, to $996.6 million during 2009 from $988.1 million during 2008. Average money market balances increased $22.1 million, or 22.5%, to $120.6 million during 2009 from $98.4 million during 2008. In addition, the effective rate paid on money markets during 2009 was 1.55% compared to 1.90% during 2008. Average short-term borrowings balances decreased $22.2 million, or 29.1%, to $54.2 million during 2009 from $76.4 million during 2008. The effective rate paid during 2009 on these borrowings was 2.51% compared to 2.61% during 2008. Average long-term borrowings balances increased $9.5 million, or 4.6%, to $215.6 million during 2009 from $206.2 million during 2008. The effective rate paid during 2009 on these borrowings was 2.73% compared to 3.49% during 2008. Provision for Loan Losses. The provision for loan losses increased $4.1 million to $10.5 million during 2009 compared to $6.4 million during 2008. The Company had net charge-offs of $8.7 million or 1.28% of average loans receivable, net during 2009 compared to net charge-offs of $5.1 million or 0.66% of average loans receivable, net during 2008. The allowance for loan losses was 1.85% of net loans receivable, or $13.0 million at December 31, 2009, an increase of $1.7 million from the allowance for loan losses of $11.3 million or 1.44% of the loans receivable, at December 31, 2008. The 41 basis point increase in the allowance for loan losses as a percentage of loans receivable, net is primarily due to the increase in non-performing assets to loans receivable, net to 5.17% at December 31, 2009 from 2.71% at December 31, 2008. An additional cause of the increase is continued review of the risk factors related to the underlying loan portfolio, including increased delinquencies of construction mortgages, internal loan level risk rating changes, and slowing external economic conditions in the residential real estate market. Noninterest Income. Total noninterest income increased $18.7 million, or 202.8%, to $27.9 million during 2009 from $9.2 million during 2008. This increase is primarily attributable to an increase in net gain on sale of loans of $19.4 million, net of a reduction in the gain on derivatives of $728,000 and an increase in the loss on extinguishment of debt of $659,000. Net gain on sale of loans held for sale increased $19.4 million, or 423.7%, to $24.0 million during 2009 compared to $4.6 million during 2008. The increase in net gain on sale of loans held for sale is due to increased volume and margin. Loans held for sale originations increased to $1.7 billion during 2009 compared to $712.8 million during 2008. Margin on loan sales, which includes the gain on sale of loans, net fee income and the change in market value of the pipeline, was 129.6 basis points during 2009 compared to 64.1 basis points during 2008. Net gain on derivatives in 2009 totaled $411,000 compared to $1.1 million during 2008. The decrease in the derivative fair values during the year ended December 31, 2009 was due to unfavorable movement in mortgage interest rates at year-end resulting in a decrease in the derivative values. The Company incurred losses on extinguishment of debt totaling $711,000 and $52,000 in 2009 and 2008, respectively on the prepayment of certain debt advances with interest rates higher than market at the time of the prepayment. Noninterest Expense. Total noninterest expense increased $13.8 million, or 57.7%, to $37.7 million during 2009 from $23.9 million during 2008. This increase is primarily attributable to increases in salaries and employee benefits expense, other real estate expense, mortgage loan repurchase losses, FDIC insurance and other expenses. Salaries and employee benefits expense increased a net $5.7 million, or 39.2%, to $20.2 million during 2009 from $14.5 million during 2008. The increase in compensation and benefits in 2009 of $4.8 million over 2008 primarily relates to an increase in the number of employees at the mortgage company and the related incentives earned during 2009. Other real estate expense increased $1.8 million during 2009 related to write-downs of other real estate and the additional expenses of managing other real estate. Mortgage loan repurchase losses increased $3.1 million during 2009 as the Company provided for exposure on mortgage loan production related to potential reimbursements for loans sold to third parties for borrower fraud, underwriting and documentation issues, early defaults and prepayments of sold loans. - 10 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION FDIC insurance expense increased $1.6 million, or 256.7%, to $2.2 million during 2009 from $617,000 during 2008 primarily due to higher insurance rates and the FDIC special assessment of $514,000 in the second quarter of 2009. Other expense increased $1.2 million, or 27.0%, to $5.8 million during 2009 from $4.5 million during 2008 primarily related to the increased loan volumes at the mortgage company. There were no other individually significant changes. Income Tax Expense. Income tax expense increased $1.1 million to $4.4 million during 2009 from $3.3 million during 2008. The increase was due to an increase in income before income taxes in 2009. The Company’s effective tax rate was 37.8% and 37.0% during 2009 and 2008, respectively. Comparison of Operating Results for the Years Ended December 31, 2008 and 2007 Net Income. Net income decreased $2.7 million, or 32.9%, to $5.6 million, or $2.83 diluted earnings per share, during 2008 compared to $8.3 million, or $4.23 diluted earnings per share, during 2007. The net decrease in net income resulted from increases in net interest income of $1.5 million to $29.8 million during 2008 compared to $28.3 million during 2007 offset by an increase in provision for loan losses of $4.6 million to $6.4 million during 2008 compared to $1.8 million during 2007. Noninterest income increased by $358,000 to $9.2 million during 2008 compared to $8.9 million during 2007. There was also an increase in noninterest expense of $1.6 million to $23.9 million during 2008 compared to $22.3 million during 2007. Income tax expense decreased $1.6 million in 2008 over 2007. Net Interest Income. Net interest income increased $1.5 million, or 5.4%, to $29.8 million during 2008 from $28.3 million during 2007. This increase is a result of an increase in average interest-earning assets of $220.3 million, or 26.8%, to $1.0 billion in 2008 from $823.2 million in 2007, which was predominately funded by an increase in average interest-bearing liabilities of $232.6 million, or 30.8%, to $988.1 million in 2008 from $755.5 million in 2007. The Company’s net interest margin also decreased 16.9% to 2.9% in 2008 from 3.4% in 2007. This decrease was due to the Company’s asset sensitive balance sheet. The majority of the Company’s loan portfolio consisting of adjustable rate loans that are indexed to the Company’s prime rate began to decrease during the second half of 2007 through 2008 and repriced much more quickly and severely than the Company’s borrowings. In addition, due to national liquidity issues, deposits were very competitive in local markets and repriced much less than the federal funds rate. From January 1, 2008 to December 31, 2008 the federal funds rate decreased 4.0% while the Company’s cost of deposits only decreased 1.3%. Additionally, the Company’s net interest margin was adversely affected by the Company’s nonperforming assets, consisting of nonaccrual loans and real estate acquired through foreclosure, that were not accruing interest, increasing to $21.0 million at the end of 2008 from $16.1 million at the end of 2007. Lost interest, interest not recorded in the accompanying consolidated statements of operations related to loans on nonaccrual, loans charged off during the period, and loans transferred to real estate acquired through foreclosure totaled approximately $1.2 million and $240,000 for fiscal 2008 and 2007, respectively. Total interest income decreased $2.5 million, or 3.8%, to $63.0 million during 2008 from $65.6 million during 2007. This decrease is primarily attributable to the dynamics of average loan and securities balances and the average annual yields earned. Average loans receivable, net increased $65.6 million, or 9.2%, to $774.2 million during 2008 from $708.6 million during 2007. The yield earned on loans receivable, net decreased to 6.2% from 8.3% during 2008 and 2007, respectively. Approximately 70% of the loan portfolio consists of adjustable rate loans and 30% are fixed rate loans. During fiscal 2008 the prime rate dropped from 7.25% at December 31, 2007 to 3.25% at December 31, 2008. Accordingly, loans tied to the prime rate, or other variable index, resulted in a reduction of the interest rates on these adjustable rate loans. The average balance of securities available for sale increased $121.4 million, or 168.3%, to $193.6 million during 2008 from $72.2 million during 2007. The yield earned on securities available for sale increased to 5.8% from 5.3% during 2008 and 2007, respectively. At September 30, 2008, the Company transferred approximately $112.3 million of securities available for sale to securities held to maturity. The average balance of securities held to maturity was $24.0 million with a yield of 6.3%. Total interest expense decreased $4.1 million, or 10.9%, to $33.2 million during 2008 from $37.3 million during 2007. The decrease in interest expense is attributable to the dynamics of the average balances of interest-bearing liabilities and the yield paid on those liabilities. During fiscal 2008 the prime rate dropped from 7.25% at December 31, 2007 to 3.25% at December 31, 2008. Accordingly, deposits and borrowings, either directly or indirectly tied to the prime rate, or other variable index, resulted in a reduction of the interest rates on these deposits and borrowings. Average interest-bearing liabilities increased $232.6 million, or 30.8%, to $988.1 million during 2008 from $755.5 million during 2007. The increase in the average interest-earning assets was funded primarily through certificates of deposit and borrowings from FHLB and FRB. Average certificate of deposit balances increased $107.6 million, or 22.8%, to $580.3 million during 2008 from $472.7 million during 2007. In addition, the effective yield paid during 2008 was 3.8% compared to 5.1% during 2007. Average short-term and long-term borrowings balances increased $144.2 million, or 104.1%, to $282.6 million during 2008 from $138.4 million during 2007. The effective yield paid during 2008 on these borrowings was 3.2% compared to 6.0% during 2007. Provision for Loan Losses. The provision for loan losses increased $4.6 million to $6.4 million during 2008 compared to $1.8 million during 2007. The Company had net charge-offs of $5.1 million or 0.66% of average loans receivable, net during 2008 compared to net charge-offs of $98,000 or 0.01% of average loans receivable, net during 2007. The allowance for loan losses was 1.4% of loans receivable, or $11.3 million, at December 31, 2008, an increase of $1.2 million from the allowance for loan losses of $10.1 million or 1.4% of the loans receivable, at December 31, 2007. The 0.09% increase in the allowance for loan losses as a percentage of loans receivable, net is primarily due to the increase in non-performing assets to loans receivable, net to 2.7% at December 31, 2008 from 2.2% at December 31, - 11 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION 2007. An additional cause of the increase is continued review of the risk factors related to the underlying loan portfolio, including increased delinquencies of construction mortgages, internal loan level risk rating changes, and slowing external economic conditions in the residential real estate market. Noninterest Income. Total noninterest income increased $358,000, or 4.0%, to $9.2 million during 2008 from $8.9 million during 2007. This increase is primarily attributable to an increase in net gain on derivatives of $1.2 million, an increase in sales of non-depository products of $810,000 and an increase in deposit service charges of $374,000, net of a decrease in the net gain on sale of loans held for sale of $1.9 million in 2008 compared to 2007. Net gain on sale of loans held for sale decreased $1.9 million, or 29.2%, to $4.6 million during 2008 compared to $6.5 million during 2007. The decrease in net gain on sale of loans held for sale was primarily due to decreased volume as originations of loans held for sale decreased to $712.8 million during 2008 compared to $949.1 million during 2007. The Company’s margin on loan sales was 64.1 basis points during 2008 compared to 67.3 basis points during 2007. Deposit service charges increased $374,000, or 34.8%, to $1.4 million during 2008 from $1.1 million during 2007. This increase is primarily attributable to an increase in commercial NSF charges. During the latter part of 2007, the Company began offering non-depository products through its relationship with Raymond James Financial Services (“Raymond James”), including stocks, bonds, mutual funds, annuities, insurance and retirement products. Revenues from sales of these non-depository products were $867,000 and $57,000 in 2008 and 2007, respectively. During the fourth quarter of 2007 and the first six months of 2008, the Company restructured part of its securities portfolio to add more duration in anticipation of falling interest rates and take advantage of higher yields in various investment grade securities. In 2008, the Banks sold $65.0 million of securities recognizing a $952,000 net gain on sale of available for sale securities. In 2007, the Banks sold $18.8 million of securities recognizing a $477,000 gain on sale of available for sale securities. The Banks used the proceeds in both years to purchase various mortgage-backed securities. Net gain on derivatives in 2008 totaled $1.1 million compared to a $13,000 loss during 2007. The increase in the derivative fair values during the year ended December 31, 2008 was due to favorable movement in mortgage interest rates resulting in an increase in the derivative values as well as an increase in the volume of interest rate locks. Noninterest Expense. Total noninterest expense increased $1.6 million, or 7.1%, to $23.9 million during 2008 from $22.3 million during 2007. This increase is attributable to increases in salaries and employee benefits expense, occupancy and equipment expense, FDIC insurance and other expenses. Salaries and employee benefits expense increased a net $376,000, or 2.7%, to $14.5 million during 2008 from $14.1 million during 2007. During 2008, compensation and benefits increased $1.6 million, offset by a $1.1 million reduction of expense related to a change in the Company’s short-term disability program. Prior to changing the short-term disability program to a third-party insurance program, the Company self-insured for short-term disability. Upon termination of the plan, the Company reversed an accrual of approximately $1.1 million into 2008 earnings. The increase in compensation and benefits primarily relates to an increase in commission expense related to the Raymond James relationship of $379,000, normal annual merit increases and an increase in full-time equivalents at December 31, 2008 to 217 compared to 204 at December 31, 2007. Occupancy and equipment expense increased $274,000, or 10.0%, to $3.0 million during 2008 from $2.7 million during 2007. The year over year increase is primarily attributable to an $84,000 increase in ATM expenses for the five ATM machines added during fiscal 2008. In addition, depreciation increased approximately $96,000 related to additions to property and equipment. Rent expense increased approximately $60,000 primarily due to acquiring space for the non-depository operations. FDIC insurance expense increased $151,000, or 32.4%, to $617,000 during 2008 from $466,000 during 2007. The increase is primarily related to an increase in bank deposits. During 2007, the FDIC started charging deposit insurance assessments to all insured institutions in order to increase the reserve ratios of the FDIC Deposit Insurance Fund. Other expense increased $734,000, or 17.9%, to $4.8 million during 2008 from $4.1 million during 2007. The increase is primarily attributable to an increase in legal and other expenses related to managing nonperforming assets of $201,000, mortgage-banking expenses related to reimbursements related to early defaults and prepayments of sold loans of $190,000. There were no other individually significant changes. Income Tax Expense. Income tax expense decreased $1.6 million to $3.3 million during 2008 from $4.8 million during 2007. The decrease was due to lower income before income taxes in 2008. The Company’s effective tax rate was 37.0% and 36.7% during 2008 and 2007, respectively. - 12 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Analysis of Changes in Net Interest Income The following table shows changes in interest income and interest expense based upon changes in volume and changes in interest rates during the periods indicated: 2009 vs. 2008 Increase (decrease) due to Volume Rate Rate/ Volume For The Years Ended December 31, 2008 vs. 2007 Net Dollar Change (Dollars In Thousands) Increase (decrease) due to Volume Rate Rate/ Volume Net Dollar Change Loans held for sale Loans receivable, net Interest-bearing cash Securities available for sale Securities held to maturity FHLB stock Other investments Interest income Demand accounts Money market accounts Savings accounts Certificates of deposit Short-term borrowed funds Long-term debt Interest expense $ 780 (2,283) 16 (5,086) 6,801 24 (26) 226 10 421 4 (110) (581) 330 74 Net interest income $ 152 248 (4,732) (388) (1,164) (177) (367) (32) (6,612) (50) (351) (2) (6,125) (79) (1,479) (8,086) 1,474 138 225 (15) 531 (797) (22) 13 73 (3) (79) (1) 31 23 (68) (97) 170 1,166 (6,790) (387) (5,719) 5,827 (365) (45) (6,313) (43) (9) 1 (6,204) (637) (1,217) (8,109) 1,796 (401) 5,459 511 6,434 - 306 (2) 12,307 (9) (706) 1 5,512 3,311 5,500 13,609 (1,302) (178) (14,970) (159) 331 - (156) (37) (15,169) (117) (2,242) (9) (6,311) (1,067) (2,625) (12,371) 37 (1,385) (259) 558 1,514 (126) 1 340 4 354 - (1,436) (2,006) (2,211) (5,295) (2,798) 5,635 (542) (10,896) 93 7,323 1,514 24 (38) (2,522) (122) (2,594) (8) (2,235) 238 664 (4,057) 1,535 - 13 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Yields on Average Interest-Earning Assets and Rates on Average Interest-Bearing Liabilities The following table summarizes the Company’s yields on average interest-earning assets and rates on average interest-bearing liabilities during the periods indicated: Interest-earning assets: Loans held for sale Loans receivable, net (1) Interest-bearing cash Securities available for sale Securities held to maturity Federal Home Loan Bank stock Other investments Total interest-earning assets Non-earning assets Total assets Interest-bearing liabilities: Demand accounts Money market accounts Savings accounts Certificates of deposit Short-term borrowed funds Long-term debt Total interest-bearing liabilities Noninterest-bearing deposits Other liabilities Stockholders' equity Average Balance $ 35,761 737,448 17,038 105,265 131,760 12,153 465 1,039,890 58,170 1,098,060 26,231 120,573 2,643 577,364 54,211 215,626 996,648 41,003 9,422 50,987 Total liabilities and stockholders' equity $ 1,098,060 Net interest spread Net interest margin Net interest income 3.05% (1) Average balances of loans include non-accrual loans. For The Years Ended December 31, 2009 Interest Paid/ Earned Average Yield/ Rate Average Balance (Dollars In Thousands) 2008 Interest Paid/ Earned Average Yield/ Rate 2,567 41,325 19 5,427 7,341 39 18 56,736 123 1,864 16 15,778 1,361 5,877 25,019 22,973 7.18% 774,183 5.60% 16,412 0.11% 193,616 5.16% 23,991 5.57% 11,474 0.32% 3.87% 802 5.46% 1,043,451 47,336 1,090,787 24,726 98,448 2,029 580,264 76,455 206,170 988,092 44,643 10,500 47,552 1,090,787 2.86% 0.47% 1.55% 0.61% 2.73% 2.51% 2.73% 2.51% 2.95% 1,401 48,115 407 11,146 1,514 403 63 63,049 166 1,873 14 21,983 1,998 7,193 33,227 6.10% 6.21% 2.48% 5.76% 6.31% 3.51% 7.86% 6.04% 0.67% 1.90% 0.69% 3.79% 2.61% 3.49% 3.36% 2.68% 31,717 29,822 - 14 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Loans by Type The following table summarizes loans by type and percent of total at the end of the periods indicated: At December 31, 2009 2008 Amount % of Total Loans Amount % of Total Loans (Dollars In Thousands) Loans Receivable: Residential mortgage Commercial mortgage Construction mortgage Commercial loans Consumer loans Total gross loans receivable Less: Undisbursed loans in process Allowance for loan losses Deferred fees, net 7.31% 41.46% 2.01% 39.19% 10.03% 100.00% $ 53,094 301,344 14,639 284,889 72,917 726,883 23,230 13,032 458 Loans receivable, net $ 690,163 Non-Performing and Problem Assets 6.87% 38.42% 7.89% 37.17% 9.65% 100.00% 57,682 322,595 66,279 312,099 80,993 839,648 51,000 11,300 727 776,621 The following table summarizes non-performing and problem assets at the end of the periods indicated. At December 31, 2009 2008 (In Thousands) Non-Performing Assets Non-accrual loans-renegotiated loans Non-accrual loans-other Accruing loans 90 days or more delinquent Real estate acquired through foreclosure, net Total Non-Performing Assets $ 3,505 23,554 771 7,853 35,683 $ - 13,923 13 7,105 21,041 Problem Assets not included in Non-Performing Assets Accruing renegotiated loans $ 5,269 1,103 Substantially all of the non-accrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans for fiscal 2009 and 2008 are collateralized by real estate. 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. 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 repricing opportunities in those accounts to produce consistent net income during periods of changing interest rates. The Banks’ Asset/Liability Management Committees ("ALCO") monitor 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 repricing opportunities of interest- earning assets, deposits and borrowed funds. It is the responsibility of the ALCO to determine and achieve the most appropriate volume - 15 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION 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 also set policy guidelines and establishes long-term strategies with respect to interest rate risk exposure and liquidity. The ALCO meet regularly to review the Company’s interest rate risk and liquidity positions in relation to present and prospective market and business conditions, and adopt 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 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 twelve 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. The following table summarizes the Company’s interest rate sensitivity position at the Banks as of December 31, 2009: Interest Rate Scenario Change 0.00% 1.00% 2.00% 3.00% Prime Rate 3.25% 4.25% 5.25% 6.25% Percentage Change in Net Interest Income 0.00% -1.05% -1.73% 3.25% The Company also uses derivatives intended to reduce interest rate risk incurred as a result of market movements. These derivatives primarily consist of mortgage loan interest rate lock commitments, forward mortgage loan sales commitments and options to deliver mortgage-backed securities. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. The Company uses derivatives primarily to minimize interest rate risk related to its pipeline of loan interest rate lock commitments issued on residential mortgage loans in the process of origination for sale or loans held for sale. Forward mortgage loan sales commitments and options to deliver mortgage-backed securities that generally correspond with the composition of the locked pipeline are used to economically hedge a percentage of the Company’s locked pipeline. The Company’s Secondary Market Committee has developed a comprehensive hedging policy to monitor the use of derivatives to reduce interest rate risk. The Company’s derivative positions are classified as trading assets and liabilities, and as such, the changes in the fair market value of the derivative positions are recognized in the consolidated statement of operations. The derivative positions of the Company at December 31, 2009 and 2008 are as follows: 2009 Fair Value Notional Value 2008 Fair Value Notional Value Derivative assets - Mortgage loan interest rate lock commitments Forward mortgage loan sales commitments Derivative liabilities - $ $ 428 1,914 2,342 (In Thousands) 46,588 130,000 1,999 - 1,999 222,994 - Forward mortgage loan sales commitments $ 891 177,282 959 121,000 - 16 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Liquidity and Financial Condition The Company’s assets and liabilities are monitored on a daily basis to ensure funds are available to meet liquidity requirements. The Company also utilizes borrowing facilities in order to maintain adequate liquidity including: the Federal Home Loan Bank of Atlanta (“FHLB”) advance window, the Federal Reserve Bank (“FRB”), federal funds purchased, and warehouse lines of credit. Periodically, the Company will use 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 Federal Home Loan Bank of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Banks have pledged approximately $177.8 million of first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements as collateral for these advances. In addition, the Company has pledged $59.8 million of securities for these advances. At December 31, 2009, the Banks had maximum FHLB lines of $339.1 million based on FHLB limits. At December 31, 2009, the Banks pledged collateral totaling $237.6 million to support FHLB advances. At December 31, 2009 the Banks had FHLB advances of $176.5 million outstanding, with excess collateral pledged to the FHLB that would support additional borrowings of approximately $61.0 million. Lines of credit with the FRB are based on collateral pledged. The Banks have pledged certain non-mortgage commercial, acquisition and development, and lot loan portfolios under blanket lien agreements as collateral to the FRB for these advances. At December 31, 2009 the Banks had lines available with the FRB for $71.6 million. At December 31, 2009 the Banks had no FRB advances outstanding, with excess collateral pledged to the FRB that would support additional borrowings of approximately $71.6 million. The mortgage loan warehouse line of credit is an extension of credit facility from a correspondent bank to Crescent Mortgage with a $35.0 million credit limit, of which $15.9 million is still available. The facility is secured by Crescent Mortgage’s residential mortgage loans held for sale and other assets. During 2008, the Company modified a $5.0 million unsecured line of credit with a correspondent bank, of which $3.0 million is outstanding at December 31, 2009, to be extended to March 31, 2020. In connection with this modification, the Company obtained a $3.0 million subordinated debenture that, as a condition to the line of credit modification, requires the Company to keep at least a $500,000 principal balance outstanding on the line of credit until the subordinated debenture is paid in full. If the Company does not maintain the $500,000 balance, there is a $150,000 prepayment penalty. During 2009, the Company has maintained at least a $500,000 principal balance outstanding on the line of credit. During 2009, the correspondent bank was put into receivership with the Federal Deposit Insurance Corporation (“FDIC”). As a result, the undrawn $2 million of availability under this unsecured line of credit has been withdrawn by the FDIC. The line of credit also has debt covenants, the more restrictive of which requires the Company to maintain certain capital ratios and return on asset ratios. As of December 31, 2009, the Company is not in compliance with all of the covenants. While the lender has not called the line of credit, it has the right to do so. Accordingly, the Company has developed alternatives to replace this line of credit, if necessary, by obtaining financing from other sources or by receiving dividends from its subsidiaries in accordance with regulatory requirements to pay off the debt. As a result, management does not believe that default of this covenant will have a material adverse affect on the Company’s financial condition or the results of its operations. Capital Resources The Company and the Banks are subject to numerous regulatory capital requirements administered by federal banking agencies. If these capital requirements are not met, regulators can initiate certain mandatory – and possibly additional discretionary – actions that, if undertaken, could affect operations. Under capital adequacy guidelines and the regulatory framework for corrective action, the Company and the Banks must meet certain capital guidelines, which involve quantitative measures of the Company’s and the Banks’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and the Banks’ capital amounts and classification are subject to qualitative judgments by the regulators about components, risk weightings and certain other factors. Quantitative measures set up by regulation to guarantee capital adequacy require the Company and the Banks to sustain minimum amounts and ratios of Tier 1 capital and total risk based capital to risk-weighted assets and Tier 1 capital to total average assets. The Company and the Banks are required to maintain minimum Tier 1 capital and total risk based capital to risk weighted assets, and Tier 1 capital to total average assets of 4%, 8%, and 3%, respectively. To be considered “Well Capitalized”, the Company and the Banks must maintain at least Tier 1 capital and total risk based capital to risk weighted assets, and Tier 1 capital to total average assets of 6%, 10%, and 5%, respectively. As of December 31, 2008, the Company and the Banks are considered “Well Capitalized” under regulatory capital adequacy guidelines. - 17 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION The following schedule shows the Company’s and the Banks’ actual capital amounts and ratios at December 31, 2009 and 2008: Carolina Financial Corporation Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total average assets) Community FirstBank Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total average assets) Crescent Bank Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total average assets) Recently Adopted Accounting Standards 2009 2008 Amount Ratio Amount Ratio (Dollars In Thousands) $ 78,773 101,696 78,773 45,166 55,633 45,166 35,404 47,849 35,404 9.2% 11.9% 7.3% 10.4% 12.8% 7.7% 8.4% 11.4% 7.2% 71,208 94,780 71,208 36,590 46,754 36,590 33,806 47,027 33,806 8.4% 11.2% 6.4% 8.9% 11.3% 6.6% 8.1% 11.3% 6.3% The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and disclosure of financial information by the Company. In June 2009, the Financial Accounting Standards Board (“FASB”) issued guidance that restructured generally accepted accounting principles (“GAAP”) and simplified access to all authoritative literature by providing a single source of authoritative nongovernmental GAAP. The guidance is presented in a topically organized structure referred to as the FASB Accounting Standards Codification (“ASC”). The new structure is effective for interim or annual periods ending after September 15, 2009. All existing accounting standards have been superseded and all other accounting literature not included are considered nonauthoritative. The FASB issued new accounting guidance on accounting for transfer of financial assets in June 2009. The guidance limits the circumstances in which a financial asset should be derecognized when the transferor has not transferred the entire financial asset by taking into consideration the transferor’s continuing involvement. The standard requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. The concept of a qualifying special-purpose entity is no longer applicable. The standard is effective for the first annual reporting period that begins after November 15, 2009, for interim periods within the first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company does not expect the guidance to have any impact on the Company’s financial statements. The ASC was amended in December 2009 to include this guidance. In October 2009, updated guidance was issued to provide for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with prior guidance and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the shares-lending arrangement occurs. The amendment also requires several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendment are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company has no plans to issue convertible debt and, therefore, does not expect the update to have an impact on its financial statements. In January 2010, guidance was issued to alleviate diversity in the accounting for distributions to shareholders that allowed the shareholder to elect to receive their entire distribution in cash or shares but with a limit on the aggregate amount of cash to be paid. The amendment states that the stock portion of the distribution to shareholders that allows them to elect to receive cash or shares with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance. The amendment is effective for interim and annual periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements. Also in January 2010, an amendment was issued to clarify the scope of subsidiaries for consolidation purposes. The amendment provides that the decrease in ownership guidance should apply to (1) a subsidiary or group of assets that is a business or a nonprofit activity, (2) a subsidiary that is a business or nonprofit activity that is transferred to an equity method investee or joint venture, and (3) an exchange of a group of assets that constitutes a business or nonprofit activity for a noncontrolling interest in an entity. The guidance does not apply to a decrease in ownership in transactions related to sales of in-substance real estate or conveyance of oil or gas mineral rights. The update is effective for the interim or annual reporting periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements. - 18 - CAROLINA FINANCIAL CORPORATION FINANCIAL DISCUSSION Other accounting standards that have been issued 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. Effect of Inflation and Changing Prices The consolidated financial statements have been prepared in accordance with generally accepted accounting principles that require the measurement of financial position and results of operations in terms of historical dollars without consideration of changes in the relative purchasing power over time due to inflation. Unlike many other industries, nearly all assets and liabilities of a financial institution are monetary in nature. Therefore, interest rates usually have a more significant impact on a financial institution’s performance than does the effect of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the price of goods and services since such prices are affected by inflation. We are committed to continuing to actively manage the gap between our interest-sensitive assets and interest-sensitive liabilities. - 19 - INSERT INDEPENDENT AUDITOR’S REPORT - 20 - CAROLINA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2009 AND 2008 ASSETS Cash and due from banks Interest-bearing cash Cash and cash equivalents Securities available for sale (cost of $102,119 and $125,872 at December 31, 2009 and 2008, respectively) Securities held to maturity (fair value of $105,450 and $106,485 at December 31, 2009 and 2008, respectively) Federal Home Loan Bank stock, at cost Other investments Derivative assets Loans held for sale Loans receivable, net of allowance for loan losses of $13,032 and $11,300 at December 31, 2009 and 2008, respectively Premises and equipment, net Accrued interest receivable Real estate acquired through foreclosure, net Deferred tax assets, net Prepaid FDIC insurance Other assets Total assets LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Noninterest-bearing deposits Interest-bearing deposits Total deposits Short-term borrowed funds Long-term debt Derivative liabilities Drafts outstanding Advances from borrowers for insurance and taxes Accrued interest payable Accrued expenses and other liabilities Total liabilities Commitments and contingencies Stockholders' equity: Preferred stock, par value $.01; 200,000 shares authorized; no shares issued or outstanding at December 31, 2009 and 2008 Common stock, par value $.01; 2,800,000 shares authorized; 1,912,492 and 1,912,212 shares issued and outstanding at December 31, 2009 and 2008, respectively Additional paid-in capital Retained earnings, restricted Accumulated other comprehensive income (loss), net of tax Total stockholders' equity Total liabilities and stockholders' equity See accompanying notes to consolidated financial statements. - 21 - 2009 2008 (In Thousands) $ 2,901 17,759 20,660 104,401 125,633 12,456 465 2,342 71,233 690,163 17,443 4,550 7,853 10,349 5,677 5,532 25,206 16,285 41,491 120,988 113,689 11,874 465 1,999 28,283 776,621 17,980 4,510 7,105 9,547 - 4,442 $ 1,078,757 1,138,994 $ 37,543 723,565 761,108 43,787 203,638 891 3,117 198 1,484 8,396 39,952 677,437 717,389 148,090 218,465 959 2,316 158 2,764 2,262 1,022,619 1,092,403 - 19 21,320 42,433 (7,634) 56,138 - 19 20,925 35,264 (9,617) 46,591 $ 1,078,757 1,138,994 CAROLINA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 2009 2008 (In Thousands, Except Per Share Data) 2007 Interest income Loans Debt securities Dividends Interest-bearing cash Total interest income Interest expense Deposits Short-term borrowed funds Long-term debt Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Net gain on sale of loans held for sale Deposit service charges Income from ATM and debit card transactions Income from sales of non-depository products Net loss on extinguishment of debt Net gain on sale of available for sale securities Net loss on other investments Net gain (loss) on sale of real estate acquired through foreclosure Net gain (loss) on derivatives Other Total noninterest income Noninterest expense Salaries and employee benefits Occupancy and equipment Marketing and public relations FDIC insurance Expense from ATM and debit card transactions Other real estate expense Mortgage loan repurchase losses Other Total noninterest expense Income before income taxes Income tax expense Net income Earnings per common share: Basic Diluted Average common shares outstanding: Basic Diluted See accompanying notes to consolidated financial statements. $ 43,892 12,786 39 19 56,736 17,781 1,361 5,877 25,019 31,717 10,460 21,257 23,982 1,584 320 788 (711) 963 - (26) 411 627 27,938 20,182 3,413 630 2,201 281 1,843 3,362 5,761 37,673 11,522 4,353 $ 7,169 $ $ 3.75 3.72 49,516 12,660 466 407 63,049 24,036 1,998 7,193 33,227 29,822 6,361 23,461 4,579 1,449 308 867 (52) 952 (337) (55) 1,139 377 9,227 14,497 3,011 655 617 276 5 285 4,536 23,882 8,806 3,256 5,550 2.95 2.83 60,954 3,823 481 314 65,572 28,995 1,760 6,530 37,285 28,287 1,775 26,512 6,466 1,075 270 57 - 477 - 35 (13) 502 8,869 14,121 2,737 658 466 227 - - 4,092 22,301 13,080 4,806 8,274 4.61 4.23 1,912,449 1,924,720 1,883,101 1,960,362 1,794,659 1,954,392 - 22 - CAROLINA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 Balance, December 31, 2006 Exercise of stock options Stock-based compensation expense, net Net income Other comprehensive income: Unrealized gain on securities, net of tax of $276 Reclassification adjustment for gains included in net income, net of tax of $174 Other comprehensive income Comprehensive income Balance, December 31, 2007 Exercise of stock options Stock-based compensation expense, net Net income Other comprehensive income (loss): Unrealized loss on securities, net of tax of $5,234 Reclassification adjustment for gains included in net income, net of tax of $343 Other comprehensive loss Comprehensive loss Balance, December 31, 2008 Exercise of stock options Stock-based compensation expense, net Net income Other comprehensive income (loss): Unrealized gain on securities, net of tax of $1,583 Reclassification adjustment for gains included in net income, net of tax of $366 Other comprehensive income Comprehensive income Common Stock Shares Amount Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Total (In Thousands, Except Shares Data) 1,790,862 $ 18 19,291 21,440 (90) 40,659 7,400 - - - - 1,798,262 103,950 10,000 - - - - - - - - 18 1 - - - - 111 315 - - - - - 8,274 - - - - - 479 (303) 176 111 315 8,274 176 8,450 19,717 29,714 86 49,535 843 365 - - - - - 5,550 - - - - - (9,094) (609) (9,703) 844 365 5,550 (9,703) (4,153) 1,912,212 19 20,925 35,264 (9,617) 46,591 280 - - - - - - - - - 5 390 - - - - - 7,169 - - - - - 2,580 (597) 1,983 5 390 7,169 1,983 9,152 Balance, December 31, 2009 1,912,492 $ 19 21,320 42,433 (7,634) 56,138 See accompanying notes to consolidated financial statements. - 23 - CAROLINA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: 2009 2008 (In Thousands) 2007 $ 7,169 5,550 8,274 Provision for loan losses Deferred tax benefit Amortization of unearned discount/premiums on investments, net Amortization of deferred loan fees Gain on sale of available for sale securities Loss on write off of other investments Gain on sale of loans held for sale Originations of loans held for sale Proceeds from sale of loans held for sale Loss on extinquishment of debt Loss (gain) on derivatives Stock-based compensation Depreciation Loss on disposals of premises and equipment Loss (gain) on sale of real estate acquired through foreclosure Write-down of real estate acquired through foreclosure Decrease (increase) in: Accrued interest receivable Other assets Increase (decrease) in: Accrued interest payable Accrued expenses and other liabilities Net cash (used in) provided by operating activities Cash flows from investing activities: Activity in available-for-sale securities: Purchases Maturities, payments and calls Sales Activity in held-to-maturity securities: Purchases Maturities, payments and calls Increase in Federal Home Loan Bank stock Decrease in other investments Decrease (increase) in loans receivable, net Purchase of premises and equipment Proceeds from disposals of premises and equipment Proceeds from sale of real estate acquired through foreclosure Net cash provided by (used in) investing activities Cash flows from financing activities: Net increase in deposit accounts Net (decrease) increase in Federal Home Loan Bank advances Net (decrease) increase in Federal Reserve Bank advances Net increase (decrease) in other short-term borrowed funds Procceds from issuance of TLGP debt Proceeds from issuance of subordinated debt Net increase (decrease) in drafts outstanding Net increase in advances from borrowers for insurance and taxes Proceeds from exercise of stock options Net cash (used in) provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year 10,460 (2,019) (128) (604) (963) - (23,982) (1,700,377) 1,681,410 711 (411) 390 1,254 59 26 1,495 (39) (6,862) (1,279) 6,133 (27,557) (64,365) 23,759 29,054 (4,052) 24,632 (583) - 68,092 (807) 32 6,238 82,000 43,719 (47,211) (91,000) (2,029) 20,400 - 802 40 5 (75,274) (20,831) 41,491 $ 20,660 - 24 - 6,361 (633) (212) (831) (952) 337 (4,579) (712,784) 714,110 52 (1,139) 365 1,265 20 55 - 936 419 (420) (465) 7,455 (175,843) 20,229 64,996 (3,585) 2,829 (1,727) - (50,969) (1,104) 68 636 (144,470) 25,289 29,199 91,000 19,737 - 3,000 (3,390) 11 844 165,690 28,675 12,816 41,491 1,775 (869) (76) (1,303) (477) - (6,466) (949,068) 960,893 - 13 315 1,169 1 (35) - 18 259 1,723 (1,239) 14,907 (123,677) 6,309 18,834 - - (4,458) 48 (78,320) (2,158) - 1,075 (182,347) 69,644 95,200 - 2,786 - - (5,792) 15 111 161,964 (5,476) 18,292 12,816 Continued CAROLINA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 Supplemental disclosure Cash paid for: Interest on deposits and borrowed funds Income taxes paid, net of refunds Non-cash investing and financing activities: Transfer of loans held for sale to loans receivable Transfer of loans receivable to real estate acquired through foreclosure Transfer of available for sale securities to held to maturity securities Unrealized gain (loss) in securities available for sale, net See accompanying notes to consolidated financial statements. 2009 2008 (In Thousands) 2007 $ 26,298 3,666 - 8,507 30,597 2,580 33,647 4,050 - 7,524 112,343 (9,094) 35,562 6,800 60 668 - 479 - 25 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 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 multi- bank holding company with two wholly owned subsidiary banks, Community FirstBank of Charleston (“Community FirstBank”) and Crescent Bank (together, the “Banks”), and one wholly-owned service corporation, Carolina Services Corporation of Charleston (“Carolina Services”). Effective July 27, 2009, Carolina Financial contributed 100% of its wholly owned mortgage subsidiary Crescent Mortgage Company (“Crescent Mortgage”) to Community FirstBank. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Community FirstBank, Crescent Bank and Carolina Services. 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 December 31, 2009 and 2008, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15,000,000. The principal assets of the Trusts are $15,465,000 of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 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. Management’s Estimates The financial statements are prepared in accordance with generally accepted accounting principles in the United States of America 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 mortgage servicing rights, the determination of the reserve for mortgage loan repurchase losses, 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. While management uses available information to recognize losses on loans and foreclosed real estate, 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 Banks’ allowances for loan losses and foreclosed real estate. Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowances for loan losses and foreclosed real estate may change materially in the near term. Subsequent Events Subsequent events are 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. Nonrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management has reviewed events occurring through March 5, 2010, the date the financial statements were available to be issued and no subsequent events occurred requiring accrual or disclosure. Cash and Cash Equivalents Cash and cash equivalents consists of cash and due from banks and interest-bearing cash with banks. Substantially all of the interest-bearing cash at December 31, 2009 and 2008 is Federal Home Loan Bank overnight deposits. Cash and cash equivalents have maturities of three months or less. Accordingly, the carrying amount of such instruments is considered a reasonable estimate of fair value. The Banks are required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2009 and 2008, these reserve balances amounted to $1,259,000 and $1,736,000, respectively. Securities Investment securities are classified into three categories: (a) Held to Maturity – debt securities that the Company has positive intent and ability to hold to maturity, which are reported at amortized cost; (b) Trading – debt and equity securities that are bought and held principally for the purpose of selling them in the near term, which are reported at fair value, with unrealized gains and losses included in earnings; and (c) Available for Sale – debt and equity securities that may be sold under certain conditions, which are reported at fair value, with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income as a separate component of stockholders’ equity, net of income taxes. - 26 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 The Company determines investment and mortgage-backed securities classification at the time of purchase. If a security is transferred from available for sale to held to maturity, the fair value at the time of transfer becomes the held to maturity security’s new cost basis. Premiums and discounts on securities are accreted and amortized as an adjustment to interest yield over the estimated life of the security using a method which approximates a level yield. Dividends and interest income are recognized when earned. Unrealized losses on securities, reflecting a decline in value judged by the Company to be other than temporary, are charged to income in the consolidated statements of operations. The cost basis of securities sold is determined by specific identification. Purchases and sales of securities are recorded on a trade date basis. Loans Held for Sale The Company’s residential mortgage lending activities for sale in the secondary market are comprised of accepting residential mortgage loan applications, qualifying borrowers to standards established by investors, funding residential mortgage loans and selling mortgage loans to investors under pre-existing commitments. Funded residential mortgages held for sale to investors are reported at the lower of aggregate cost or estimated fair value. Net unrealized losses, if any, are recognized in a valuation allowance by charges to operations. Gains or losses realized on the sales of loans are recognized at the time of sale and are determined by the difference between the net sales proceeds and the carrying value of the loans sold, adjusted for any servicing asset or liability retained. Gains and losses on sales of loans are included in noninterest income. The Company issues rate lock commitments to borrowers on prices quoted by secondary market investors. Derivatives related to these commitments are recorded as either assets or liabilities in the balance sheet and are measured at fair value. Changes in the fair value of the derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting. The Company does not currently engage in any activities that qualify for hedge accounting. Accordingly, changes in fair values of these derivative instruments are included in noninterest income in the consolidated statements of operations. Loans Receivable, Net Loans that management has the intent and ability to hold for the foreseeable future are reported at their outstanding principal balances net of any unearned income, charge-offs, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. The net amount of nonrefundable loan origination fees, commitment fees and certain direct costs associated with the lending process are deferred and amortized to interest income over the contractual lives of the loans using methods which approximate a level yield. Discounts and premiums on purchased loans are amortized to interest income over the estimated life of the loans using methods that approximate a level yield. Commercial loans and substantially all installment loans accrue interest on the unpaid balance of the loans. A loan is 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. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral-dependent. When the fair value of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a specific reserve allocation that is a component of the allowance for loan losses. A loan is charged-off against the allowance for loan losses when all meaningful collection efforts have been exhausted and the loan is viewed as uncollectible in the immediate or foreseeable future. Loan origination and commitment fees, net of related costs are amortized in interest income over the contractual life of the loan using a method that approximates the level yield method, adjusted for prepayments, or noninterest income when the loan is sold. Mortgage Servicing Rights, Fees and Costs 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. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of the mortgage servicing rights is analyzed periodically and is adjusted to reflect changes in prepayment rates and other estimates. The Company evaluates potential impairment of mortgage servicing rights based on the difference between the carrying amount and current estimated fair value of the servicing rights. In determining impairment, the Company aggregates all servicing rights and stratifies them into tranches based on predominant risk characteristics of interest rate, loan type and investor type. If impairment exists, a valuation allowance is established for any excess of amortized cost over the current estimated fair value by a charge to income. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. Service fee income is recorded for fees earned for servicing mortgage loans under servicing agreements with the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”) and certain private investors. The fees are based on a - 27 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 contractual percentage of the outstanding principal balance of the loans serviced and are recorded as income when received. The amortization of mortgage servicing rights is netted against loan servicing fee income. Mortgage servicing costs are charged to expense when incurred. Nonperforming 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. Loans are generally placed on nonaccrual status when concern exists that principal or interest is not fully collectible, or when any portion of principal or interest becomes 90 days past due, whichever occurs first. Loans past due 90 days or more may remain on accrual status if management determines that concern over the collectibility of principal and interest is not significant. When loans are placed on nonaccrual status, interest receivable is reversed against interest income in the current period. Interest payments received thereafter are applied as a reduction to the remaining principal balance as long as concern exists as to the ultimate collection of the principal. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectibility of principal or interest. Assets acquired as a result of foreclosure are carried at the lower of cost or fair value less estimated selling costs. If cost exceeds fair value less estimated selling costs at the time of foreclosure, the asset is written down to fair value less estimated selling costs with the difference being charged against the allowance for loan losses. Generally, such properties are appraised annually, and the carrying value, if greater than the fair value less estimated selling costs, is adjusted with a charge to noninterest expense. Routine maintenance costs and declines in market value are included in noninterest expense. Net gains or losses on sale are included in noninterest income. 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. This evaluation is inherently subjective because it requires material estimates and is based on evaluations of the collectibility of loans. Impaired loans, including nonaccrual loans, loans past due 90 or more days and still accruing, troubled-debt restructured loans, and loans in excess of a defined threshold that are not paying in accordance with contractual terms, are evaluated for specific impairment. The specific reserves are determined on a loan-by-loan basis based on Management’s evaluation of the Company’s exposure for each credit, given the current payment status of the loan and the value of any underlying collateral. Management’s estimate of losses in the remainder of the portfolio is based on certain observable data that Management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; portfolio aging; loan volumes; geographic, borrower and industry concentrations; seasoning of the loan portfolio; the findings of internal credit quality assessments and results from external bank regulatory examinations. 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. Guarantees Standby letters of credit obligate the Company to meet certain financial obligations of its customers, under the contractual terms of the agreement, if the customers are unable to do so. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. The Company can seek recovery of the amounts paid from the borrower; however, these standby letters of credit are generally not collateralized. Commitments under standby letters of credit are usually one year or less. At December 31, 2009, the Company had recorded no liability for the current carrying amount of the obligation to perform as a guarantor; as such amounts are not considered material. The maximum potential amount of undiscounted future payments related to standby letters of credit at December 31, 2009 was $910,000. Premises and Equipment, Net Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the asset’s estimated useful life. Estimated lives range up to forty years for buildings and improvements and up to ten years for furniture, fixtures and equipment. Maintenance and repairs are charged to expense as incurred. Improvements that extend the lives of the respective assets are capitalized. When property or equipment is sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the respective accounts and the resulting gain or loss is reflected in income. Advertising The Company expenses advertising costs as incurred. Income Taxes The provision for income taxes is based upon income before taxes for financial statement purposes, adjusted for nontaxable income and nondeductible expenses. Deferred income taxes have been provided when different accounting methods have been used in determining income for income tax purposes and for financial reporting purposes. Deferred tax assets and liabilities are recognized based on future tax - 28 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 consequences attributable to differences arising from the financial statement carrying values of assets and liabilities and their tax bases. In the event of changes in the tax laws, deferred tax assets and liabilities are adjusted in the period of the enactment of those changes, with the cumulative effects included in the current year’s income tax provision. Positions taken by the Company’s tax returns may be subject to challenge by the taxing authorities upon examination. The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain tax positions have been recorded. Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement. The Company had no interest or penalties during fiscal 2009, 2008 and 2007. Drafts Outstanding The Company invests excess funds on deposit at other banks (including amounts on deposit for payment of outstanding disbursement checks) on a daily basis in an overnight interest-bearing account. Accordingly, outstanding checks are reported as a liability. Reserve for Mortgage Loan Repurchase Losses The Company sells mortgage loans to various third parties, including government-sponsored entities, under contractual provisions that include various representations and warranties that typically cover ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, and similar matters. The Company may be required to repurchase the mortgage loans with identified defects, indemnify the investor or insurer, or reimburse the investor for credit loss incurred on the loan (collectively “repurchase”) in the event of a material breach of such contractual representations or warranties. Risk associated with potential repurchases or other forms of settlement is managed through underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards. The Company establishes mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses based on a combination of factors. Such factors incorporate 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. The Company establishes a reserve at the time loans are sold and continually updates the reserve estimate during the estimated loan life. The reserve for repurchases, included in Accrued expenses and other liabilities in the accompanying consolidated statements of financial condition, was $3.0 million at December 31, 2009 and $183,000 at December 31, 2008. To the extent that economic conditions and the housing market do not recover or future investor repurchase demand and appeals success rates differ from past experience, the Company could continue to have increased demands and increased loss severities on repurchases, causing future additions to the repurchase reserve. Transfers of Financial Assets Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Comprehensive Income Comprehensive income consists of net income and net unrealized gains (losses) on securities and is presented in the consolidated statements of changes in stockholders’ equity and comprehensive income. The Company’s other comprehensive income for the years ended December 31, 2009, 2008 and 2007 and accumulated other comprehensive income as of December 31, 2009 and 2008 are comprised solely of unrealized gains (losses) on certain investment securities. Off-Balance-Sheet Financial Instruments In the ordinary course of business, the Company entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commitments under revolving credit agreements, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded. Stock-Based Compensation At December 31, 2009, the Company had three stock-based payment plans for directors, officers and other key employees, which are described below. - 29 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 The fair value at the date of grant of the stock option is estimated using the Black-Scholes option-pricing model based on assumptions noted in a table below. The dividend yield is based on estimated future dividend yields. The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatilities are generally based on historical volatilities. The expected term of share options granted is generally derived from historical experience. Compensation expense is recognized on a straight-line basis over the stock option vesting period. The expense recognition of employee awards resulted in net expense of approximately $390,000, $365,000 and $315,000 during the twelve months ended December 31, 2009, 2008 and 2007, respectively. The Company adopted the 2006 Recognition and Retention Plan under which an aggregate of 60,000 shares have been reserved for issuance by the Company upon the grant of non-vested common stock. The plan provides for the grant of stock to key employees and Directors of the Company and its subsidiaries. The non-vested common stock vests ratably over a five-year period. During 2008, 10,000 shares of non-vested common stock of the Company were granted to a key employee of the Company at $37.57 per share. As of December 31, 2009, 50,000 shares have been awarded under the plan, of which 26,000 shares have vested. At December 31, 2009, 24,000 shares are unvested. Additionally, the Company has adopted the 1998 Stock Option Plan and the 2002 Stock Option Plan under which an aggregate of 7,590 shares and 138,750 shares, respectively, have been reserved for issuance by the Company upon the grant of stock options or limited rights. The plans provide for the grant of options to key employees and Directors as determined by a Stock Option Committee. The options vest ratably over a five-year period and have a ten-year term, both of which begin at the date of grant. The aggregate options available and the option exercise prices have been adjusted to reflect the issuance of a 15% stock dividend during 1998 and the issuance of a 10% stock dividend during 2000. A summary of the status of the Company’s stock option plans at December 31, 2009, 2008 and 2007 and changes during the years then ended is presented below: Outstanding at beginning of year Granted Exercised Forfeited or expired 2009 2008 2007 Weighted Average Exercise Price $ 15.86 - 17.57 24.00 Shares 145,760 - (280) (500) Weighted Average Exercise Price 12.67 $ - 8.12 38.50 Shares 249,990 - (103,950) (280) Weighted Average Exercise Price 12.74 $ - 15.00 15.00 Shares 257,590 - (7,400) (200) Outstanding at end of year 144,980 $ 15.83 145,760 $ 15.86 249,990 $ 12.67 Options exercisable at end of year 142,920 $ 15.63 141,050 $ 15.49 242,450 $ 12.23 The following table summarizes information about the options outstanding at December 31, 2009: Range of Exercise Prices $ 15.00 to $20.00 $ 20.00 to $25.00 $ 35.00 to $40.00 Options Outstanding Options Exercisable Number Outstanding 137,090 5,840 2,050 Weighted Avg. Remaining Years Contractual Life 2.4 5.5 6.8 Weighted Average Exercise Price $ 15.15 24.00 38.50 Number Outstanding 137,090 4,600 1,230 Weighted Average Exercise Price 15.15 24.00 38.50 $ 144,980 2.6 $ 15.83 142,920 $ 15.63 There were no options granted during the years ended December 31, 2009, 2008 and 2007. The total intrinsic value of options exercised during the twelve months ended December 31, 2009, 2008 and 2007 was $2,000, $246,000, and $32,000, respectively. Fair values have been retroactively restated for all stock dividends since the date the option was granted. As of December 31, 2009, there was approximately $751,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements. Unrecognized cost is projected to be recognized over a weighted average period of approximately two years. The Company generally issues authorized but previously unissued shares to satisfy option exercises. - 30 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 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 the net income as previously reported. Recently Adopted Accounting Standards The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and disclosure of financial information by the Company. In June 2009, the Financial Accounting Standards Board (“FASB”) issued guidance that restructured generally accepted accounting principles (“GAAP”) and simplified access to all authoritative literature by providing a single source of authoritative nongovernmental GAAP. The guidance is presented in a topically organized structure referred to as the FASB Accounting Standards Codification (“ASC”). The new structure is effective for interim or annual periods ending after September 15, 2009. All existing accounting standards have been superseded and all other accounting literature no included is considered nonauthoritative. The FASB issued new accounting guidance on accounting for transfer of financial assets in June 2009. The guidance limits the circumstances in which a financial asset should be derecognized when the transferor has not transferred the entire financial asset by taking into consideration the transferor’s continuing involvement. The standard requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. The concept of a qualifying special-purpose entity is no longer applicable. The standard is effective for the first annual reporting period that begins after November 15, 2009, for interim periods within the first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company does not expect the guidance to have any impact on the Company’s financial statements. The ASC was amended in December 2009 to include this guidance. In October 2009, updated guidance was issued to provide for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with prior guidance and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the shares-lending arrangement occurs. The amendment also requires several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendment are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company has no plans to issue convertible debt and, therefore, does not expect the update to have an impact on its financial statements. In January 2010, guidance was issued to alleviate diversity in the accounting for distributions to shareholders that allowed the shareholder to elect to receive their entire distribution in cash or shares but with a limit on the aggregate amount of cash to be paid. The amendment states that the stock portion of the distribution to shareholders that allows them to elect to receive cash or shares with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance. The amendment is effective for interim and annual periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements. Also in January 2010, an amendment was issued to clarify the scope of subsidiaries for consolidation purposes. The amendment provides that the decrease in ownership guidance should apply to (1) a subsidiary or group of assets that is a business or a nonprofit activity, (2) a subsidiary that is a business or nonprofit activity that is transferred to an equity method investee or joint venture, and (3) an exchange of a group of assets that constitutes a business or nonprofit activity for a noncontrolling interest in an entity. The guidance does not apply to a decrease in ownership in transactions related to sales of in-substance real estate or conveyance of oil or gas mineral rights. The update is effective for the interim or annual reporting periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements. Other accounting standards that have been issued 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. Risks and Uncertainties In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on a different basis, than its interest-earning assets. Credit risk is the risk of default on the loan portfolio or certain securities that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company. The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. Periodic examinations by the regulatory agencies may subject the Company to further changes with respect to asset - 31 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 valuations, amounts of required loss allowances and operating restrictions from the regulators’ judgments based on information available to them at the time of their examination. NOTE 2 - SECURITIES The amortized cost, gross unrealized gains, gross unrealized losses and fair value of investments securities available for sale and held to maturity at December 31, 2009 and 2008 follows: Fair Value - 107,472 13,516 - (2,345) (3,791) (6,136) 120,988 (8,062) (60) 104,796 1,689 (8,122) 106,485 2008 Gross Unrealized Gains Gross Unrealized Losses 2009 Gross Gross Amortized Cost Unrealized Unrealized Gains Losses Fair Value Amortized Cost Securities available for sale: GNMA Mortgage-backed securities Asset-backed securities $ 4,088 98,031 - Total securities available for sale $ 102,119 Securities held to maturity: Mortgage-backed securities Asset-backed securities $ 111,660 13,973 Total securities held to maturity $ 125,633 29 2,661 - 2,690 1,144 - 1,144 - (408) - (408) (In Thousands) 4,117 100,284 - - 108,565 17,307 104,401 125,872 (13,552) (7,775) 99,252 6,198 (21,327) 105,450 111,940 1,749 113,689 The amortized cost and fair value of debt securities by contractual maturity at December 31, 2009 follows: Amortized Cost (In Thousands) Securities available for sale: One year to five years Six to ten years After ten years Total Securities held to maturity: Six to ten years After ten years Total $ 4,135 3,358 94,626 102,119 404 125,229 125,633 $ $ $ - 1,252 - 1,252 918 - 918 Fair Value 4,137 3,448 96,816 104,401 415 105,035 105,450 The contractual maturity dates of the securities was used for mortgage-backed securities and asset-backed securities. No estimates were made to anticipate principal repayments. The gross unrealized losses and fair value of the Company’s investments available for sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2009 are as follows: - 32 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Less than 12 Months 12 Months or Greater Amortized Cost Fair Value Unrealized Losses Amortized Cost Fair Value Unrealized Losses Amortized Cost Total Fair Value Unrealized Losses (In Thousands) $ 19,847 19,451 (396) 2,531 2,519 (12) 22,378 21,970 (408) $ 23,228 - $ 23,228 18,146 - 18,146 (5,082) - (5,082) 70,489 13,973 84,462 62,019 6,198 (8,470) (7,775) 93,717 13,973 68,217 (16,245) 107,690 80,165 6,198 86,363 (13,552) (7,775) (21,327) Securities available for sale: Mortgage-backed securities Securities held to maturity: Mortgage-backed securities Asset-backed securities Total The gross unrealized losses and fair value of the Company’s investments available for sale and held to maturity with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008 are as follows: Less than 12 Months Fair Value Amortized Cost Unrealized Losses 12 Months or Greater Fair Value Amortized Cost Unrealized Losses Securities available for sale: Mortgage-backed securities Asset-backed securities $ 10,306 6,011 9,913 4,899 Total $ 16,317 14,812 (In Thousands) (393) (1,112) (1,505) 27,230 10,288 25,278 7,609 37,518 32,887 (1,952) (2,679) (4,631) Securities held to maturity: Mortgage-backed securities Asset-backed securities Total $ 62,535 - $ 62,535 55,195 - 55,195 (7,340) - (7,340) 27,666 1,749 26,944 1,689 29,415 28,633 (722) (60) (782) Amortized Cost Total Fair Value Unrealized Losses 37,536 16,299 53,835 90,201 1,749 91,950 35,191 12,508 47,699 82,139 1,689 83,828 (2,345) (3,791) (6,136) (8,062) (60) (8,122) At December 31, 2009 and 2008, the Company had 14 and 42, respectively, individual investments available for sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in mortgage-backed securities and asset-backed securities summarized above were attributable primarily to credit quality, credit rating changes and liquidity. Management has performed various analyses, including cash flows, and believes that the securities are not other-than-temporarily impaired at December 31, 2009. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. The Banks, as members of the Federal Home Loan Bank ("FHLB") of Atlanta, are required to own capital stock in the FHLB of Atlanta based generally upon a membership-based requirement and an activity based requirement. FHLB capital stock is pledged to secure FHLB advances. No secondary market exists for this stock, and it has no quoted market price. However, redemption through the FHLB of this stock has historically been at par value. The Company’s investment in FHLB capital stock was $12.5 million and $11.9 million at December 31, 2009 and 2008, respectively. Other investments at December 31, 2009 and 2008 consisted of $465,000 invested in capital stock of statutory business trusts (See Note 10 – Long-term debt). NOTE 3 – DERIVATIVES The derivative positions of the Company at December 31, 2009 and 2008 are as follows: - 33 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 2009 2008 Fair Value Notional Value Fair Value Notional Value Derivative assets - Mortgage loan interest rate lock commitments Forward mortgage loan sales commitments Derivative liabilities - $ $ 428 1,914 2,342 (In Thousands) 46,588 130,000 1,999 - 1,999 222,994 - Forward mortgage loan sales commitments $ 891 177,282 959 121,000 NOTE 4 - LOANS RECEIVABLE, NET Loans receivable, net at December 31, 2009 and 2008 are summarized by category as follows: Residential mortgage Commercial mortgage Construction mortgage Commercial loans Consumer loans Total loans Less: Undisbursed loans in process Allowance for loan losses Deferred fees, net Loans receivable, net 2009 2008 (In Thousands) $ 53,094 301,344 14,639 284,889 72,917 726,883 23,230 13,032 458 36,720 690,163 $ 57,682 322,595 66,279 312,099 80,993 839,648 51,000 11,300 727 63,027 776,621 The composition of gross loans outstanding, net of undisbursed amounts, by rate type is as follows: 2009 2008 (In Thousands) Variable rate loans Fixed rate loans Total gross loans $ $ 456,128 247,525 703,653 Activity in the allowance for loan losses for the years ended December 31, 2009 and 2008 are as follows: 2009 2008 (In Thousands) 2007 Balance at beginning of year Provision for loan losses Charge-offs Recoveries Balance at end of year $ $ 11,300 10,460 (9,442) 714 13,032 10,083 6,361 (5,190) 46 11,300 583,103 205,545 788,648 8,406 1,775 (243) 145 10,083 - 34 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 The following is a summary of information pertaining to impaired and nonaccrual loans at December 31: 2009 2008 (In Thousands) Impaired loans without a valuation allowance Impaired loans with a valuation allowance Total impaired loans Valuation allowance related to impaired loans Average of impaired loans during the year Total nonaccrual loans Total loans past due 90 days and still accruing interest $ $ 45,735 23,244 68,979 $ 3,827 44,393 27,059 771 8,802 6,708 15,510 1,180 19,932 13,923 13 Substantially all of the non-accrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans for fiscal 2009 and 2008 are collateralized by real estate. 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. The company recognized interest income of $4,000, $0 and $0 on loans that are past due 90 days and still accruing during the year ended December 31, 2009, 2008 and 2007, respectively. The Company had $8.9 million and $1.1 million of restructured loans as of December 31, 2009 and 2008, respectively. Loans serviced for the benefit of others under loan participation arrangements amounted to approximately $32,443,000 and $35,112,000 at December 31, 2009 and 2008, respectively. Activity in loans to officers, directors and other related parties for the years ended December 31, 2009 and 2008 is summarized as follows: 2009 2008 (In Thousands) Balance at beginning of year New loans Repayments Balance at end of year $ $ 20,584 9,044 (8,271) 21,357 18,586 9,951 (7,953) 20,584 In management’s opinion, related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with an unrelated person and generally do not involve more than the normal risk of collectibility. In the normal course of business, to meet the financing needs of its customers, the Company is a party to financial instruments with off- balance-sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. - 35 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 NOTE 5 - PREMISES AND EQUIPMENT, NET Premises and equipment, net at December 31, 2009 and 2008 consists of the following: 2009 2008 (In Thousands) Land Buildings Furniture, fixtures and equipment Construction in process Total premises and equipment Less: accumulated depreciation Premises and equipment, net $ 5,040 11,277 7,123 25 23,465 (6,022) 17,443 $ 5,040 11,277 7,023 25 23,365 (5,385) 17,980 Depreciation expense included in operating expenses for the years ended December 31, 2009, 2008 and 2007 amounted to $1.2 million, $1.3 million, and $1.2 million, respectively. There was no interest capitalized during fiscal 2009 and 2008. NOTE 6 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE Transactions in other real estate owned for the years ended December 31, 2009 and 2008 are summarized below: 2009 2008 (In Thousands) Balance, beginning of year Additions Sales Write downs Balance, end of year $ $ 7,105 8,507 (6,264) (1,495) 7,853 272 7,524 (691) - 7,105 NOTE 7 – MORTGAGE SERVICING RIGHTS Mortgage loans serviced for others are not included in the accompanying statement of financial condition. The value of mortgage servicing rights is included in other assets on the Company’s statement of financial condition. The unpaid principal balances of loans serviced for others were $282.5 million and $45.3 million, respectively, at December 31, 2009 and 2008. The estimated fair values of mortgage servicing rights were $3.1 million and $250,000, respectively, at December 31, 2009 and 2008. The estimated fair value of servicing rights at December 31, 2009 were determined using discount rates ranging from 9.50% to 17.29%, prepayment speed assumptions (“PSA”) ranging from 135.5 to 423.6, depending upon the stratification of the specific right, and a weighted average delinquency rate of 3.89% as determined by a third party. The estimated fair value of servicing rights at December 31, 2008 were determined using discount rates ranging from 10.0% to 20.81%, prepayment speed assumptions (“PSA”) ranging from 194 to 1,455, depending upon the stratification of the specific right, and a weighted average delinquency rate of 4.23% as determined by a third party. The following summarizes the activity in mortgage servicing rights, along with the aggregate activity in the related valuation allowances, for the years ended December 31, 2009 and 2008: 2009 2008 (In Thousands) MSR beginning balance Amount capitalized Amount amortized Recovery (provision) for loss in fair value MSR ending balance - 36 - $ 250 1,717 (275) 105 1,797 $ 310 118 (103) (75) 250 CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Activity in the allowance for loss in fair value in mortgage servicing rights for the years ended December 31, 2009 and 2008 are as follows: Balance at beginning of year Provision for loss in fair value Impairment recoveries Balance at end of year 2009 2008 (In Thousands) 105 $ - (105) $ - 30 75 - 105 The estimated amortization expense for mortgage servicing rights for the years ended December 31, 2010, 2011, 2012, 2013, 2014 and thereafter is $235,000, $215,000, $190,000, $165,000, $144,000 and $848,000, respectively. The estimated amortization expense is based on current information regarding loan payments and prepayments. Amortization expense could change in future periods based on changes in the volume of prepayments and economic factors. At December 31, 2009 and 2008, servicing related trust funds of approximately $401,000 and $489,000, respectively, representing both principal and interest due investors and escrows received from borrowers, are on deposit in affiliated trust bank custodial accounts and are included in noninterest-bearing deposits in the accompanying financial statements. At December 31, 2009 and 2008, the Company had blanket bond coverage of $5.0 million and errors and omissions coverage of $5.0 million. NOTE 8 - DEPOSITS Deposits outstanding by type of account at December 31, 2009 and 2008 are summarized as follows: Noninterest-bearing demand accounts Interest-bearing demand accounts Savings accounts Money market accounts Certificates of deposit 1.00% to 2.99% 3.00% to 4.99% 5.00% to 7.99% Total certificates of deposit Total deposits 2009 2008 (In Thousands) $ 37,543 31,710 2,824 155,019 465,140 67,389 1,483 534,012 761,108 $ 39,952 24,902 2,252 81,451 181,576 385,464 1,792 568,832 717,389 The aggregate amount of certificates of deposit, excluding brokered deposits, with a minimum denomination of $100,000 was $118.9 million and $141.3 million at December 31, 2009 and 2008, respectively. The aggregate amount of brokered certificates of deposit was $115.7 million and $246.0 million at December 31, 2009 and 2008, respectively. The amounts and scheduled maturities of certificates of deposit at December 31, 2009 and 2008 are as follows: 2009 2008 (In Thousands) Maturing within one year Maturing one through three years Maturing after three years $ $ 425,397 105,422 3,193 534,012 521,394 46,633 805 568,832 The Company has pledged $11.8 million of U.S. government agencies and corporations’ securities available for sale as of December 31, 2009 to secure public agency funds. - 37 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 NOTE 9 – SHORT-TERM BORROWED FUNDS Short-term borrowed funds at December 31, 2009 and 2008 are summarized as follows: 2009 2008 Balance Interest Rate Balance Interest Rate Unsecured line of credit Short-term FHLB advances Short-term FRB advances Mortgage loan warehouse line of credit Subordinated debenture, due 2020 Total short-term borrowed funds $ 3,000 21,500 - 19,062 225 43,787 $ (In Thousands) 4.75% 0.36%-2.715% - 5.25%-8.50% 2.75% 3,000 33,000 91,000 21,090 - 148,090 2.75% 0.00% - 4.38% 0.50% 3.48% - Lines of credit with the Federal Home Loan Bank of Atlanta are based upon FHLB approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Banks have pledged approximately $177.8 million first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under a blanket lien agreement as collateral to the FHLB for these advances. In addition, the Company has pledged $59.8 million of securities for these advances. At December 31, 2009, the Banks had maximum FHLB lines of $339.1 million based on FHLB limits. At December 31, 2009, the Banks pledged collateral totaling $237.6 million to support FHLB advances. At December 31, 2009 the Banks had FHLB advances of $176.5 million outstanding, with excess collateral pledged to the FHLB that would support additional borrowings of approximately $61.0 million. Lines of credit with the FRB are based on collateral pledged. The Banks pledged $139.9 million of non-mortgage commercial, acquisition and development, and lot loan portfolios under blanket lien agreements as collateral to the FRB for these advances. At December 31, 2009 the Banks had lines available with the FRB for $71.5 million. At December 31, 2009 the Banks had no FRB advances outstanding. The mortgage loan warehouse line of credit is an extension of credit facility to Crescent Mortgage with a $35.0 million credit limit, of which $15.9 million is still available. The facility is secured by certain Crescent Mortgage’s residential mortgage loans held for sale and its other assets. The Company has $3.0 million outstanding on an unsecured line of credit with a correspondent bank. See Note 10 – Long-Term Debt for additional disclosure. The Company has a subordinated debenture totaling $3.0 million that has principal repayments beginning in 2010. See Note 10 – Long- Term Debt for additional disclosure. In addition, the Banks had $11.2 million available under federal funds purchase line agreements with correspondent banks. NOTE 10 – LONG-TERM DEBT Long-term debt at December 31, 2009 and 2008 are summarized as follows: December 31, 2009 Balance Interest Rate (In Thousands) Long-term FHLB advances, due 2011 through 2021 TLGP, due 2012 Subordinated debentures, due 2016 through 2020 Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032 Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034 Total long-term debt - 38 - $ $ 155,000 20,398 12,775 5,155 10,310 203,638 0.00% - 4.23% 2.74% 1.78% - 2.75% 3.75% 3.33% CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 December 31, 2008 Balance Interest Rate (In Thousands) Long-term FHLB advances, due 2010 through 2021 Subordinated debentures, due 2016 through 2020 Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032 Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034 Total long-term debt $ $ 190,000 13,000 5,155 10,310 218,465 1.40% - 4.23% 6.21% - 6.32% 5.50% 7.80% As of December 31, 2009, the principal amounts due on long-term debt in 2010, 2011, 2012, 2013, 2014 and thereafter were $0, $42.8 million, $43.2 million, $20.3 million, $5.3 million and $92.1 million, respectively. As of December 31, 2009, the principal amounts callable by the FHLB on advances in 2010, 2011, 2012, 2013, 2014 and thereafter were $12.5 million, $55.0 million, $5.0 million, $5.0 million, and $0, respectively. During 2009 the Company issued $20.4 million of indebtedness under the Federal Deposit Insurance Corporation’s (“FDIC”) Temporary Liquidity Guarantee Program (“TLGP”). The FDIC guarantees the debt until its maturity in 2012. At December 31, 2009 and 2008, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15.0 million. The trust preferred securities have floating interest rates ranging from 5.50% to 7.80% at December 31, 2009 and maturities ranging from December 31, 2032 to January 7, 2034. The principal assets of the Trusts are $15.5 million of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 of common securities to the Company. The trust preferred securities, the assets of the Trusts and the common securities issued by the Trusts are redeemable in whole or in part beginning on or after December 31, 2008, or at any time in whole but not in part from the date of issuance on the occurrence of certain events. The obligations of the Company with respect to the issuance of the trust preferred securities constitutes a full and unconditional guarantee by the Company of the Trusts’ obligations with respect to the trust preferred securities. Subject to certain exceptions and limitations, the Company may elect from time to time to defer subordinated debenture interest payments, which would result in a deferral of distribution payments on the related trust preferred securities. As currently defined by the Federal Reserve Board, the Company had $15.0 million of long-term debt that qualified as Tier 1 capital at December 31, 2009 and 2008. The Company had $12.2 million and $13.0 million of long-term debt that qualified as Tier 2 capital at December 31, 2009 and 2008, respectively. During 2008, the Company modified a $5.0 million unsecured line of credit with a correspondent bank, of which $3.0 million is outstanding at December 31, 2009, to be extended to March 31, 2020. In connection with this modification, the Company obtained a $3.0 million subordinated debenture that, as a condition to the line of credit modification, requires the Company to keep at least a $500,000 principal balance outstanding on the line of credit until the subordinated debenture is paid in full. If the Company does not maintain the $500,000 balance, there is a $150,000 prepayment penalty. During 2009, the Company has maintained at least a $500,000 principal balance outstanding on the line of credit. During 2009, the correspondent bank was put into receivership with the FDIC. As a result, the undrawn $2 million of availability under this unsecured line of credit has been withdrawn by the FDIC. The line of credit also has debt covenants, the more restrictive of which requires the Company to maintain certain capital ratios and return on asset ratios. As of December 31, 2009, the Company is not in compliance with all of the covenants. While the lender has not called the line of credit, it has the right to do so. Accordingly, the Company has developed alternatives to replace this line of credit, if necessary, by obtaining financing from other sources, raising capital or by receiving dividends from its subsidiaries to pay off the debt. As a result, management does not believe that default of this covenant will have a material adverse affect on the Company’s financial condition or the results of its operations. NOTE 11 - INCOME TAXES Deferred tax assets are recognized for future deductible amounts resulting from differences in the financial statement and tax bases of assets and liabilities and operating loss carryforwards. A valuation allowance is then established to reduce that deferred tax asset to the level that it is "more likely than not" that the tax benefit will be realized. The realization of a deferred tax benefit by the Company depends upon having sufficient taxable income of an appropriate character in the future periods. - 39 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Income tax expense for the years ended December 31, 2009, 2008 and 2007 consists of the following: Current income tax expense Federal State Deferred income tax expense (benefit) Federal State 2009 2008 (In Thousands) 2007 $ 5,776 596 6,372 (2,248) 229 (2,019) 3,565 324 3,889 (551) (82) (633) 3,256 5,210 465 5,675 (801) (68) (869) 4,806 Total income tax expense $ 4,353 A reconciliation from expected Federal tax expense to actual income tax expense for the years ended December 31, 2009, 2008 and 2007, using the base federal tax rates of 35%, 34% and 35%, respectively, is as follows: 2009 2008 (In Thousands) 2007 Computed federal income taxes State income tax, net of federal benefit Change in valuation allowance Other, net Total income tax expense $ $ 4,033 311 (38) 47 4,353 2,994 300 43 (81) 3,256 4,578 262 38 (72) 4,806 The following is a summary of the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 2009 and 2008: Deferred tax assets: Loan loss reserve Loan fees Unrealized loss on securities available for sale Tax vs. book gain on loans held for sale Debt issuance costs Net operating loss carryforwards Reserve for mortgage loan buy-back OREO write-downs Securities yield adjustments Other Valuation allowance Total gross deferred tax assets Deferred tax liabilities: Depreciation Stock-based compensation Short-term disability accrual Total gross deferred tax liabilities 2009 2008 (In Thousands) $ 4,431 157 4,417 26 101 106 1,031 353 230 218 11,070 (106) 10,964 (360) (123) (132) (615) Deferred tax assets, net $ 10,349 - 40 - 4,071 240 5,528 50 106 203 62 - - 92 10,352 (203) 10,149 (102) (254) (246) (602) 9,547 CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 A portion of the annual change in the net deferred income tax asset relates to unrealized gains and losses on debt and equity securities. The related 2009 and 2008 deferred income tax benefit of $2.1 million and $5.6 million, respectively, was recorded directly to stockholders’ equity as a component of accumulated other comprehensive income. The balance of the 2009 and 2008 change in the net deferred tax asset of $2.0 million and $633,000, respectively, is reflected as a deferred income tax benefit in the consolidated statement of operations. The 2009 and 2008 valuation allowances related to state net operating loss carryforwards. It is management’s belief that the realization of the remaining net deferred tax assets is more likely than not. At December 31, 2009, income tax returns from 2008, 2007 and 2006 remain subject to review by tax authorities. NOTE 12 - COMMITMENTS AND CONTINGENCIES The Company has entered into agreements to lease its office facilities under noncancellable operating lease agreements expiring on various dates through June 2020. The Company’s rental expense for its office facilities for the years ended December 31, 2009, 2008 and 2007 totaled $807,000, $524,000 and $507,000, respectively. Minimum rental commitments (in thousands) under the leases are as follows: 2010 2011 2012 2013 2014 Thereafter Total $ 517 482 495 507 339 292 $ 2,632 NOTE 13 – 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. Certain items are specifically excluded from disclosure requirements, including the Company’s stock, premises and equipment, accrued interest receivable and payable and other assets and liabilities. 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 estimates are made 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. 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. Cash and due from banks - The carrying amount 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 approximate fair value. Securities available for sale and securities held to maturity – Fair values for investment securities available for sale and securities held to maturity are based upon quoted prices, if available. If quoted 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 the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Federal Home Loan Bank stock and other non-marketable equity securities - The carrying amount of these financial instruments approximate fair value. - 41 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Derivative assets – Fair values are based on quoted market prices, where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments. Loans held for sale and loans receivable, net - For variable-rate loans that reprice frequently and have no significant change in credit risk, estimated fair values are based on carrying values. Estimated fair values for certain mortgage loans, credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Estimated fair values for commercial real estate and commercial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Estimated fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Accrued interest receivable - The fair value approximates the carrying 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 within 90 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. Derivative liabilities - Fair values are based on quoted market prices, where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments. Commitments to extend credit – The carrying amount of these commitments is considered to be a reasonable estimate of fair value because the commitments underlying interest rates are based upon current market rates. Accrued interest payable - The fair value approximates the carrying value. - 42 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 The carrying amount and estimated fair value of the Company's financial instruments at December 31, 2009 and 2008 are as follows: Financial assets: Cash and due from banks Interest-bearing cash Securities available for sale Securities held to maturity Federal Home Loan Bank stock Other investments Derivative assets Loans held for sale Loans receivable, net Accrued interest receivable Financial liabilities: Deposits Short-term borrowed funds Long-term debt Derivative liabilities Accrued interest payable 2009 Carrying Amount Fair Value 2008 Carrying Amount Fair Value (In Thousands) $ 2,901 17,759 104,401 125,633 12,456 465 2,342 71,233 690,163 4,550 761,108 43,787 203,638 891 1,484 2,901 17,759 104,401 105,450 12,456 465 2,342 71,682 699,069 4,550 731,567 45,599 209,359 891 1,484 25,206 16,285 120,988 113,689 11,874 465 1,999 28,283 776,621 4,510 717,389 148,090 218,465 959 2,764 25,206 16,285 120,988 106,485 11,874 465 1,999 28,823 766,178 4,510 721,736 148,095 230,856 959 2,764 Off-Balance Sheet Financial Instruments: Commitments to extend credit Standby letters of credit Notional Amount Estimated Fair Value Notional Amount Estimated Fair Value $ $ 50,100 910 - $ $ - 85,100 3,400 - - 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. Assets and liabilities that are carried at fair value are classified in one of the following three categories based on a hierarchy for ranking the quality and reliability of the information used to determine fair value: Level 1 Quoted prices in active markets for identical assets or liabilities. Level 2 Observable market based inputs or unobservable inputs that are corroborated by market data. Level 3 Unobservable inputs that are not corroborated by market data. Assets and liabilities measured at fair value on a recurring basis are as follows as of December 31, 2009 and 2008: Quoted market price in active markets (Level 1) Significant other observable inputs (Level 2) Significant other unobservable inputs (Level 3) December 31, 2009 Available-for-sale investment securities Mortgage-backed securities Asset-back securities Total December 31, 2008 Available-for-sale investment securities Mortgage-backed securities Asset-back securities Total - $ - - $ - - $ - - $ - 4,117 100,284 - 104,401 - 107,472 13,516 120,988 - - - - - - - - - 43 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Assets measured at fair value on a nonrecurring basis are as follows as of December 31, 2009 and 2008: December 31, 2009 Impaired loans Real estated owned Total December 31, 2008 Impaired loans Real estated owned Total Quoted market price in active markets (Level 1) Significant other observable inputs (Level 2) Significant other unobservable inputs (Level 3) - $ - $ - - $ - $ - 68,979 7,853 76,832 15,510 7,105 22,615 - - - - - - The Company predominantly lends with real estate serving as collateral on a substantial majority of loans. Loans that are deemed to be impaired are primarily valued at fair values of the underlying real estate collateral. NOTE 14 - OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISK 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. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments as for on-balance sheet instruments. At December 31, 2009 and 2008, the Banks had commitments to extend credit in the amount of $50.1 million and $85.1 million, respectively. At December 31, 2009 and 2008, the Banks had standby letters of credit in the amount of $910,000 and $3.4 million, respectively. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require a payment of a fee. Since commitments may expire without being drawn upon, the total commitments do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the party. Collateral held varies, but may include inventory, property and equipment, residential real estate and income producing commercial properties. Standby letters of credit obligate the Company to meet certain financial obligations of its customers, if, under the contractual terms of the agreement, the customers are unable to do so. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. The Company can seek recovery of the amounts paid from the borrower and the letters of credit are generally not collateralized. Commitments under standby letters of credit are usually one year or less. At December 31, 2009, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor; as such amounts are not considered material. The maximum potential of undiscounted future payments related to standby letters of credit at December 31, 2009 was approximately $910,000. The Company uses derivatives primarily to neutralize interest rate risk related to its pipeline of interest rate lock commitments issued on residential mortgage loans in the process of origination for sale. At December 31, 2009 and 2008, the Company’s outstanding mortgage interest rate lock commitments totaled $223.9 million and $223.0 million, respectively. The Company uses forward mortgage loan sales commitments that generally correspond with the composition of the locked pipeline to hedge a percentage of the Company’s pipeline of mortgage loan interest rate lock commitments and loans held for sale. At December 31, 2009 and 2008, the Company’s outstanding forward mortgage loan sales commitments totaled $130.0 million and $121.0 million, respectively. The Company’s derivative positions are marked to market as shown in Note 3 - Derivatives. Management closely monitors its credit concentrations and attempts to diversify the portfolio within its market area. The Company’s markets are concentrated along coastal South Carolina. At December 31, 2009, the Company has approximately $612.9 million of commercial real estate loan exposure. - 44 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 NOTE 15 - EMPLOYEE BENEFIT PLANS The Company maintains a 401(k) plan that covers substantially all employees of Community FirstBank, Crescent Bank, and Carolina Services (“CFC participants”). During 2004, the Company added Crescent Mortgage (“CMC Participants”) as a separate group that participated in the plan. Participants may contribute up to the maximum allowed by the regulation. During 2008, and 2007 the Company matched 75% of an employee’s contribution up to 6.00% of the participant’s compensation of the CFC Participants and matched 50% of an employee’s contribution up to 4.00% of the participant’s compensation of the CMC Participants. During 2009, the Company matched 75% of an employee’s contribution up to 6.00% of the participant’s compensation of the CFC Participants and the CMC Participants. For the years ended December 31, 2009, 2008 and 2007, the Company made matching contributions of $370,000, $289,000 and $290,000, respectively. The Company has an arrangement with four executives whereby the Company paid a lump sum payment to an insurance company on behalf of the executives. The advance is treated as a loan to the executives and the cash surrender value of the payment to the insurance company is included in other assets in the accompanying consolidated statements of financial condition. The cash surrender value of the advance at December 31, 2009 and 2008 is $1.6 million and $1.7 million, respectively. The executives are entitled to the increase in cash value above the Company’s original cash value insurance contributions. The executives pay the Company imputed interest on the loan balance and the increase in the cash value is recorded as compensation to the executives. The insurance policy premiums are paid in full by the executives. Generally, each executive is entitled to receive a $1.0 million death benefit and the Company will receive a $1.8 million death benefit. Since the executives pay the insurance premiums, the insurance proceeds will be taxable to the Company. NOTE 16 - EARNINGS PER SHARE Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per 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 share include the effects of outstanding stock options 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 were used to acquire shares of common stock at the average market price during the reporting period. The following is a summary of the reconciliation of average shares outstanding for the years ended December 31, 2009, 2008 and 2007: 2009 2008 2007 Basic Diluted Basic Diluted Basic Diluted Weighted average shares outstanding 1,912,449 1,912,449 1,883,101 1,883,101 1,794,659 1,794,659 Effect of dilutive securities: Stock options - 12,271 - 77,261 - 159,733 Average shares outstanding 1,912,449 1,924,720 1,883,101 1,960,362 1,794,659 1,954,392 The average market price used in calculating the dilutive securities under the treasury stock method for the years ended December 31, 2009, 2008 and 2007 was $17.53, $44.92 and $50.40, respectively. For fiscal 2009, 42,703 option shares were excluded from the calculation of diluted earnings per share at some time during the period because the exercise prices were greater than the average market price of the common shares, and therefore would have been anti-dilutive. For fiscal years 2008 and 2007, there were no options excluded from the calculation of diluted earnings per share. The Company does not have an actively traded market for its shares and, accordingly, the average market price used in calculating dilutive securities is based on a very limited number of transactions. NOTE 17 - CAPITAL REQUIREMENTS AND OTHER RESTRICTIONS The Company and the Banks 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 Banks’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of the Company’s and the Banks’ assets, liabilities, and certain off-balance sheet items as calculated under regulatory methods. The Company’s and the Banks’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weighting and other factors. As of December 31, 2009, the most recent notification from federal banking agencies categorized the Company and the Banks as “well capitalized” under the regulatory framework. In order to be considered “adequately capitalized”, the Company and the Banks are required to maintain minimum Tier 1 capital and total risk based capital to risk weighted assets and Tier 1 capital to total average assets of 4%, 8%, and 3%, respectively. In order to be considered “well capitalized”, the Company and the Banks are required to maintain minimum Tier 1 capital and total risk based capital to risk weighted assets and Tier 1 capital to total - 45 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 average assets of 6%, 10%, and 5%, respectively. Since December 31, 2009, there have been no events or conditions that management believes have changed the Company’s or the Banks’ regulatory capital categories. The actual capital amounts and ratios for the Company and the Banks at December 31, 2009 and 2008 are as follows: Carolina Financial Corporation Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total avg assets) Community FirstBank Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total avg assets) Crescent Bank Tier 1 capital (to risk weighted assets) Total risk based capital (to risk weighted assets) Tier 1 capital (to total avg assets) 2009 2008 Amount Ratio Amount Ratio (Dollars In Thousands) $ 78,773 101,696 78,773 45,166 55,633 45,166 35,404 47,849 35,404 9.2% 11.9% 7.3% 10.4% 12.8% 7.7% 8.4% 11.4% 7.2% 71,208 94,780 71,208 36,590 46,754 36,590 33,806 47,027 33,806 8.4% 11.2% 6.4% 8.9% 11.3% 6.6% 8.1% 11.3% 6.3% Any future dividend payments by the Company will be made primarily from dividends received from the Banks and Crescent Mortgage. Under applicable federal law, the Banks are restricted to total dividend payments in any calendar year to net profits of that year combined with retained net profits for the two preceding years. At December 31, 2009, the Banks had $18.0 million of retained net profits free of such restriction. NOTE 18 – SUPPLEMENTAL SEGMENT INFORMATION The Company has three reportable segments: community banking, mortgage banking and other. The community banking segment provides traditional banking services offered through Community FirstBank and Crescent 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 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 years ended December 31, 2009, 2008 and 2007 (In Thousands): - 46 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 For the Year Ended December 31, 2009 Interest income Interest expense Net interest income (expense) Provision for loan losses Noninterest income from external customers Intersegment noninterest income Noninterest expense Intersegment noninterest expense Income (loss) before income taxes Income tax expense (benefit) Community Banking $ 55,296 23,283 32,013 10,460 4,014 - 18,038 3,840 3,689 1,348 Net income (loss) $ 2,341 Assets Loans receivable, net Loans held for sale Deposits Borrowed funds For the Year Ended December 31, 2008 Interest income Interest expense Net interest income Provision for loan losses Noninterest income (expense) from external customers Intersegment noninterest income Noninterest expense Intersegment noninterest expense Income (loss) before income taxes Income tax expense (benefit) $ 1,051,233 690,563 43,412 763,538 209,899 Community Banking $ 62,064 31,488 30,576 6,361 4,304 - 14,186 3,780 10,553 3,853 Net income (loss) $ 6,700 Assets Loans receivable, net Loans held for sale Deposits Borrowed funds $ 1,111,268 776,802 6,684 719,655 327,001 Mortgage Banking Other Eliminations Total 1,431 1,037 394 - 23,924 - 14,211 582 9,525 3,594 5,931 35,607 - 27,821 - 19,062 23 713 (690) - - 4,422 5,424 - (1,692) (589) (1,103) 83,753 - - - 18,865 (14) (14) - - - (4,422) - (4,422) - - - (91,836) (400) - (2,430) (401) 56,736 25,019 31,717 10,460 27,938 - 37,673 - 11,522 4,353 7,169 1,078,757 690,163 71,233 761,108 247,425 Mortgage Banking Other Eliminations Total 72 1,247 (1,175) - (337) 4,536 4,757 - (1,733) (592) (1,141) 76,520 - - - 18,802 (47) (47) - - - (4,536) - (4,536) - - - (75,621) (337) - (2,266) (338) 63,049 33,227 29,822 6,361 9,227 - 23,882 - 8,806 3,256 5,550 1,138,994 776,621 28,283 717,389 366,555 960 539 421 - 5,260 - 4,939 756 (14) (5) (9) 26,827 156 21,599 - 21,090 - 47 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 For the Year Ended December 31, 2007 Interest income Interest expense Net interest income (expense) Provision for loan losses Noninterest income from external customers Intersegment noninterest income Noninterest expense Intersegment noninterest expense Income (loss) before income taxes Income tax expense (benefit) Community Banking $ 65,042 35,332 29,710 1,775 3,495 - 12,902 3,924 14,604 5,329 Net income (loss) $ 9,275 Assets Loans receivable, net Loans held for sale Deposits Borrowed funds $ 970,440 738,638 22,361 693,780 203,751 Mortgage Banking Other Eliminations Total 468 365 103 - 5,374 - 5,129 372 (24) (8) (16) 5,969 404 2,669 - 1,353 120 1,646 (1,526) - - 4,296 4,270 - (1,500) (515) (985) 70,206 - - - 18,802 (58) (58) - - - (4,296) - (4,296) - - - (69,476) (337) - (1,680) (338) 65,572 37,285 28,287 1,775 8,869 - 22,301 - 13,080 4,806 8,274 977,139 738,705 25,030 692,100 223,568 NOTE 19 - PARENT COMPANY FINANCIAL INFORMATION The condensed financial statements for the parent company are presented below: Carolina Financial Corporation Condensed Statements of Financial Condition December 31, 2009 and 2008 Assets: Cash and cash equivalents Investment in bank subsidiaries Investment in non-bank subsidiaries Investment in unconsolidated statutory business trusts Securities available for sale Other assets Total assets Liabilities and stockholders' equity: Accrued expenses and other liabilities Short-term debt Long-term debt Stockholders' equity Total liabilities and stockholders' equity 2009 2008 $ (In Thousands) 895 72,627 372 465 502 127 74,988 385 3,000 15,465 56,138 74,988 $ 747 60,779 3,681 465 - 6 65,678 622 3,000 15,465 46,591 65,678 - 48 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 Carolina Financial Corporation Condensed Statements of Operations For the Years Ended December 31, 2009, 2008 and 2007 2007 2009 $ 900 1,000 23 126 2,049 2008 (In Thousands) - - 40 300 340 Net income $ 7,169 Carolina Financial Corporation Condensed Statements of Cash Flows For the Years Ended December 31, 2009, 2008 and 2007 2009 2008 (In Thousands) 2007 $ 7,169 5,550 8,274 Dividend income from bank subsidiaries Dividend income from non-bank subsidiaries Interest income Other income Total income Interest expense General and administrative expenses Total expenses Loss before income taxes and equity in undistributed earnings of subsidiaries Income tax benefit Income (loss) before equity in undistributed earnings of subsidiaries Equity in undistributed earnings of Community FirstBank Equity in undistributed earnings of Crescent Bank Equity in undistributed earnings (losses) of Crescent Mortgage Equity in undistributed (losses) earnings of Carolina Services Total equity in undistributed earnings of subsidiaries Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in undistributed earnings in subsidiaries Stock-based compensation (Increase) decrease in other assets Increase (decrease) in other liabilities Net cash provided by (used in) operating activities Cash flows from investing activities: Purchase of securities available for sale Equity investment in bank subsidiaries Net cash used in financing activities Cash flows from financing activities: Proceeds from issuance of short-term borrowed funds Proceeds from exercise of stock options Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year 1,500 150 58 372 2,080 1,607 666 2,273 (193) (643) 450 3,410 4,366 (16) 64 7,824 8,274 1,210 755 1,965 (1,625) (552) (1,073) 3,108 3,592 (9) (68) 6,623 5,550 (6,623) 365 39 (111) (780) - - - - 844 844 64 683 747 (7,824) 315 93 340 1,198 - (3,000) (3,000) 2,000 111 2,111 309 374 683 704 805 1,509 540 (464) 1,004 1,894 1,598 2,881 (208) 6,165 (6,165) 390 (8) (508) 878 (35) (700) (735) - 5 5 148 747 Cash and cash equivalents, end of year $ 895 - 49 - CAROLINA FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2009 AND 2008 NOTE 20 – QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The tables below represent the quarterly results of operations for the years ending December 31, 2009, 2008 and 2007 respectively: First Second Third Fourth (In Thousands, Except Per Share Data) 2009 Total interest income Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Noninterest expense Income before taxes Income tax expense Net income Basic earnings per share Diluted earnings per share Total interest income Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Noninterest expense Income before taxes Income tax expense Net income Basic earnings per share Diluted earnings per share Total interest income Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Noninterest expense Income before taxes Income tax expense Net income Basic earnings per share Diluted earnings per share First Second Third Fourth (In Thousands, Except Per Share Data) 2008 14,458 6,626 7,832 2,206 5,626 8,469 10,097 3,998 1,525 2,473 1.29 1.29 14,039 5,950 8,089 2,516 5,573 5,624 9,049 2,148 813 1,335 0.70 0.70 13,652 5,451 8,201 4,077 4,124 8,491 10,626 1,989 766 1,223 0.64 0.61 15,612 8,311 7,301 607 6,694 2,473 6,488 2,679 979 1,700 0.89 0.87 15,401 7,725 7,676 1,524 6,152 1,713 5,152 2,713 1,012 1,701 0.89 0.86 15,342 7,715 7,627 2,950 4,677 1,849 6,015 511 197 314 0.16 0.16 16,598 9,293 7,305 445 6,860 2,267 5,548 3,579 1,311 2,268 1.26 1.16 17,210 9,751 7,459 270 7,189 2,245 5,908 3,526 1,297 2,229 1.24 1.14 16,393 9,657 6,736 680 6,056 2,388 5,640 2,804 1,032 1,772 0.99 0.91 First Second Third Fourth (In Thousands, Except Per Share Data) 2007 $ $ $ $ $ $ $ $ $ 14,587 6,992 7,595 1,661 5,934 5,354 7,901 3,387 1,249 2,138 1.12 1.12 16,694 9,476 7,218 1,280 5,938 3,192 6,227 2,903 1,068 1,835 1.01 0.94 15,371 8,584 6,787 380 6,407 1,969 5,205 3,171 1,166 2,005 1.12 1.02 $ $ $ - 50 - CAROLINA FINANCIAL CORPORATION CAROLINA FINANCIAL CORPORATION OFFICERS John D. Russ President and Chief Executive Officer Frank J. Cole, Jr. Executive Vice President, Secretary and Chief Financial Officer David L. Morrow Executive Vice President William A. Gehman, III Vice President and Controller M. J. Huggins, III Executive Vice President and Assistant Secretary Jerry L. Rexroad Executive Vice President BOARD OF DIRECTORS William H. Alford Vice President and Secretary A & I, Inc. Robert G. Clawson, Jr., Esq. Member Clawson and Staubes, LLC G. Manly Eubank Chairman Palmetto Ford, Inc. Frank E. Lucas Chairman LS3P Associates, LTD Benedict P. Rosen Retired AVX Corporation Bonum S. Wilson, Jr. Venture Capitalist Howell (Skeets) V. Bellamy, Jr. Member Bellamy, Rutenberg, Copeland, Epps, Gravely & Bowers, P.A. Frank J. Cole, Jr. Executive Vice President, Secretary and Chief Financial Officer Carolina Financial Corporation M. J. Huggins, III President and Secretary Crescent Bank Robert M. Moïse, CPA, CVA Partner WebsterRogers, LLP John D. Russ President and Chief Executive Officer Carolina Financial Corporation W. Scott Brandon President The Brandon Agency Jeffery L. Deal, M.D. Founding Member, Charleston ENT (Retired) Director of Health Services Water Missions International Robert C. KenKnight Retired Crescent Mortgage Company David L. Morrow Chief Executive Officer Community FirstBank and Crescent Bank Lt. Gen. Claudius E. Watts, III Chairman (USAF – Retired) Past President, The Citadel - 51 - CAROLINA FINANCIAL CORPORATION COMMUNITY FIRSTBANK OFFICERS John D. Russ Chairman Gail A. Brown Vice President Senior Consumer Lender Andrew J. DeMasi Vice President Commercial Banking William A. Gehman III Vice President and Controller Richard Pierce Vice President and Branch Manager Meeting Street Robert L. Tennyson Vice President Commercial Banking BOARD OF DIRECTORS Robert G. Clawson, Jr., Esq. Member Clawson and Staubes, LLC G. Manly Eubank Chairman Palmetto Ford, Inc. David L. Morrow Chief Executive Officer Community FirstBank and Crescent Bank Lt. General Claudius E. Watts, III (USAF – Retired) Past President The Citadel David L. Morrow Chief Executive Officer Ellen M. Cavanaugh Vice President Loan Administration Doug Driggers Vice President and Branch Manager West Ashley Harold E. Jervey, III Executive Vice President Business Development Leon G. Runey Vice President Commercial Banking Robert H. Warrick Senior Vice President Senior Credit Officer Frank J. Cole, Jr. President, Treasurer, Secretary and Chief Financial Officer A. Taylor Clarkson, III Senior Vice President Summerville City Executive Mary D. Garcia Senior Vice President Senior Commercial Lender Linda H. Kennedy Vice President Commercial Banking Barbara W. Schoppe Vice President West Ashley Elizabeth D. Williams Vice President and Branch Manager Summerville Frank J. Cole, Jr. Executive Vice President, Secretary and Chief Financial Officer Carolina Financial Corporation Jeffery L. Deal, M.D. Founding Member, Charleston ENT (Retired) Director of Health Services Water Missions International Frank E. Lucas Chairman LS3P Associates, LTD John D. Russ Chairman President and Chief Executive Officer Carolina Financial Corporation Bonum S. Wilson, Jr. Venture Capitalist Robert M. Moïse, CPA, CVA Partner WebsterRogers, LLP John M. Settle Vice Chairman SUMMERVILLE ADVISORY BOARD Dr. Ron Givens Partner Lowcountry Women’s Specialists Dr. Robert S. Randall Member Dental Associates of Summerville, LLC Jack Kersting President Mr. K’s Piggly Wiggly Jan Waring-Woods Partner Dixon, Hughes PLLC Johnny Linton Special Counsel Duffy & Young - 52 - CAROLINA FINANCIAL CORPORATION CRESCENT BANK OFFICERS David L. Morrow Chief Executive Officer Jean E. Chestnut Vice President Charles J. Fehlig, Jr. Executive Vice President G. Timothy Hoag Vice President F. Ross Rankin Senior Vice President BOARD OF DIRECTORS William H. Alford Vice President and Secretary A & I, Inc. M. J. Huggins, III President and Secretary Marshall K. Cooper Vice President William A. Gehman Vice President and Controller Frederick W. Jasper, Jr. Senior Vice President M. Wayne Staton Senior Vice President Howell (Skeets) V. Bellamy, Jr. Member Bellamy, Rutenberg, Copeland, Epps, Gravely & Bowers, P.A. Mary Eleanor Eaddy President The Wordsmith, Inc. Special Asst. to the President of CCU M. J. Huggins, III President and Secretary Crescent Bank Frank J. Cole, Jr. Executive Vice President and Chief Financial Officer Michael L. Evans Vice President E. Hayden Hamilton, Jr. Vice President Travis A. Minter Senior Vice President W. Scott Brandon Vice Chairman President The Brandon Agency Daniel H. Isaac, Jr. President A & I, Inc. Daniel W. R. Moore, Sr. President DM Development Co., Inc. Benedict P. Rosen Chairman Retired AVX Corporation Advisory Boards North Myrtle Beach Dr. Robert DeGrood President – Southern Surgical, P.A. David L. Morrow Chief Executive Officer Community FirstBank and Crescent Bank Edward L. Proctor, Jr., M.D. Partner Diagnostic Pathology, P.A. Steve C. Taylor President Native Sons Screenprinting and Embroidery Conway Joseph O. Burroughs, Jr. Partner – Singleton, Burroughs, and Young Law Firm South Strand A. Carroll Atkisson President – Affordable Suites of America, Inc. John Harrison Retired Executive, Exxon Corporation Dr. Robert J. Farrar, Jr., DMD Family and Cosmetic Dentistry Gary F. Fette President – Fette Realty, LLC and Socastee Management, LLC Jacqui Isbil Owner – Umberto’s at Coquina Harbor Mrs. Fran B. Gilbert Assoc. VP for Development CCU William B. Wilhelm Broker Associate – Surfside Realty Company, Inc. Dr. Garnett Ramsbottom President – North Myrtle Beach Family Practice George M. Hearn, Jr. Partner – Hearn, Brittan and Martin Law Firm Ray E. Skidmore, Jr. President – Fox Fire Communities Christopher S. Huggins, CPA Smith, Sapp, Bookhout, Crumpler and Callihan, P.A. Dr. William T. Davis Carolina Family Dental, PA Dr. Ronald Ingle President – Coastal Carolina University James J. Johnson Retired - 53 - CAROLINA FINANCIAL CORPORATION CRESCENT MORTGAGE COMPANY OFFICERS Michael P. Leddy President and Chief Executive Officer Patricia J. Anthony Vice President Credit/Risk Manager John S. Kaminer Vice President Secondary Marketing Fowler C. Williams Executive Vice President National Sales Manager Jerry L. Rexroad Chairman Parthiv J. Dave Vice President Secondary Marketing Michael A. Perkins Vice President Underwriting Manager Kelly A. Byers Chief Financial Officer William F. Fowler Vice President Operations Manager Jemille Y. Robinson Senior Vice President Quality Control and Post Closing Manager BOARD OF DIRECTORS Frank J. Cole, Jr. Executive Vice President, Secretary and Chief Financial Officer Carolina Financial Corporation Robert C. KenKnight Retired Crescent Mortgage Company Michael P. Leddy President and Chief Executive Officer Crescent Mortgage Company Benedict P. Rosen Retired AVX Corporation Jerry L. Rexroad Chairman Executive Vice President Carolina Financial Corporation John D. Russ President and Chief Executive Officer Carolina Financial Corporation - 54 - CAROLINA FINANCIAL CORPORATION CAROLINA SERVICE CORPORATION OFFICERS Joseph Bonacci Senior Vice President Human Resources Frank J. Cole, Jr. Executive Vice President Robert W. Haile, Jr. Vice President Treasurer Jamin M. Hujik Vice President Special Assets Group James Potasky Vice President Internal Auditor Sara Sowell Vice President Loan Review Brian L. Canady Senior Vice President Retail Sales Manager William A. Gehman III Vice President and Controller John Heinemann Vice President Information Technology Sandra Lewis Senior Vice President Operations John D. Russ Chairman President and Chief Executive Officer Richard A. Tripp Vice President Compliance BOARD OF DIRECTORS Frank J. Cole, Jr. Executive Vice President, Secretary and Chief Financial Officer Carolina Financial Corporation Harvey L. Glick Bank Consultant M. J. Huggins, III President and Assistant Secretary Crescent Bank John D. Russ Chairman President and Chief Executive Officer Carolina Financial Corporation David L. Morrow Chief Executive Officer Community FirstBank and Crescent Bank Donald B. Shackelford Bank Consultant - 55 - CAROLINA FINANCIAL CORPORATION CORPORATE INFORMATION STOCK TRANSFER AGENT Registrar and Transfer Company 10 Commerce Drive Cranford, N.J. 07016 800-866-1340 SPECIAL COUNSEL Luse Gorman Pomerenk & Schick 5335 Wisconsin Avenue, N.W., Suite 780 Washington, D.C. 20015 INDEPENDENT AUDITORS Elliott Davis, LLC 1901 Main Street, Suite 1650 P. O. Box 2227 Columbia, SC 29202-2227 DISCLAIMER This annual report has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation. - 56 - 

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