HCSB Financial (HCFB) 10-Q 2017 Q1 Quarterly report

 UNITED STATES

 SECURITIES AND EXCHANGE COMMISSION

 WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
	For the Quarterly Period Ended March 31, 2017
	OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _________to_________

Commission File Number 000-26995

HCSB FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

South Carolina	57-1079444
(State or other jurisdiction of incorporation)	(I.R.S. Employer Identification No.)

5201 Broad Street

Loris, South Carolina 29569

(Address of principal executive
offices, including zip code)

(843) 756-6333

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yesx  Noo

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yesx  Noo

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

Large accelerated filer	o	Accelerated filer	o
Non-accelerated filer	o	Smaller reporting company	x
		Emerging growth company	o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso  Nox

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Voting Common Stock, par value $0.01 per share	405,232,383 shares outstanding as of May 3, 2017
Non-voting Common Stock, par value $0.01 per share	90,531,557 shares outstanding as of May 3, 2017

Index

PART I. FINANCIAL INFORMATION	Page No.
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets –   March 31, 2017 and December 31, 2016	3
Condensed Consolidated Statements of Operations – Three months ended March 31, 2017 and 2016	4
Condensed Consolidated Statements of Comprehensive Income (Loss) –  Three months ended March 31, 2017 and 2016	5
Condensed Consolidated Statements of Changes in Shareholders’ Equity – Three months ended March 31, 2017 and 2016	6
Condensed Consolidated Statements of Cash Flows – Three months ended March 31, 2017 and 2016	7
Notes to Unaudited Condensed Consolidated Financial Statements	8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	44
Item 3. Quantitative and Qualitative Disclosures about Market Risk	56
Item 4. Controls and Procedures	56
PART II. OTHER INFORMATION
Item 1. Legal Proceedings	57
Item 1A. Risk Factors	57
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	57
Item 3. Defaults Upon Senior Securities	57
Item 4. Mine Safety Disclosures	57
Item 5. Other Information	57
Item 6. Exhibits	57
SIGNATURES

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

	March 31,			December 31,
(Dollars in thousands except share amounts)	2017			2016
Assets:		(unaudited)			(audited)
Cash and due from banks	$	22,190		$	25,429
Securities available-for-sale		104,341			106,529
Nonmarketable equity securities		1,359			1,345
Total investment securities		105,700			107,874
Loans receivable		229,033			215,112
Less allowance for loan losses		(3,717	)		(3,750	)
Loans, net		225,316			211,362
Premises and equipment, net		14,182			14,314
Accrued interest receivable		1,289			1,303
Cash value of life insurance		11,721			11,643
Other real estate owned		2,617			2,887
Other assets		999			1,122
Total assets	$	384,014		$	375,934
Liabilities:
Deposits:
Noninterest-bearing transaction accounts	$	43,666		$	41,324
Interest-bearing transaction accounts		42,405			42,408
Money market savings accounts		97,130			71,486
Other savings accounts		12,575			11,820
Time deposits $250 and over		14,405			18,510
Other time deposits		112,158			127,721
Total deposits		322,339			313,269
Repurchase agreements		848			1,983
Advances from the Federal Home Loan Bank		24,000			24,000
Accrued interest payable		134			155
Other liabilities		581			1,200
Total liabilities		347,902			340,607
Commitments and contingencies
Shareholders’ Equity:
Preferred stock, $0.01 par value; 5,000,000 shares authorized;
Series A, no shares issued and outstanding		—			—
Common stock, Voting, $0.01 par value; 500,000,000 shares authorized; 405,232,383 shares issued and outstanding		4,053			4,053
Common stock, Non-voting, $0.01 par value; 150,000,000 shares authorized; 90,531,557 shares issued and outstanding		905			905
Capital surplus		68,550			68,411
Retained deficit		(34,490	)		(34,783	)
Accumulated other comprehensive loss		(2,906	)		(3,259	)
Total shareholders’ equity		36,112			35,327
Total liabilities and shareholders’ equity	$	384,014		$	375,934
The accompanying notes are an integral part of the consolidated financial statements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
	Three months ended March 31,
(Dollars in thousands except share amounts)	2017			2016
Interest income:
Loans, including fees	$	2,724		$	2,483
Investment securities:
Taxable		480			461
Nonmarketable equity securities		15			14
Other interest income		40			31
Total		3,259			2,989
Interest expense:
Deposits		486			523
Borrowings		151			523
Total		637			1,046
Net interest income		2,622			1,943
Provision for loan losses		—			1,424
Net interest income after provision for loan losses		2,622			519
Noninterest income:
Service charges on deposit accounts		162			161
Gains on sales of securities available-for-sale		—			17
Mortgage loan income		31			—
Other fees and commissions		91			72
Brokerage commissions		—			9
Income from cash value of life insurance		108			110
Other operating income		21			47
Total		413			416
Noninterest expenses:
Salaries and employee benefits		1,560			1,286
Net occupancy expense		244			275
Furniture and equipment expense		232			224
FDIC insurance premiums		44			309
Net cost (profit) of operations of other real estate owned		(65	)		1,564
Other operating expenses		727			560
Total		2,742			4,218
Income (loss) before income taxes		293			(3,283	)
Income tax expense		—			—
Net income (loss)		293			(3,283	)
Preferred dividends		—			(398	)
Net income (loss) available to common shareholders	$	293		$	(3,681	)
Net income (loss) per common share
Basic	$	0.00		$	(0.96	)
Diluted	$	0.00		$	(0.96	)
Weighted average common shares outstanding
Basic		468,013,940			3,846,340
Diluted		469,054,565			3,846,340
The accompanying notes are an integral part of the consolidated financial statements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited)

	Three months ended March 31,
(Dollars in thousands)	2017		2016
Net income (loss)	$	293	$	(3,283	)
Other comprehensive income:
Unrealized gains on securities available-for-sale:
Net unrealized holding gains arising during the period		353		902
Reclassification to realized gains		—		(17	)
Other comprehensive income		353		885
Comprehensive income (loss)	$	646	$	(2,398	)
The accompanying notes are an integral part of the consolidated financial statements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Three months ended March 31, 2017 and 2016
(unaudited)
	Common Stock				Common Stock		Preferred Stock				Capital		Retained			Accumulated Other Comprehensive
	Shares		Amount		Warrant		Shares		Amount		Surplus		Deficit			Loss			Total
(Dollars in thousands except share data)
Balance, December 31, 2015		3,846,340	$	38	$	1,012		12,895	$	12,895	$	30,220	$	(54,807	)	$	(1,608	)	$	(12,250	)
Net loss		—		—		—		—		—		—		(3,283	)		—			(3,283	)
Other comprehensive income		—		—		—		—		—		—		—			885			885
Balance, March 31, 2016		3,846,340	$	38	$	1,012		12,895	$	12,895	$	30,220	$	(58,090	)	$	(723	)	$	(14,648	)
Balance, December 31, 2016		495,763,940	$	4,958	$	—		—	$	—	$	68,411	$	(34,783	)	$	(3,259	)	$	35,327
Net income		—		—		—		—		—		—		293			—			293
Other comprehensive income		—		—		—		—		—		—		—			353			353
Stock-based compensation expense		—		—		—		—		—		139		—			—			139
Balance, March 31, 2017		495,763,940	$	4,958	$	—		—	$	—	$	68,550	$	(34,490	)	$	(2,906	)	$	36,112
The accompanying notes are an integral part of the consolidated financial statements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(Dollars in thousands)	Three months ended March 31,
	2017			2016
Cash flows from operating activities:
Net income (loss)	$	293		$	(3,283	)
Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities:
Depreciation and amortization		162			170
Amortization of debt issuance costs		—			3
Provision for loan losses		—			1,424
Amortization less accretion on investments		251			13
Stock-based compensation expense		139			—
Net gains on sales of securities available-for-sale		—			(17	)
Gains on sales of other real estate owned		(11	)		(15	)
Write-downs of other real estate owned		2			1,369
Decrease in accrued interest receivable		14			229
Increase (decrease) in accrued interest payable		(21	)		375
(Increase) decrease in other assets		123			(486	)
Income (net of mortality cost) on cash value of life insurance		(78	)		(81	)
Decrease in other liabilities		(619	)		(202	)
Net cash provided (used) by operating activities		255			(501	)
Cash flows from investing activities:
Purchases of securities available-for-sale		—			(7,558	)
Maturities, calls and principal paydowns of securities available-for-sale		2,290			10,790
Proceeds from sales of securities available-for-sale		—			4,153
(Purchases) redemptions of nonmarketable equity securities		(14	)		54
(Increase) decrease in loans to customers		(13,954	)		6,947
Purchases of premises and equipment, net		(30	)		(11	)
Proceeds from sale of other real estate owned		279			1,479
Net cash provided (used) by investing activities		(11,429	)		15,854
Cash flows from financing activities:
Net increase in demand deposits and savings		28,738			5,980
Net decrease in time deposits		(19,668	)		(1,350	)
Net decrease in repurchase agreements		(1,135	)		(468	)
Net cash provided by financing activities		7,935			4,162
Net increase (decrease) in cash and cash equivalents		(3,239	)		19,515
Cash and cash equivalents, beginning of period		25,429			22,137
Cash and cash equivalents, end of period	$	22,190		$	41,652
Cash paid during the period for:
Income taxes	$	—		$	—
Interest	$	658		$	671
Noncash investing and financing activities:
Transfers of loans to other real estate owned	$	—		$	479
Unrealized gains on investments	$	353		$	885
The accompanying notes are an integral part of the consolidated financial statements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS

Organization and Significant Accounting Policies

Basis of Presentation and Consolidation - The accompanying consolidated financial statements include the accounts of HCSB Financial Corporation (the “Company”) which was incorporated on June 10, 1999 to serve as a bank holding company for its wholly owned subsidiary, Horry County State Bank (the “Bank”). The Bank was incorporated on December 18, 1987, and opened for operations on January 4, 1988. The principal business activity of the Company is to provide commercial banking services in Horry County, South Carolina, and in Columbus and Brunswick Counties, North Carolina. The Bank is a state-chartered bank, and its deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”). HCSB Financial Trust I (the “Trust”) is a special purpose subsidiary organized for the sole purpose of issuing trust preferred securities. The trust preferred securities were redeemed in the second quarter of 2016. The operations of the Trust were not consolidated in the financial statements prior to the dissolution.

The accompanying consolidated financial statements have been prepared in accordance with the requirements for interim financial statements and, accordingly, they are condensed and omit disclosures, which would substantially duplicate those contained in the most recent annual report to shareholders. The financial statements as of March 31, 2017 and for the interim periods ended March 31, 2017 and 2016 are unaudited and, in our opinion, include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation. Operating results for the three-month period ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. The financial information as of December 31, 2016 has been derived from the audited financial statements as of that date. For further information, refer to the financial statements and the notes included in HCSB Financial Corporation’s 2016 Annual Report on Form 10-K which was filed with the Securities and Exchange Commission (the “SEC”) on March 3, 2017, as amended on April 27, 2017.

Management’s Estimates - In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and income and expenses for the period. Actual results could differ significantly from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, including valuation allowances for impaired loans, and the carrying amount of real estate acquired in connection with foreclosures or in satisfaction of loans. 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 Company’s allowances for losses on loans and foreclosed real estate. Such agencies may require the Company 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 losses on loans and foreclosed real estate may change materially in the near term.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

Investment Securities - Investment securities available-for-sale owned by the Company are carried at amortized cost and adjusted to their estimated fair value for reporting purposes. The unrealized gain or loss is recorded in shareholders’ equity net of any deferred tax effects. Management does not actively trade securities classified as available-for-sale, but intends to hold these securities for an indefinite period of time and may sell them prior to maturity to achieve certain objectives. Reductions in fair value considered by management to be other than temporary are reported as a realized loss and a reduction in the cost basis in the security. The adjusted cost basis of securities available-for-sale is determined by specific identification and is used in computing the realized gain or loss from a sales transaction.

Nonmarketable Equity Securities - Nonmarketable equity securities include the Company’s investments in the stock of the Federal Home Loan Bank (the “FHLB”). The FHLB stock is carried at cost because the stock has no quoted market value and no ready market exists. Investment in FHLB stock is a condition of borrowing from the FHLB, and the stock is pledged to collateralize the borrowings. Dividends received on FHLB stock are included as a separate component in interest income.

Loans Receivable - Loans receivable are stated at their unpaid principal balance less any charge-offs. Interest income on loans is computed based upon the unpaid principal balance. Interest income is recorded in the period earned.

The accrual of interest income is generally discontinued when a loan becomes contractually 90 days past due as to principal or interest. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral exceeds the principal balance and accrued interest.

Loan origination and commitment fees and certain direct loan origination costs (principally salaries and employee benefits) are deferred and amortized to income over the contractual life of the related loans or commitments, adjusted for prepayments, using the straight-line method.

For all classes of loans, loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impaired loans may include all classes of nonaccrual loans and loans modified in a troubled debt restructuring (“TDR”). If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the interest rate implicit in the original agreement or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is probable, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. When management determines that a loan is impaired, the difference between the Company’s investment in the related loan and the present value of the expected future cash flows, or the fair value of the collateral, is charged off with a corresponding entry to the allowance for loan losses or a specific reserve is set aside within the allowance for loan losses. The accrual of interest is discontinued on an impaired loan when management determines the borrower may be unable to meet payments as they become due. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

Concentrations of Credit Risk - Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans receivable, investment securities, federal funds sold and amounts due from banks.

The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily throughout Horry County in South Carolina and Columbus and Brunswick counties of North Carolina. The Company’s loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. However, the loan portfolio does include a concentration in loans secured by residential and commercial real estate and commercial and industrial non-real estate loans. These loans are especially susceptible to being adversely effected by unfavorable economic conditions. The recent economic recession resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declined real estate market during this time had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. While economic conditions and real estate in our primary markets have improved since the end of the economic recession, there can be no assurance that this improvement will continue or that our local markets will not experience another economic decline. If real estate values in our market areas were to decline, it is also more likely that we would be required to increase our allowance for loan losses.

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries and geographic regions, management monitors exposure to credit risk from concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.), and loans with high loan-to-value ratios. Management has determined that there is no concentration of credit risk associated with its lending policies or practices. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.

The Company’s investment portfolio consists principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in its investment portfolio. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.

Allowance for Loan Losses – The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Management’s judgments about the adequacy of the allowance are based on numerous assumptions about current events, which management believes to be reasonable, but which may or may not prove to be accurate. Thus, there can be no assurance that loan losses in future periods will not exceed the current allowance amount or that future increases in the allowance will not be required. No assurance can be given that management’s ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the allowance, thus adversely affecting the operating results of the Company. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

The allowance is subject to examination by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require the Company to adjust its allowance based on information available to them at the time of their examination.

The methodology used to determine the reserve for unfunded lending commitments, which is included in other liabilities, is inherently similar to that used to determine the allowance for loan losses adjusted for factors specific to binding commitments, including the probability of funding and historical loss ratio.

Premises, Furniture and Equipment - Premises, furniture and equipment are stated at cost less accumulated depreciation. The provision for depreciation is computed by the straight-line method. Rates of depreciation are generally based on the following estimated useful lives: buildings - 40 years; furniture and equipment - three to ten years. The cost of assets sold or otherwise disposed of and the related accumulated depreciation is eliminated from the accounts, and the resulting gains or losses are reflected in the Statement of Operations.

Maintenance and repairs are charged to current expense as incurred, and the costs of major renewals and improvements are capitalized.

Other Real Estate Owned - Other real estate owned (“OREO”) includes real estate acquired through foreclosure. OREO is initially recorded at appraised value, less estimated costs to sell.

Any write-downs at the dates of acquisition are charged to the allowance for loan losses. Subsequent write-downs are charged to a reserve for OREO losses. Expenses to maintain such assets, subsequent write-downs, and gains and losses on disposal are included in net cost (profit) of operations of other real estate owned on the statement of operations.

Income and Expense Recognition - The accrual method of accounting is used for all significant categories of income and expense. Immaterial amounts of insurance commissions and other miscellaneous fees are reported when received.

Income Taxes – The Company files a consolidated federal income tax return and separate company state income tax returns. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The Company accounts for income taxes based on two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period and includes income tax expense related to uncertain tax positions, if any.

Deferred income taxes are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is based on the tax impacts of the differences between the book and tax bases of assets and liabilities and recognizes enacted changes in tax rates and laws in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized subject to the Company’s judgment that realization is more likely than not. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement. Interest and penalties, if any, are recognized as a component of income tax expense. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

The Company reviews the deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years, projections of future operating results, cumulative tax losses over the past three years, tax loss deductibility limitations, and available tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, a valuation allowance against the deferred tax asset must be established with a corresponding charge to income tax expense. The deferred tax assets and valuation allowance are evaluated each quarter, and a portion of the valuation allowance may be reversed in future periods. The determination of how much of the valuation allowance that may be reversed and the timing is based on future results of operation and the amount and timing of actual loan charge-offs and asset write-downs. At March 31, 2017 and December 31, 2016, the Company’s deferred tax asset was offset in its entirety by a valuation allowance.

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 income tax positions have been recorded.

Net Income (Loss) Per Common Share - Basic net income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed based on net income divided by the weighted average number of common and potential common shares. The computation of diluted net loss per share does not include potential common shares as their effect would be anti-dilutive. At March 31, 2017, the only potential common share equivalents are restricted stock.

Comprehensive Income - Accounting principles generally require recognized income, expenses, gains, and losses to be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income and are also presented in a separate statement of comprehensive income. Accumulated other comprehensive income for the Company consists entirely of unrealized holding gains and losses on available for sale securities.

Statements of Cash Flows- For purposes of reporting cash flows, the Company considers certain highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash equivalents include amounts due from banks, federal funds sold, and interest-bearing deposits with other banks.

Off-Balance Sheet Financial Instruments - In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. These financial instruments are recorded in the financial statements when they become payable by the customer.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

Recently Issued Accounting Pronouncements – The following is a summary of recent authoritative pronouncements.

In May 2014, the Financial Accounting Standards Board (“FASB”) issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. This guidance also includes expanded disclosure requirements that result in an entity providing users of financial statements with comprehensive information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from the entity’s contracts with customers. In August 2015, the FASB deferred the effective date of Accounting Standards Update (“ASU”) 2014-09. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In January 2016, the FASB issued ASU 2016-01 updating the Financial Instruments topic of the Accounting Standards Codification to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.

In February 2016, the FASB amended the Leases topic of the ASC to require all leases with lease terms over 12 months to be capitalized as a right-of-use asset and lease liability on the balance sheet at the date of lease commencement. Leases will be classified as either finance leases or operating leases. This distinction will be relevant for the pattern of expense recognition in the income statement. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently in the process of evaluating the impact of adoption of this guidance on the financial statements.

In March 2016, the FASB amended the Revenue from Contracts with Customers topic of the ASC to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them to apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. The amendments were effective for the Company on January 1, 2017 and did not have a material effect on its financial statements.

In May 2016, the FASB amended the Revenue from Contracts with Customers topic of the ASC to clarify guidance related to collectability, noncash consideration, presentation of sales tax, and transition. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements. 

-13-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

In June 2016, the FASB issued guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. The guidance requires a financial asset (including trade receivables) measured at amortized cost basis to be presented at the net amount expected to be collected. Thus, the income statement will reflect the measurement of credit losses for newly-recognized financial assets as well as the expected increases or decreases of expected credit losses that have taken place during the period. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. The Company is currently in the process of evaluating the impact of adoption of this guidance on the financial statements.

In August 2016, the FASB amended the Statement of Cash Flows topic of the ASC to clarify how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017 including interim periods within those fiscal years. The Company does not expect these amendments to have a material effect on its financial statements.

In October 2016, the FASB amended the Income Taxes topic of the ASC to modify the accounting for intra-entity transfers of assets other than inventory. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017 including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

In October 2016, the FASB amended the Consolidation topic of the ASC to revise the consolidation guidance on how a reporting entity that is the single decision maker of a variable interest entity (VIE) should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. The amendments became effective for the Company on January 1, 2017 and did not have a material effect on the financial statements.

In November 2016, the FASB amended the Statement of Cash Flows topic of the ASC to clarify how restricted cash is presented and classified in the statement of cash flows. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017 including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

In December 2016, the FASB issued technical corrections and improvements to the Revenue from Contracts with Customers Topic. These corrections make a limited number of revisions to several pieces of the revenue recognition standard issued in 2014. The effective date and transition requirements for the technical corrections will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In January 2017, the FASB issued guidance to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendment to the Business Combinations Topic is intended to address concerns that the existing definition of a business has been applied too broadly and has resulted in many transactions being recorded as business acquisitions that in substance are more akin to asset acquisitions. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

In January 2017, the FASB updated the Accounting Changes and Error Corrections and the Investments—Equity Method and Joint Ventures Topics of the ASC.  The update incorporates into the ASC recent SEC guidance about disclosing, under SEC SAB Topic 11.M, the effect on financial statements of adopting the revenue, leases, and credit losses standards.  The ASU was effective upon issuance. The Company is currently evaluating the impact on additional disclosure requirements as each of the standards is adopted, however it does not expect these amendments to have a material effect on its financial position, results of operations or cash flows. 

-14-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

In February 2017, the FASB amended the Other Income Topic of the Accounting Standards Codification to clarify the scope of the guidance on nonfinancial asset derecognition as well as the accounting for partial sales of nonfinancial assets. The amendments conform the derecognition guidance on nonfinancial assets with the model for transactions in the new revenue standard. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

In March 2017, the FASB amended the requirements in the Receivables—Nonrefundable Fees and Other Costs Topic of the ASC related to the amortization period for certain purchased callable debt securities held at a premium. The amendments shorten the amortization period for the premium to the earliest call date. The amendments will be effective for the Company for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

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

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 Company’s loan portfolio that results from a borrower’s 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. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset 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.

Reclassifications- Certain captions and amounts for prior periods have been reclassified to conform to the March 31, 2017 presentation. These reclassifications had no effect on net income (loss) or shareholders’ equity as previously reported. 

-15-

NOTE 2 - REGULATORY MATTERS AND OTHER CONSIDERATIONS

Termination of the Written Agreement with the Federal Reserve Bank of Richmond

On March 23, 2017, the Company received notification from the Federal Reserve Bank of Richmond that the Written Agreement it has been operating under since May 9, 2011 was terminated effective March 21, 2017. Pursuant to the Written Agreement, the Company agreed, among other things, to seek the prior written approval of the Federal Reserve Bank of Richmond before declaring or paying any dividends, directly or indirectly taking dividends or any other form of payment representing a reduction in capital from the Bank, making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, directly or indirectly, incurring, increasing or guarantying any debt, and directly or indirectly, purchasing or redeeming any shares of its stock. Although the Written Agreement has been terminated, certain regulatory requirements and restrictions remain, including prohibitions on (i) increasing or guarantying any debt, (ii) directly or indirectly or purchasing or redeeming any shares of its stock, and (iii) making dividend payments, each without prior approval from the Federal Reserve.

Termination of the Consent Order

As a result of the recent economic recession, the Bank entered into a Consent Order (the “Consent Order”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the South Carolina Board of Financial Institutions (the “State Board”) on February 10, 2011, which, among other things, required the Bank to achieve and maintain total risk based capital at least equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% of total assets and to seek to sell or merge the Bank if it cannot satisfy or maintain the requisite capital. October 26, 2016, the Bank received notification from the FDIC and the State Board that the Consent Order had been terminated. The Consent Order was replaced with certain regulatory requirements and restrictions, including a requirement to continue to improve credit quality and earnings, a restriction prohibiting dividend payments without prior approval from the supervisory authorities, and a requirement to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. We believe that we are currently in substantial compliance with the new regulatory requirements and restrictions.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 - REGULATORY MATTERS AND OTHER CONSIDERATIONS -continued

Other Considerations

During the economic recession, the Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, experienced a decline in the value of the collateral securing its loan portfolio as well as a rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. However, since 2012, the Bank’s nonperforming assets have begun to stabilize. In addition to increasing write-downs on OREO to expedite sales during 2016, the Bank sold $4.3 million of nonperforming loans and $270 thousand of OREO in a bulk sale. The loans and OREO had been reduced to fair value prior to the sale. Additional OREO properties totaling $5.6 million were also sold during 2016.

The Bank’s nonperforming assets at March 31, 2017 were $4.5 million compared to $4.9 million at December 31, 2016. As a percentage of total assets, nonperforming assets were 1.18% and 1.31% as of March 31, 2017 and December 31, 2016, respectively. As a percentage of total loans, nonperforming loans were 0.84% and 0.94% as of March 31, 2017 and December 31, 2016, respectively.

The Company and the Bank operate in a highly-regulated industry and must plan for the liquidity needs of each entity separately. A variety of sources of liquidity have historically been available to the Bank to meet its short-term and long-term funding needs. Although several of these sources have been limited following execution of the Consent Order (which was terminated on October 26, 2016), management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during 2017 in an effort to ensure that the sources available are sufficient to meet the Bank’s projected liquidity needs for this period.

Prior to the most recent economic downturn, the Company, if needed, would have relied on dividends from the Bank as its primary source of liquidity. The Company is a legal entity separate and distinct from the Bank. However, various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends. In addition, regulatory restrictions remaining following the termination of the Consent Order further limit the Bank’s ability to pay dividends to the Company to satisfy its funding needs.

Management believes the Bank’s liquidity sources are adequate to meet its needs for at least the next 12 months. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3 - INVESTMENT SECURITIES

Securities available-for-sale consisted of the following:

(Dollars in thousands)			Gross Unrealized					Estimated
March 31, 2017	Amortized Cost		Gains		Losses			Fair Value
Government-sponsored enterprises	$	8,315	$	—	$	(72	)	$	8,243
Mortgage-backed securities		84,039		239		(2,228	)		82,050
State and political subdivisions		14,893		18		(863	)		14,048
Total	$	107,247	$	257	$	(3,163	)	$	104,341
December 31, 2016
Government-sponsored enterprises	$	8,489	$	—	$	(80	)	$	8,409
Mortgage-backed securities		86,394		202		(2,598	)		83,998
State and political subdivisions		14,905		14		(797	)		14,122
Total	$	109,788	$	216	$	(3,475	)	$	106,529

The following is a summary of maturities of securities available-for-sale as of March 31, 2017. The amortized cost and estimated fair values are based on the contractual maturity dates. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty.

	Amortized Cost
March 31, 2017(in thousands)	Due Within One Year		After One Through Five Years		After Five Through Ten Years		After Ten Years		Total		Market Value
Investment securities
Government-sponsored enterprises	$	—	$	210	$	2,000	$	6,105	$	8,315	$	8,243
Mortgage-backed securities		—		—		19,761		64,278		84,039		82,050
State and political subdivisions		—		—		13,279		1,614		14,893		14,048
Total	$	—	$	210	$	35,040	$	71,997	$	107,247	$	104,341

The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at:

	March 31, 2017
	Less than twelve months					Twelve months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses			Value		Losses
Government-sponsored enterprises	$	6,137	$	(52	)	$	2,106	$	(20	)	$	8,243	$	(72	)
Mortgage-backed securities		53,208		(1,769	)		14,087		(489	)		67,295		(2,228	)
State and political subdivisions		12,831		(863	)		—		—			12,831		(863	)
Total	$	72,176	$	(2,654	)	$	16,193	$	(509	)	$	88,369	$	(3,163	)

	December 31, 2016
	Less than twelve months					Twelve months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses			Value		Losses			Value		Losses
Government-sponsored enterprises	$	8,161	$	(79	)	$	249	$	(1	)	$	8,410	$	(80	)
Mortgage-backed securities		56,319		(1,986	)		19,069		(612	)		75,388		(2,598	)
State and political subdivisions		12,904		(797	)		—		—			12,904		(797	)
Total	$	77,384	$	(2,862	)	$	19,318	$	(613	)	$	96,702	$	(3,475	)

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3 - INVESTMENT SECURITIES- continued

Management evaluates its investment portfolio periodically to identify any impairment that is other than temporary. At March 31, 2017, the Company had two government-sponsored enterprise securities and 16 mortgage-backed securities that have been in an unrealized loss position for more than twelve months. At December 31, 2016, the Company had one government-sponsored enterprise security and twenty mortgage-backed securities that had been in an unrealized loss position for more than twelve months. Management believes these losses are temporary and are a result of the current interest rate environment. 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.

At March 31, 2017 and December 31, 2016, investment securities with a book value of $42.5 million and $43.8 million, respectively, and a market value of $41.5 million and $42.6 million, respectively, were pledged to secure deposits.

Proceeds from sales of available-for-sale securities were $4.2 million for the three-month period ended March 31, 2016. There were no sales during the three-month period ended March 31, 2017. Gross realized gains and losses on sales of available-for-sale securities for the periods ended were as follows:

(Dollars in thousands)	Three months ended March 31,
	2017		2016
Gross realized gains	$	—	$	17
Gross realized losses		—		—
Net gain	$	—	$	17

NOTE 4 – LOAN PORTFOLIO

Loans consisted of the following:

(Dollars in thousands)	March 31,		December 31,
	2017		2016
Residential	$	73,908	$	71,444
Commercial Real Estate		112,393		104,875
Commercial		37,041		33,800
Consumer		5,691		4,993
Total gross loans	$	229,033	$	215,112

Provision and Allowance for Loan Losses

An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

In evaluating the adequacy of the Company’s loan loss reserves, management identifies loans believed to be impaired. Impaired loans are those not likely to be repaid as to principal and interest in accordance with the terms of the loan agreement. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, or liquidation value and discounted cash flows. Reserves are maintained for each loan in which the principal balance of the loan exceeds the net present value of cash flows. In addition to the specific allowance for individually reviewed loans, a general allowance for potential loan losses is established based on management’s review of the composition of the loan portfolio with the purpose of identifying any concentrations of risk, and an analysis of historical loan charge-offs and recoveries.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

The final component of the allowance for loan losses incorporates management’s evaluation of current economic conditions and other risk factors which may impact the inherent losses in the loan portfolio. These evaluations are highly subjective and require that a great degree of judgmental assumptions be made by management. This component of the allowance for loan losses includes additional estimated reserves for internal factors such as changes in lending staff, loan policy and underwriting guidelines, and loan seasoning and quality, and external factors such as national and local economic trends and conditions. 

During 2016, we introduced certain enhancements to our allowance for loan loss model and methodology that, in management’s opinion, provide a better estimate and an allowance for loan loss which better reflects the inherent loss in the loan portfolio. The most significant enhancement was the implementation of a new third party software for the calculation of the allowance for loan losses. While this change did not result in an overall change in methodology, it did allow management to further analyze the portfolio. Additionally, as we regularly review the look back period being used for the calculation of historical losses. As economic conditions have improved and the overall risk profile of the loan portfolio has changed, it was determined that the historic look back period should be increased to 12 quarters from six quarters to present an estimated risk and loss consistent with expectations. This change in the look back period resulted in an increase in reserves of approximately $570,000 at December 31, 2016.

The following table details the activity within our allowance for loan losses as of and for the three-month periods ended March 31, 2017 and 2016 and as of and for the year ended December 31, 2016, by portfolio segment:

March 31, 2017
(Dollars in thousands)
				Commercial
	Commercial			Real Estate		Consumer			Residential			Total
Allowance for loan losses:
Beginning balance	$	400		$	2,291	$	103		$	956		$	3,750
Charge-offs		(36	)		—		(51	)		(12	)		(99	)
Recoveries		6			12		19			29			66
Provision		66			33		22			(121	)		—
Ending balance	$	436		$	2,336	$	93		$	852		$	3,717
Ending balances:
Individually evaluated for impairment	$	21		$	236	$	6		$	329		$	592
Collectively evaluated for impairment	$	415		$	2,100	$	87		$	523		$	3,125
Loans receivable:
Ending balance, total	$	37,041		$	112,393	$	5,691		$	73,908		$	229,033
Ending balances:
Individually evaluated for impairment	$	1,656		$	10,978	$	88		$	7,171		$	19,893
Collectively evaluated for impairment	$	35,385		$	101,415	$	5,603		$	66,737		$	209,140

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

March 31, 2016
(Dollars in thousands)
				Commercial
	Commercial			Real Estate			Consumer			Residential			Total
Allowance for loan losses:
Beginning balance	$	952		$	2,543		$	80		$	1,026		$	4,601
Charge-offs		(18	)		(2,322	)		(6	)		(33	)		(2,379	)
Recoveries		34			14			7			18			73
Provision		(439	)		1,750			29			84			1,424
Ending balance	$	529		$	1,985		$	110		$	1,095		$	3,719
Ending balances:
Individually evaluated for impairment	$	95		$	518		$	10		$	617		$	1,240
Collectively evaluated for impairment	$	434		$	1,467		$	100		$	478		$	2,479
Loans receivable:
Ending balance, total	$	29,842		$	92,461		$	4,729		$	72,603		$	199,635
Ending balances:
Individually evaluated for impairment	$	2,466		$	19,121		$	118		$	9,248		$	30,953
Collectively evaluated for impairment	$	27,376		$	73,340		$	4,611		$	63,355		$	168,682

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

December 31, 2016

(Dollars in thousands)

				Commercial
	Commercial			Real Estate			Consumer			Residential			Total
Allowance for loan losses:
Beginning balance	$	952		$	2,543		$	80		$	1,026		$	4,601
Charge-offs		(1,132	)		(4,595	)		(72	)		(809	)		(6,608	)
Recoveries		1,382			202			79			171			1,834
Provision		(802	)		4,141			16			568			3,923
Ending balance	$	400		$	2,291		$	103		$	956		$	3,750
Ending balances:
Individually evaluated for impairment	$	25		$	291		$	7		$	320		$	643
Collectively evaluated for impairment	$	375		$	2,000		$	96		$	636		$	3,107
Loans receivable:
Ending balance, total	$	33,800		$	104,875		$	4,993		$	71,444		$	215,112
Ending balances:
Individually evaluated for impairment	$	1,667		$	12,616		$	84		$	7,254		$	21,621
Collectively evaluated for impairment	$	32,133		$	92,259		$	4,909		$	64,190		$	193,491

Loan Performance and Asset Quality

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

The following chart summarizes delinquencies and nonaccruals, by portfolio class, as of March 31, 2017 and December 31, 2016.

March 31, 2017  

(Dollars in thousands)

	30-59 Days		60-89 Days		90+ Days		Total				Total Loans		Non-
	Past Due		Past Due		Past Due		Past Due		Current		Receivable		accrual
Commercial	$	83	$	46	$	16	$	145	$	36,896	$	37,041	$	16
Commercial real estate:
Construction		23		—		—		23		26,174		26,197		20
Other		50		—		1,219		1,269		84,927		86,196		1,407
Real Estate:
Residential		150		—		251		401		73,507		73,908		464
Consumer:
Other		24		3		—		27		5,124		5,151		8
Revolving credit		—		3		—		3		537		540		—
Total	$	330	$	52	$	1,486	$	1,868	$	227,165	$	229,033	$	1,915

December 31, 2016
(Dollars in thousands)
	30-59 Days		60-89 Days		90+ Days		Total				Total Loans		Non-
	Past Due		Past Due		Past Due		Past Due		Current		Receivable		accrual
Commercial	$	82	$	—	$	16	$	98	$	33,702	$	33,800	$	32
Commercial real estate:
Construction		96		—		—		96		22,885		22,981		21
Other		782		—		1,219		2,001		79,893		81,894		1,413
Real Estate:
Residential		86		133		411		630		70,814		71,444		559
Consumer:
Other		34		17		—		51		4,403		4,454		—
Revolving credit		2		—		—		2		537		539		—
Total	$	1,082	$	150	$	1,646	$	2,878	$	212,234	$	215,112	$	2,025

There were no loans outstanding 90 days or more and still accruing interest at March 31, 2017 or December 31, 2016.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

The following table summarizes management’s internal credit risk grades, by portfolio class, as of March 31, 2017 and December 31, 2016.

March 31, 2017

(Dollars in thousands)

	Commercial		Commercial Real Estate		Consumer		Residential		Total
Grade 1 - Minimal	$	1,755	$	—	$	400	$	—	$	2,155
Grade 2 - Modest		813		116		150		661		1,740
Grade 3 -Average		2,131		18,861		134		7,015		28,141
Grade 4 - Satisfactory		23,146		62,213		4,503		46,851		136,713
Grade 5 - Watch		7,081		22,560		310		12,916		42,867
Grade 6 - Special Mention		1,543		1,413		107		1,651		4,714
Grade 7- Substandard		572		7,230		87		4,814		12,703
Grade 8 - Doubtful		—		—		—		—		—
Grade 9- Loss		—		—		—		—		—
Total loans receivable	$	37,041	$	112,393	$	5,691	$	73,908	$	229,033

December 31, 2016
(Dollars in thousands)
			Commercial
	Commercial		Real Estate		Consumer		Residential		Total
Grade 1 - Minimal	$	1,781	$	—	$	383	$	—	$	2,164
Grade 2  -  Modest		934		122		112		573		1,741
Grade 3 - Average		2,226		13,877		84		6,588		22,775
Grade 4 - Satisfactory		19,973		58,149		3,971		45,208		127,301
Grade 5 - Watch		7,125		21,807		234		11,531		40,697
Grade 6 - Special Mention		1,484		900		140		1,517		4,041
Grade 7 - Substandard		277		10,020		69		6,027		16,393
Grade 8 - Doubtful		—		—		—		—		—
Grade 9 - Loss		—		—		—		—		—
Total loans receivable	$	33,800	$	104,875	$	4,993	$	71,444	$	215,112

-24-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

Loans graded one through four are considered “pass” credits. As of March 31, 2017, $168.7 million, or 73.7% of the loan portfolio had a credit grade of “minimal,” “modest,” “average” or “satisfactory.” For loans to qualify for these grades, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

Loans with a credit grade of “watch” and “special mention” are not considered classified; however, they are categorized as a watch list credit and are considered potential problem loans. This classification is utilized by us when there is an initial concern about the financial health of a borrower.  These loans are designated as such in order to be monitored more closely than other credits in the portfolio.  Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of March 31, 2017, loans with a credit grade of “watch” and “special mention” totaled $47.6 million. Watch list loans are considered potential problem loans and are monitored as they may develop into problem loans in the future. 

Loans graded “substandard” or greater are considered classified credits. At March 31, 2017 classified loans totaled $12.7 million, with $12.0 million being collateralized by real estate. Classified credits are evaluated for impairment on a quarterly basis. Loans showing improvement may be upgraded to “watch”.

TDRs at March 31, 2017 were $17.9 million. TDRs totaling $6.8 million were graded as classified loans, of which $5.7 million were considered to be performing at March 31, 2017.

The Company identifies impaired loans through its normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less selling costs, if the loan is collateral dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs), an impairment is recognized by establishing or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value.When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve, if any.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impaired consumer and residential loans are identified for impairment disclosures; however, it is policy to individually evaluate for impairment all loans with a credit grade of “special mention”, “substandard”, “doubtful”, and “loss.” Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral, less any selling costs, or based on the net present value of cash flows. For loans valued based on collateral, market values were obtained using independent appraisals, updated every 18 to 24 months, in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At March 31, 2017, the recorded investment in impaired loans was $19.9 million, compared to $21.6 million at December 31, 2016.

The following chart details our impaired loans by category as of March 31, 2017 and December 31, 2016, respectively:

-25-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO– continued

March 31, 2017
(Dollars in thousands)			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	854	$	910	$	—	$	867	$	15
Commercial real estate		8,107		11,473		—		9,342		106
Residential		4,235		4,428		—		4,987		59
Consumer		45		45		—		46		1
Total:	$	13,241	$	16,856	$	—	$	15,242	$	181
With an allowance recorded:
Commercial		802		802		21		810		8
Commercial real estate		2,871		2,871		236		2,883		40
Residential		2,936		2,936		329		2,942		30
Consumer		43		43		6		43		1
Total:	$	6,652	$	6,652	$	592	$	6,678	$	79
Total:
Commercial		1,656		1,712		21		1,677		23
Commercial real estate		10,978		14,344		236		12,225		146
Residential		7,171		7,364		329		7,929		89
Consumer		88		88		6		89		2
Total:	$	19,893	$	23,508	$	592	$	21,920	$	260

December 31, 2016
(Dollars in thousands)			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
With no related allowance recorded:
Commercial	$	720	$	720	$	—	$	732	$	43
Commercial real estate		9,194		12,597		—		9,332		574
Residential		4,365		4,553		—		4,390		248
Consumer		33		33		—		34		3
Total:	$	14,312	$	17,903	$	—	$	14,488	$	868
With an allowance recorded:
Commercial		947		947		25		956		37
Commercial real estate		3,422		3,422		291		3,433		178
Residential		2,889		2,889		320		2,895		120
Consumer		51		51		7		52		2
Total:	$	7,309	$	7,309	$	643	$	7,336	$	337
Total:
Commercial		1,667		1,667		25		1,688		80
Commercial real estate		12,616		16,019		291		12,765		752
Residential		7,254		7,442		320		7,285		368
Consumer		84		84		7		86		5
Total:	$	21,621	$	25,212	$	643	$	21,824	$	1,205

-26-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 - LOAN PORTFOLIO -continued

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. We only restructure loans for borrowers in financial difficulty that have designed a viable business plan to fully pay off all obligations, including outstanding debt, interest and fees, either by generating additional income from the business or through liquidation of assets. Generally, these loans are restructured to provide the borrower additional time to execute upon their plans.

With respect to restructured loans, we grant concessions by (1) reduction of the stated interest rate for the remaining original life of the debt, or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. We do not generally grant concessions through forgiveness of principal or accrued interest. Restructured loans where a concession has been granted through extension of the maturity date generally include extension of payments in an interest only period, extension of payments with capitalized interest and extension of payments through a forbearance agreement. These extended payment terms are also combined with a reduction of the stated interest rate in certain cases.

Success in restructuring loans has been mixed but it has proven to be a useful tool in certain situations to protect collateral values and allow certain borrowers additional time to execute upon defined business plans. In situations where a TDR is unsuccessful and the borrower is unable to follow through with terms of the restructured agreement, the loan is placed on nonaccrual status and continues to be written down to the underlying collateral value.

Our policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual going forward. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on nonaccrual status.

We will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured note terms. If, after previously being classified as a TDR, a loan is restructured a second time, then that loan is automatically placed on nonaccrual status. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms before that loan can be placed back on accrual status. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. In addition, there are times when a loan previously considered a TDR was restructured under a new agreement that does not qualify as a TDR. This includes restructurings whereby the customer is no longer in financial difficulty and the restructured terms offer no concessions from the original loan terms. During the quarter ended March 31, 2017, there were $1.5 million in TDRs that were restructured into new agreements that no longer qualified as TDRs. We believe that all of our modified loans meet the definition of a TDR. 

-27-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CondensedConsolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO -continued

The following is a summary of information pertaining to our TDRs:

	March 31,		December 31,
(Dollars in thousands)	2017		2016
Nonperforming TDRs	$	1,179	$	1,269
Performing TDRs:
Commercial		1,562		1,635
Commercial real estate		8,860		10,554
Residential		6,257		6,133
Consumer		79		84
Total performing TDRs		16,758		18,406
Total TDRs	$	17,937	$	19,675

The following tables summarize how loans that were considered TDRs were modified during the periods indicated:

For the Three Months ended March 31, 2017

(Dollars in thousands)

	TDRs identified during the period						TDRs identified in the last twelve months that subsequently defaulted(1)
	Number of contracts		Pre- modification outstanding recorded investment		Post modification outstanding recorded investment		Number of contracts		Pre- modification outstanding recorded investment		Post modification outstanding recorded investment
Commercial		—	$	—	$	—		1	$	30	$	30
Residential		4		994		970		—		—		—
Total		4	$	994	$	970		1	$	30	$	30

⁽¹⁾Loans past due 90 days or more are considered to be in default.

During the quarter ended March 31, 2017, four loans were modified that were considered to be TDRs. Term concessions were granted for all four loans and payment deferrals were also granted for one of the loans.

For the Three Months ended March 31, 2016

(Dollars in thousands)

	TDRs identified during the period						TDRs identified in the last twelve months that subsequently defaulted(1)
	Number of contracts		Pre- modification outstanding recorded investment		Post modification outstanding recorded investment		Number of contracts		Pre- modification outstanding recorded investment		Post modification outstanding recorded investment
Commercial		2	$	137	$	137		1	$	106	$	25
Residential		2		135		135		3		413		373
Total		4	$	272	$	272		4	$	519	$	398

⁽¹⁾Loans past due 90 days or more are considered to be in default.

During the quarter ended March 31, 2016, four loans were modified that were considered to be TDRs. Term concessions were granted for all four loans and payment deferrals were also granted for one of the loans.

-28-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 4 - LOAN PORTFOLIO -continued

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charged-off. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

The Company is a 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 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 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 and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The fair value of standby letters of credit is insignificant.

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 payment of a fee. Since some of the commitments are expected to 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 of the counter-party.

Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties. The following table summarizes the Company’s off-balance sheet financial instruments whose contract amounts represent credit risk:

	March 31,		December 31,
(Dollars in thousands)	2017		2016
Commitments to extend credit	$	32,334	$	33,155
Standby letters of credit		1,177		444

-29-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 5 - OTHER REAL ESTATE OWNED

Transactions in OREO for the periods ended March 31, 2017 and December 31, 2016: 

	March 31,			December 31,
(Dollars in thousands)	2017			2016
Balance, beginning of period	$	2,887		$	13,624
Additions		—			796
Sales		(268	)		(5,868	)
Write-downs		(2	)		(5,665	)
Balance, end of period	$	2,617		$	2,887

Increased write-downs were taken during 2016 in an effort to expedite sales to reduce nonperforming assets.

NOTE 6 - ADVANCES FROM THE FEDERAL HOME LOAN BANK

Advances from the FHLB consisted of the following at March 31, 2017:

(Dollars in thousands)	Advance		Advance		Advance			Maturing
	Type		Amount		Rate			On
		Convertible Advance	$	2,000		3.60	%		9/4/18
		Fixed Rate		7,000		1.05	%		10/29/18
		Fixed Rate		5,000		3.86	%		8/20/19
		Fixed Rate		5,000		2.51	%		11/18/20
		Fixed Rate		5,000		2.74	%		11/18/20
			$	24,000

As of March 31, 2017, the Company had advances totaling $24.0 million with various interest rates and maturity dates. Interest on all advances is at a fixed rate and payable quarterly. Convertible advances are callable by the FHLB on their respective call dates. The Company has the option to either repay any advance that has been called or to refinance the advance as a convertible advance.

At March 31, 2017, the Company had pledged as collateral for FHLB advances approximately $4.9 million of one-to-four family first mortgage loans, $3.4 million of commercial real estate loans, $4.6 million in home equity lines of credit, $218 thousand of multi-family loans, and $17.7 million of agency and private issue mortgage-backed securities. The Company has an investment in FHLB stock of $1.4 million. The Company has $70.0 million in excess borrowing capacity with the FHLB that is available if liquidity needs should arise. As a result of negative financial performance indicators, there is also a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated, although to date the Bank has not been denied advances from the FHLB or had to pledge additional collateral for its borrowings.

As of March 31, 2017, scheduled principal reductions include $9.0 million in 2018, $5.0 million in 2019 and $10.0 million in 2020. 

-30-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS

Preferred Stock

Series T- In March 2009, in connection with the U.S. Treasury’s Capital Purchase Program (the “CPP”), the Company issued to the U.S. Treasury 12,895 shares of the Company’s fixed rate cumulative perpetual preferred stock, Series T (the “Series T preferred stock”). The Series T preferred stock had a dividend rate of 5% for the first five years and 9% thereafter, and had a call feature after three years. In connection with the sale of the Series T preferred stock, the Company also issued to the U.S. Treasury a warrant to purchase up to 91,714 shares of the Company’s common stock at an initial exercise price of $21.09 per share (the “CPP Warrant”).

The Series T preferred stock and the CPP Warrant were sold to the U.S. Treasury for an aggregate purchase price of $12.9 million in cash. The purchase price was allocated between the Series T preferred stock and the CPP Warrant based upon the relative fair values of each to arrive at the amounts recorded by the Company. This resulted in the Series T preferred stock being issued at a discount which was amortized on a level yield basis as a charge to retained earnings over an assumed life of five years.

As required under the CPP, dividend payments on and repurchases of the Company’s common stock were subject to certain restrictions. For as long as the Series T preferred stock was outstanding, no dividends could be declared or paid on the Company’s common stock until all accrued and unpaid dividends on the Series T preferred stock were fully paid. In addition, the U.S. Treasury’s consent was required for any increase in dividends on common stock before the third anniversary of issuance of the Series T preferred stock and for any repurchase of any common stock except for repurchases of common shares in connection with benefit plans.

Beginning in February 2011, the Federal Reserve Bank of Richmond required the Company to defer dividend payments on the 12,895 shares of the Series T preferred stock. Therefore, for each quarterly period beginning in February 2011, the Company notified the U.S. Treasury of its deferral of quarterly dividend payments on the Series T preferred stock. The amount of each of the Company’s quarterly interest payments was approximately $161 thousand through March 2014 and then increased to $290 thousand. At the time the shares were repurchased on April 12, 2016, as described below, the Company had $5.1 million of deferred dividend payments due on the Series T preferred stock, $398 thousand of which had previously been shown as accrued preferred dividends on the Company’s statement of operations for 2016.

On April 11, 2016, the Company repurchased all 12,895 shares of the outstanding Series T preferred stock from the U.S. Treasury for $129 thousand. The U.S. Treasury also canceled the CPP Warrant. The redemption gain realized on this settlement was approximately $13.8 million and was recorded in retained earnings and net income available to common shareholders.

Series A– As previously disclosed, on April 1, 2016, the Company designated 905,316 shares of the Company’s authorized but unissued preferred stock as shares of Series A preferred stock. On April 11, 2016, the Company issued 359,468,443 shares of common stock at $0.10 per share and 905,316 shares of its Series A stock at $10.00 per share in a private placement. A portion of the net proceeds from the private placement were used to repurchase the Company’s outstanding Series T preferred stock.

Non-Voting Common Stock - On August 23, 2016, the Company filed Articles of Amendment to the Company’s Articles of Incorporation to authorize a class of 150,000,000 shares of non-voting common stock. Also on August 23, 2016, the Company converted 905,316 shares of issued and outstanding Series A preferred stock into 90,531,557 shares of non-voting common stock. The 905,316 shares of Series A preferred stock converted into 90,531,557 shares of non-voting common stock represented all of the issued and outstanding shares of Series A preferred stock on such date and, as a result, all shares of the Series A preferred stock are no longer outstanding and resumed the status of authorized and unissued shares of the Company’s preferred stock.

Restrictions on Dividends - The Company is a legal entity separate and distinct from the Bank and has little direct income itself, and therefore relies on dividends paid to it by the Bank in order to pay dividends on its common stock. As a South Carolina state bank, the Bank may only pay dividends out of its net profits, after deducting expenses, including losses and bad debts. Under the Federal Deposit Insurance Corporation Act (“FDICIA”), the Bank may not pay a dividend if, after paying the dividend, the Bank would be undercapitalized. In addition, the Bank is still subject to regulatory restrictions that prohibit it from paying dividends without the prior approval of the Federal Reserve Bank of Richmond, FDIC and State Board.

-31-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 7 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

Regulatory Capital - The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

Regulatory capital rules released in July 2013 to implement capital standards, referred to as Basel III and developed by an international body known as the Basel Committee on Banking Supervision, impose higher minimum capital requirements for bank holding companies and banks. The rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies with more than $1 billion in total consolidated assets. More stringent requirements are imposed on “advanced approaches” banking organizations-those organizations with $250 billion or more in total consolidated assets, $10 billion or more in total foreign exposures, or that have opted in to the Basel II capital regime. The requirements in the rule began to phase in on January 1, 2015 for the Bank, and the requirements in the rule will be fully phased in by January 1, 2019.

The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets (“CET1”) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to the risk weights for certain assets and off-balance sheet exposures. Finally, CET1 includes accumulated other comprehensive income (which includes all unrealized gains and losses on available-for-sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

The new capital conservation buffer began its phase-in period on January 1, 2016 at 0.625% of risk-weighted assets and will increase each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019, as discussed above. The Bank had sufficient capital to meet the new conservation buffer requirements (1.25% of risk-weighted assets) at March 31, 2017.

To be considered “well-capitalized,” a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. The Bank is subject to additional requirements to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%.

At March 31, 2017, the Company and Bank exceeded minimum regulatory capital requirements.

-32-

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 7 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

The following table summarizes the capital ratios and the regulatory minimum requirements for the Company and the Bank.

	Actual					Minimum Capital Requirement					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
(Dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
March 31, 2017
The Company
Total Capital (to Risk-Weighted Assets)	$	42,266		16.27	%	$	20,788		8.00	%		N/A		N/A
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	39,018		15.02	%	$	11,693		4.50	%		N/A		N/A
Tier 1 Capital (to Risk-Weighted Assets)	$	39,018		15.02	%	$	10,394		4.00	%		N/A		N/A
Tier 1 Capital (to Average Assets)	$	39,018		10.29	%	$	15,178		4.00	%		N/A		N/A
The Bank
Total Capital (to Risk-Weighted Assets)(1)	$	41,429		15.94	%	$	20,787		8.00	%	$	25,984		10.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	38,175		14.69	%	$	11,693		4.50	%		16,889		6.50	%
Tier 1 Capital (to Risk-Weighted Assets)	$	38,175		14.69	%	$	15,590		6.00	%		20,787		8.00	%
Tier 1 Capital (to Average Assets)(1)	$	38,175		10.08	%	$	15,146		4.00	%	$	30,292		8.00	%
December 31, 2016
The Company
Total Capital (to Risk-Weighted Assets)	$	41,697		16.80	%	$	19,861		8.00	%		N/A		N/A
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	38,586		15.54	%	$	9,930		4.50	%		N/A		N/A
Tier 1 Capital (to Risk-Weighted Assets)	$	38,586		15.54	%	$	9,930		4.00	%		N/A		N/A
Tier 1 Capital (to Average Assets)	$	38,586		10.15	%	$	15,200		4.00	%		N/A		N/A
The Bank
Total Capital (to Risk-Weighted Assets)(1)	$	40,833		16.44	%	$	19,865		8.00	%	$	24,832		10.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	37,721		15.19	%	$	11,174		4.50	%		16,141		6.50	%
Tier 1 Capital (to Risk-Weighted Assets)	$	37,721		15.19	%	$	14,899		6.00	%		19,865		8.00	%
Tier 1 Capital (to Average Assets)(1)	$	37,721		9.95	%	$	15,162		4.00	%	$	30,324		8.00	%

⁽¹⁾ Minimum capital amounts and ratios presented as of March 31, 2017 and December 31, 2016, are amounts to be well-capitalized under the various regulatory capital requirements administered by the FDIC which includes maintaining Tier 1 leverage capital at least equal to 8% and total risk-based capital at least equal to 10%.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 8 - INCOME (LOSS) PER SHARE

(Dollars in thousands, except per share amounts)	Three Months ended March 31,
	2017		2016
Basic income (loss) per common share:
Net income (loss) available to common shareholders	$	293	$	(3,681	)
Weighted average common shares outstanding - basic		468,013,940		3,846,340
Basic income (loss) per common share	$	0.00	$	(0.96	)
Diluted income (loss) per common share:
Net income (loss) available to common shareholders	$	293	$	(3,681	)
Weighted average common shares outstanding - basic		468,013,940		3,846,340
Incremental shares		1,040,625		—
Weighted average common shares outstanding - diluted		469,054,565		3,846,340
Diluted income (loss) per common share	$	0.00	$	(0.96	)

For the three-month period ended March 31, 2016, there were 91,714 common stock equivalents outstanding which were not included in the diluted calculation because the effect would have been anti-dilutive. No common stock equivalents were excluded from the calculation for the three-month period ended March 31, 2017.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE

Fair Value Hierarchy

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Fair value estimates are made at a specific point in time based on relevant market and other information about the financial instruments. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on current economic conditions, risk characteristics of various financial instruments, and such other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Accounting principles establish a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:

Level 1	Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries and money market funds.
Level 2	Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage-backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes certain derivative contracts and impaired loans.
Level 3	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, retained residual interests in securitizations, residential mortgage servicing rights, and highly-structured or long-term derivative contracts.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

Financial Instruments

The following methods and assumptions were used to estimate the fair value of significant financial instruments:

Cash and Cash Equivalents- The carrying amount is a reasonable estimate of fair value.

Securities Available-for-Sale- Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is 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.

Nonmarketable Equity Securities- The carrying amount is a reasonable estimate of fair value since no ready market exists for these securities.

Loans Receivable- For certain categories of loans, such as variable rate loans which are repriced frequently and have no significant change in credit risk, fair values are based on the carrying amounts. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to the borrowers with similar credit ratings and for the same remaining maturities.

Deposits- The fair value of demand deposits, savings, and money market accounts is the amount payable on demand at the reporting date. The fair values of certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates to a schedule of aggregated expected maturities.

Repurchase Agreements– The carrying value of these instruments is a reasonable estimate of fair value.

Advances from the Federal Home Loan Bank- For the portion of borrowings immediately callable, fair value is based on the carrying amount. The fair value of the portion maturing at a later date is estimated using a discounted cash flow calculation that applies the interest rate of the immediately callable portion to the portion maturing at the future date.

Off-Balance Sheet Financial Instruments- The contractual amount is a reasonable estimate of fair value for the instruments because commitments to extend credit and standby letters of credit are issued on a short-term or floating rate basis and include no unusual credit risks.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

The carrying values and estimated fair values of the Company’s financial instruments were as follows:

March 31, 2017					Fair Value Measurements
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted market price in active markets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial Assets:
Cash and cash equivalents	$	22,190	$	22,190	$	22,190	$	—	$	—
Securities available-for-sale		104,341		104,341		—		104,341		—
Nonmarketable equity securities		1,359		1,359		—		—		1,359
Loans, net		225,316		225,227		—		—		225,227
Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts		195,776		195,776		195,776		—		—
Certificates of deposit		126,563		126,172		—		126,172		—
Repurchase agreements		848		848		—		848		—
Advances from the Federal Home Loan Bank		24,000		24,307		—		24,307		—

		Notional	Estimated
		Amount	Fair Value
Off-Balance Sheet FinancialInstruments:
Commitments to extend credit	$	32,334	n/a
Standby letters of credit		1,177	n/a

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE-continued

December 31, 2016					Fair Value Measurements
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted market price in active markets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial Assets:
Cash and cash equivalents	$	25,429	$	25,429	$	25,429	$	—	$	—
Securities available-for-sale		106,529		106,529		—		106,529		—
Nonmarketable equity securities		1,345		1,345		—		—		1,345
Loans, net		211,362		211,278		—		—		211,278
Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts		167,038		167,038		167,038		—		—
Certificates of deposit		146,231		145,779		—		145,779		—
Repurchase agreements		1,983		1,983		—		1,983		—
Advances from the Federal Home Loan Bank		24,000		24,307		—		24,307		—

	Notional		Estimated
	Amount		Fair Value
Off-Balance Sheet Financial Instruments:
Commitments to extend credit	$	33,155		n/a
Standby letters of credit		444		n/a

Fair Value Measurements

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Securities Available-for-Sale - Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is 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. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets. All available-for-sale investment security fair values were based on quoted market prices and therefore classified as Level 2 for the periods presented. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

Loans - The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific allowance represents loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. The fair value of Impaired Loans is generally based on judgment and therefore classified as nonrecurring Level 3.

Other Real Estate Owned - OREO is adjusted to fair value upon transfer of the loans to OREO. Real estate acquired in settlement of loans is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional allowances, which are charges to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. The fair value of OREO is generally based on judgment and therefore is classified as nonrecurring Level 3.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis as of and for the periods ended March 31, 2017 and December 31, 2016, by level within the fair value hierarchy.

			Quoted prices in		Significant
			active markets		Other		Significant
			for identical		Observable		Unobservable
(Dollars in thousands)			assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
March 31, 2017
Assets:
Government-sponsored enterprises	$	8,243	$	—	$	8,243	$	—
Mortgage-backed securities		82,050		—		82,050		—
State and political subdivisions		14,048		—		14,048		—
Total	$	104,341	$	—	$	104,341	$	—
December 31, 2016
Assets:
Government-sponsored enterprises	$	8,409	$	—	$	8,409	$	—
Mortgage-backed securities		83,998		—		83,998		—
State and political subdivisions		14,122		—		14,122		—
Total	$	106,529	$	—	$	106,529	$	—

The Company has no liabilities measured at fair value on a recurring basis.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following tables present the assets and liabilities carried on the balance sheet by caption and by level within the valuation hierarchy described above for which a nonrecurring change in fair value has been recorded.

			Quoted prices in		Significant
			active markets		Other		Significant
(Dollars in thousands)			for identical		Observable		Unobservable
			assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
March 31, 2017
Assets:
Impaired loans, net of valuation allowance	$	19,301	$	—	$	—	$	19,301
Other real estate owned		2,617		—		—		2,617
Total	$	21,918	$	—	$	—	$	21,918
December 31, 2016
Assets:
Impaired loans, net of valuation allowance	$	20,978	$	—	$	—	$	20,978
Other real estate owned		2,887		—		—		2,887
Total	$	23,865	$	—	$	—	$	23,865

The Company has no liabilities measured at fair value on a nonrecurring basis.

Level 3 Valuation Methodologies

The fair value of impaired loans is estimated using one of several methods, including collateral value and discounted cash flows and, in rare cases, the market value of the note. Those impaired loans not requiring an allowance represent loans for which the net present value of the expected cash flows or fair value of the collateral less costs to sell exceed the recorded investments in such loans. When the fair value of the collateral is based on an executed sales contract with an independent third party, the Company records the impaired loan as nonrecurring Level 1. If the collateral is based on another observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or the Company determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans can be evaluated for impairment using the present value of expected future cash flows discounted at the loan’s effective interest rate. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

Foreclosed real estate is carried at fair value less estimated selling costs. Fair value is generally based upon current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for selling costs. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the asset as nonrecurring Level 2. However, the Company also considers other factors or recent developments which could result in adjustments to the collateral value estimates indicated in the appraisals such as changes in absorption rates or market conditions from the time of valuation. In situations where management adjustments are significant to the fair value measurements in its entirety, such measurements are classified as Level 3 within the valuation hierarchy.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at March 31, 2017. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

(Dollars in thousands)
	March 31,		Valuation	Unobservable	Range
	2017		Techniques	Inputs	(Weighted Avg)
Impaired loans:
Commercial	$	1,635	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(3.71	%)
Commercial real estate		10,742	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(7.39	%)
Residential		6,842	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(8.36	%)
Consumer		82	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-25.14	%
			Flows	Independent quotes		(4.39	%)
Other real estate owned		2,617	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(10.00	%)

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Notes to unaudited CONDENSED Consolidated Financial Statements

NOTE 9 - FAIR VALUE -continued

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2016. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

(Dollars in thousands)
	December 31,		Valuation	Unobservable	Range
	2016		Techniques	Inputs	(Weighted Avg)
Impaired loans:
Commercial	$	1,642	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-23.50	%
			Flows	Independent quotes		(4.00	%)
Commercial real estate		12,325	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(6.72	%)
Residential		6,934	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(8.05	%)
Consumer		77	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(1.25	%)
Other real estate owned		2,887	Appraised Value/ Discounted Cash	Appraisals and/or sales of comparable properties/		0.00%-10.00	%
			Flows	Independent quotes		(10.00	%)

NOTE 10 - COMMITMENTS AND CONTINGENCIES

In the ordinary course of business, the Company may, from time to time, become a party to legal claims and disputes. In 2012, the Company and the Bank received subpoenas from the office of SIGTARP and has fully responded to all of the subpoenas and provided testimony. At March 31, 2017, The Company and the Bank believe that the investigation will not have a material adverse effect on the financial condition or operation of the Company. Management was not aware of any other pending or threatened litigation or unassisted claims that could result in losses, if any, that would be material to the financial statements. The details of the matter above is included in “Legal Proceedings” under Part II, Item 1 of this Form 10-Q. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 11 - 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 the date the financial statements were issued and the following subsequent events occurred requiring accrual or disclosure that are not otherwise disclosed herein.

On April 19, 2017, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with United Community Banks, Inc. (“United”), the holding company for United Community Bank, Blairsville, Georgia. Under the Merger Agreement, the Company will merge with and into United and Horry County State Bank will merge with and into United Community Bank.

Under the terms and subject to the conditions of the Merger Agreement, at the effective time of the Merger (the “Effective Time”), outstanding shares of the Company’s voting common stock and non-voting common stock will be converted into the right to receive 0.0050 shares of United’s common stock, $1.00 per value per share, together with cash in lieu of any fractional shares. The Merger Agreement also includes provisions that address the treatment of the outstanding equity awards of the Company in the merger.

The Merger Agreement has been unanimously approved by the boards of directors of each of the Company and United. The closing of the merger is subject to the required approval of the Company’s shareholders, requisite regulatory approvals, the effectiveness of the registration statement to be filed by United with respect to United’s common stock to be issued in the merger, and other customary closing conditions. The parties anticipate closing the merger during the third quarter of 2017. 

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

INTRODUCTION

The following discussion describes our results of operations for the three months ended March 31, 2017 as compared to the three months ended March 31, 2016 and also analyzes our financial condition as of March 31, 2017 as compared to December 31, 2016. The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the SEC.

OVERVIEW

For the three months ended March 31, 2017, the Company had net income of $293 thousand compared to a net loss of $3.3 million for the three months ended March 31, 2016. The change was primarily the result of write-downs on OREO of $1.4 million and a $1.4 million provision for loan losses recognized in the first quarter of 2016. In an effort to reduce nonperforming assets, the Bank recognized significant write downs on OREO during 2016 to expedite sales.

Total assets at March 31, 2017 were $384.0 million, an increase of $8.1 million from $375.9 million at December 31, 2016. Total loans increased $13.9 million while cash and cash equivalents and securities available-for-sale decreased $3.2 million and $2.2 million, respectively. Total deposits increased $9.1 million during the three months ended March 31, 2017. Money market savings accounts increased $25.6 million as part of a strategic deposit campaign.

On April 19, 2017, the Company entered into the Merger Agreement with United, pursuant to which the Company will merge with and into United and Horry County State Bank will merge with and into United Community Bank. The closing of the merger is subject to the required approval of the Company’s shareholders, requisite regulatory approvals, the effectiveness of the registration statement to be filed by United with respect to United’s common stock to be issued in the merger, and other customary closing conditions. The parties anticipate closing the merger during the third quarter of 2017. For more information on the merger with United, see Note 11 to our Unaudited Condensed Consolidated Financial Statements.

RESULTS OF OPERATIONS

Results of Operations for the Three Months ended March 31, 2017 and 2016

Total interest income increased $270 thousand for the three months ended March 31, 2017 primarily related to increased loan volume which resulted in an increase of $241 thousand, or 9.7%, to interest earned on loans for the period. The redemption of the subordinated promissory notes and the junior subordinated debentures in the second quarter of 2016 primarily provided for a decrease to total interest expense of $409 thousand, or 39.1%, for the three-month period in 2017 compared to the three-month period in 2016. Net interest income increased $679 thousand for the three months ended March 31, 2017 compared to the three months ended March 31, 2016.

The provision for loan losses is charged to earnings based upon management’s evaluation of specific loans in its portfolio and general economic conditions and trends in the marketplace. Please refer to the section “Loan Portfolio” for a discussion of management’s evaluation of the adequacy of the allowance for loan losses. No provision was considered necessary for the three-month period ended March 31, 2017. A provision for loan losses of $1.4 million was recognized for the first quarter of 2016.

Noninterest income decreased $3 thousand or 0.7% for the three months ended March 31, 2017 as compared to the three months ended March 31, 2016. No gain was recognized on sales of securities available-for-sale for the first quarter of 2017 compared to $17 thousand for the first quarter of 2016. Mortgage loan income and other fees and commissions increased $31 thousand and $19 thousand, respectively.

Noninterest expense decreased from $4.2 million for the three months ended March 31, 2016 to $2.7 million for the three months ended March 31, 2017 due to decreased costs of operations of OREO. The Company recognized increased write-downs on OREO during 2016 in an effort to expedite sales to reduce nonperforming assets. Salaries and employee benefits increased $274 thousand while FDIC insurance premiums decreased $265 thousand for the three months ended March 31, 2017 as a direct result of removal of the Consent Order.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

FINANCIAL CONDITION

Investment Portfolio

Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold them until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held-to-maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. As of March 31, 2017 and December 31, 2016, all securities were classified as available-for-sale.

The portfolio of available-for-sale securities decreased $2.2 million, or 2.1%, from $106.5 million at December 31, 2016 to $104.3 million at March 31, 2017. Our securities portfolio consists primarily of high quality mortgage securities, government agency bonds, and high quality municipal bonds.

The following tables summarize the carrying value of investment securities as of the indicated dates and the contractual maturities and weighted-average yields of those securities at March 31, 2017.

March 31, 2017(in thousands)	Amortized Cost Due
	Due			After One			After Five
	Within			Through			Through			After Ten			Market
	One Year			Five Years			Ten Years			Years			Total			Value
Investment securities
Government-sponsored enterprises	$	—		$	210		$	2,000		$	6,105		$	8,315		$	8,243
Mortgage-backed securities		—			—			19,761			64,278			84,039			82,050
State and political subdivisions		—			—			13,279			1,614			14,893			14,048
Total	$	—		$	210		$	35,040		$	71,997		$	107,247		$	104,341
Weighted average yields
Government-sponsored enterprises		—	%		2.97	%		2.13	%		1.55	%
Mortgage-backed securities		—	%		—	%		2.12	%		1.88	%
State and political subdivisions		—	%		—	%		2.37	%		3.16	%
Total		—	%		2.97	%		2.21	%		1.88	%		1.99	%

	Book		Market
December 31, 2016(in thousands)	Value		Value
Investment securities
Government-sponsored enterprises	$	8,489	$	8,409
Mortgage-backed securities		86,394		83,998
States and political subdivisions		14,905		14,122
Total	$	109,788	$	106,529

Loan Portfolio

The removal of the Consent Order and improved capital ratios allowed the Bank to focus on loan growth during the first three months of 2017, increasing the loan portfolio by $13.9 million. The following table sets forth the composition of the loan portfolio by category as of March 31, 2017 and December 31, 2016.

	March 31,		December 31,
	2017		2016
(Dollars in thousands)
Real estate:
Commercial construction and land development	$	26,197	$	22,981
Other commercial real estate		86,196		81,894
Residential construction		943		731
Other residential		72,965		70,713
Commercial and industrial		37,041		33,800
Consumer		5,691		4,993
	$	229,033	$	215,112

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Loan Portfolio-continued

The primary component of our loan portfolio is loans collateralized by real estate, which made up approximately 81.3% of our loan portfolio at March 31, 2017. These loans are secured generally by first or second mortgages on residential, agricultural or commercial property. Commercial loans and consumer loans accounted for 16.2% and 2.5%, respectively, of the loan portfolio at March 31, 2017.

Risk Elements

The recent economic recession resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declined real estate market during this time had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. While economic conditions and real estate in our primary markets have improved since the end of the economic recession, there can be no assurance that this improvement will continue or that our local markets will not experience another economic decline. Deterioration in the real estate market could cause us to adjust our opinion of the level of credit quality in our loan portfolio. Such a determination may lead to an additional increase in our provision for loan losses, which could also adversely affect our business, financial condition, and results of operations.

Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees.

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. If the borrower is able to bring the account current and establish a pattern of keeping the loan current for a specified time period, the loan is then placed back on regular accrual status.

For loans to be in excess of 90 days delinquent and still accruing interest, the borrowers must be either remitting payments although not able to get current, liquidation on loans deemed to be well secured must be near completion, or the Company must have a reason to believe that correction of the delinquency status by the borrower is near. The amount of both nonaccrual loans and loans past due 90 days or more were considered in computing the allowance for loan losses.

Nonperforming loans include nonaccrual loans and loans past due 90 days or more and still accruing interest. Nonperforming assets include nonperforming loans plus other real estate that we own as a result of loan foreclosures.

Nonperforming loans were $1.9 million or 0.8% of total loans at March 31, 2017 compared to nonperforming loans at December 31, 2016 of $2.0 million or 0.9% of total loans.

At March 31, 2017, nonperforming assets were $4.5 million compared to $4.9 million at December 31, 2016. As a percentage of total assets, nonperforming assets were 1.2% and 1.3% as of March 31, 2017 and December 31, 2016, respectively.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Loan Portfolio- continued

The following table summarizes nonperforming assets:

	March 31,			December 31,
Nonperforming Assets	2017			2016
(Dollars in thousands)
Nonaccrual loans	$	1,915		$	2,025
Loans past due 90 days or more and still accruing interest		—			—
Total nonperforming loans		1,915			2,025
Other real estate owned		2,617			2,887
Total nonperforming assets	$	4,532		$	4,912
Nonperforming assets to total assets		1.18	%		1.31	%
Nonperforming loans to total loans		0.84	%		0.94	%

We identify impaired loans through our normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs), an impairment is recognized by establishing or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve, if any.

Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral, less any selling costs, or based on the net present value of cash flows. For loans valued based on collateral, market values were obtained using independent appraisals, updated every 18 to 24 months, in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At March 31, 2017, the recorded investment in impaired loans was $19.9 million, compared to $21.6 million at December 31, 2016.

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.

At March 31, 2017 and December 31, 2016, the principal balance of TDRs totaled $17.9 million and $19.7 million, respectively. At March 31, 2017, $16.7 million of these restructured loans were performing as expected under the new terms and $1.2 million were considered to be nonperforming and evaluated for reserves on the basis of the fair value of the collateral. At December 31, 2016, $18.4 million of these restructured loans were performing as expected and $1.3 million were considered to be nonperforming. A TDR can be removed from nonperforming status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Loan Portfolio- continued

A rollforward of TDRs for the three months ended March 31, 2017 and for the year ended December 31, 2016 is presented below:

	March 31,			December 31,
TDRs	2017			2016
(Dollars in thousands)
Balance, beginning of period	$	19,675		$	29,062
New TDRs and advances		970			1,893
Repayments		(1,637	)		(3,642	)
Reclassified		(1,055	)		(2,163	)
Charged-off and foreclosed TDRs		(16	)		(2,579	)
Sold		—			(2,896	)
Balance, end of period	$	17,937		$	19,675

Provision and Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged to expense on our statements of operations. The allowance represents an amount which management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. We do not allocate specific percentages of our allowance for loan losses to the various categories of loans but evaluate the adequacy on an overall portfolio basis utilizing several factors. The primary factor considered is the credit risk grading system, which is applied to each loan. The amount of both nonaccrual loans and loans past due 90 days or more is also considered. The historical loan loss experience, the size of our lending portfolio, changes in the lending policies and procedures, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons, and current and anticipated economic conditions are also considered in determining the provision for loan losses. The amount of the allowance is adjusted periodically based on changing circumstances. Recognized losses are charged to the allowance for loan losses, while subsequent recoveries are added to the allowance.

We regularly monitor past due and classified loans. However, it should be noted that no assurances can be made that future charges to the allowance for loan losses or provisions for loan losses may not be significant to a particular accounting period.

Our judgment as to the adequacy of the allowance is based upon a number of assumptions about future events which we believe to be reasonable, but which may or may not prove to be accurate. Because of the inherent uncertainty of assumptions made during the evaluation process, there can be no assurance that loan losses in future periods will not exceed the allowance for loan losses or that additional allocations will not be required. Our losses will undoubtedly vary from our estimates, and there is a possibility that charge-offs in future periods will exceed the allowance for loan losses as estimated at any point in time.

During 2016, we introduced certain enhancements to our allowance for loan loss model and methodology that, in management’s opinion, provide a better estimate and an allowance for loan loss which better reflects the inherent loss in the loan portfolio. The most significant enhancement was the implementation of a new third party software for the calculation of the allowance for loan losses. While this change did not result in an overall change in methodology, it did allow management to further analyze the portfolio. Additionally, as we regularly review the look back period being used for the calculation of historical losses, we determined that the historic look back period for all loan types should be increased to 12 quarters. During 2012, the Bank changed the historic look back period from 12 quarters to six quarters as management believed this reduced look back period more accurately reflected the loss history of the loan portfolio during those stressed economic conditions. As economic conditions have improved and the overall risk profile of the loan portfolio has changed, it was determined that the historic look back period should be increased back to 12 quarters to present an estimated risk and loss consistent with expectations. This change in the look back period resulted in an increase in reserves of approximately $570,000 at December 31, 2016.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Provision and Allowance for Loan Losses -continued

At March 31, 2017, the allowance for loan losses was $3.7 million or 1.62% of total loans compared to $3.8 million or 1.74% of total loans as of December 31, 2016. Loan charge-offs of $99 thousand were recognized in the first quarter of 2017 compared to $2.4 million in the first quarter of 2016. A significant portion of charge-offs in 2016 consisted of one relationship. Due to the charge-offs in the first quarter of 2016, the Company recognized a provision for loan losses of $1.4 million. No such provision was considered necessary for the first three months of 2017. Reserves specifically set aside for impaired loans of $592 thousand and $643 thousand were included in the allowance as of March 31, 2017 and December 31, 2016, respectively. Management believes the allowance is adequate. The following table summarizes the activity related to our allowance for loan losses.

Summary of Loan Loss Experience	Three			Three
	months			months			Year
	ended			ended			ended
(Dollars in thousands)	March 31,			March 31,			December 31,
	2017			2016			2016
Total loans outstanding at end of period	$	229.033		$	199,635		$	215,112
Allowance for loan losses, beginning of period	$	3,750		$	4,601		$	4,601
Charge offs:
Real estate		(12	)		(2,355	)		(5,404	)
Commercial		(36	)		(18	)		(1,132	)
Consumer		(51	)		(6	)		(72	)
Total charge-offs		(99	)		(2,379	)		(6,608	)
Recoveries:
Real estate		41			32			373
Commercial		6			34			1,382
Consumer		19			7			79
Total recoveries		66			73			1,834
Net charge-offs		(33	)		(2,306	)		(4,774	)
Provision charged to operations		—			1,424			3,923
Allowance for loan losses at end of period	$	3,717		$	3,719		$	3,750
Ratios:
Allowance for loan losses to loans at end of period		1.62	%		1.86	%		1.74	%
Net charge-offs to allowance for loan losses		0.89	%		62.01	%		127.31	%
Net charge-offs to provisions for loan losses		n/a			161.94	%		121.69	%

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Advances from the Federal Home Loan Bank

The following table summarizes the Company’s FHLB borrowings for the three months ended March 31, 2017 and for the year ended December 31, 2016.

	Maximum				Weighted
	Outstanding				Average			Period
	at any		Average		Interest			End
(Dollars in thousands)	Month End		Balance		Rate			Balance
March 31, 2017
Advances from Federal Home Loan Bank	$	24,000	$	24,000		2.50	%	$	24,000
December 31, 2016
Advances from Federal Home Loan Bank	$	24,000	$	18,186		2.50	%	$	24,000

Advances from the FHLB are collateralized by one-to-four family residential mortgage loans, certain commercial real estate loans, certain securities in the Bank’s investment portfolio and the Company’s investment in FHLB stock. Although we expect to continue using FHLB advances as a secondary funding source, core deposits will continue to be our primary funding source. As a result of negative financial performance indicators, there is a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated. Although to date the Bank has not been denied advances from the FHLB, the Bank has had its collateral maintenance requirements altered to reflect the increase in our credit risk. Thus, we can make no assurances that this funding source will continue to be available to us.

Capital Resources

Total shareholders’ equity increased $785 thousand from $35.3 million at December 31, 2016 to $36.1 million at March 31, 2017. The Company recognized net income of $293 thousand for the quarter in addition to stock-based compensation expense of $139 thousand and lower unrealized losses on our available-for-sale securities, which are included in accumulated other comprehensive loss.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Capital Resources –continued

In July 2013, the federal bank regulatory agencies issued a final rule that has revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The final rule applies to all depository institutions, such as the Bank, top-tier bank holding companies with total consolidated assets of more than $1 billion and top-tier savings and loan holding companies, which we refer to below as “covered” banking organizations. Bank holding companies with $1 billion or less in total consolidated assets, such as the Company, are not subject to the final rule. Effective March 31, 2016, the Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules).

The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets (“CET1”) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to the risk weights for certain assets and off-balance sheet exposures. Finally, CET1 includes accumulated other comprehensive income (which includes all unrealized gains and losses on available-for-sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “well-capitalized” under these requirements, a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 8%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 6% being Tier 1 capital. In addition, a bank must maintain a minimum Tier 1 leverage ratio of at least 4%.

The terminated Consent Order required the Bank to achieve and maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. Although the Bank is no longer subject to the Consent Order as of its termination on October 26, 2016, the Bank must continue to maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%.

If a bank is not well capitalized, it cannot accept brokered deposits without prior FDIC approval. In addition, a bank that is not well capitalized cannot offer an effective yield in excess of 75 basis points over interest paid on deposits of comparable size and maturity in such institution’s normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the Bank’s normal market area. Moreover, the FDIC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be categorized as undercapitalized. Undercapitalized institutions are subject to growth limitations (an undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDIC determines that the proposed action will further the purpose of prompt corrective action) and are required to submit a capital restoration plan. The agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of an amount equal to 5.0% of the depository institution’s total assets at the time it became categorized as undercapitalized or the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is categorized as significantly undercapitalized.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Capital Resources–continued

Significantly undercapitalized categorized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become categorized as adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause a bank to become undercapitalized, it could not pay a management fee or dividend to the bank holding company.

The following table summarizes the capital amounts and ratios of the Company and the Bank at March 31, 2017 and December 31, 2016.

	March 31,			December 31,
	2017			2016
(Dollars in thousands)
The Company
Tier 1 capital	$	39,018		$	38,586
Tier 2 capital		3,248			3,111
Total qualifying capital	$	42,266		$	41,697
Risk-adjusted total assets
(including off-balance sheet exposures)	$	259,844		$	248,261
Common equity Tier 1 capital ratio		15.02	%		15.54	%
Tier 1 risk-based capital ratio		15.02	%		15.54	%
Total risk-based capital ratio		16.27	%		16.80	%
Tier 1 leverage ratio		10.29	%		10.15	%
The Bank
Common equity Tier 1 capital	$	38,175		$	37,721
Tier 1 capital	$	38,175		$	37,721
Tier 2 capital		3,254			3,112
Total qualifying capital	$	41,429		$	40,833
Risk-adjusted total assets
(including off-balance sheet exposures)	$	259,836		$	248,316
Common equity Tier 1 capital ratio		14.69	%		15.19	%
Tier 1 risk-based capital ratio		14.69	%		15.19	%
Total risk-based capital ratio		15.94	%		16.44	%
Tier 1 leverage ratio		10.08	%		9.95	%

At March 31, 2017, the Company and Bank exceeded all minimum regulatory capital requirements.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Capital Resources–continued

The Company does not anticipate paying dividends for the foreseeable future, and all future dividends will be dependent on the Company’s financial condition, results of operations, and cash flows, as well as capital regulations and dividend restrictions from the Federal Reserve Bank of Richmond, the FDIC, and the State Board. 

ACCOUNTING AND FINANCIAL REPORTING ISSUES

We have adopted various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to the consolidated financial statements for the year ended December 31, 2016, as filed on our Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by us which have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates which could have a material impact on our carrying values of assets and liabilities and our results of operations.

We believe the allowance for loan losses is a critical accounting policy that requires significant judgment and estimates used in preparation of our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a description of our processes and methodology for determining our allowance for loan losses.

The determination of the value of OREO is also considered a critical accounting policy as management must use significant judgment and estimates when considering the reasonableness of the value.

The income tax provision is also an accounting policy that requires judgment as the Company seeks strategies to minimize the tax effect of implementing their business strategies. The Company’s tax returns are subject to examination by both federal and state authorities. Such examinations may result in assessment of additional taxes, interest and penalties. As a result, the ultimate outcome, and the corresponding financial statement impact, can be difficult to predict with accuracy.

Fair value determination and other-than-temporary impairment is subject to management’s evaluation to determine if it is probable that all amounts due according to contractual terms will be collected to determine if any other-than-temporary impairment exists. The process of evaluating other-than-temporary impairment is inherently judgmental, involving the weighing of positive and negative factors and evidence that may be objective or subjective.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

LIQUIDITY

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and federal funds sold are the Company’s primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment securities portfolio is the Company’s principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits are the Company’s primary source of funds for credit activities. Although not historically used as principal sources of liquidity, federal funds purchased from correspondent banks and advances from the FHLB are other options available to management. Management believes that the Company’s liquidity sources will enable it to successfully meet its long-term operating needs.

The Bank has unused availability at the FHLB of $70.0 million and an unsecured line of credit with a correspondent bank available for overnight borrowing totaling $9.0 million; however, the Bank’s greatest source of liquidity resides in its unpledged securities portfolio. The book and market values of unpledged securities available-for-sale totaled $64.7 million and $62.8 million, respectively, at March 31, 2017. This source of liquidity may be adversely impacted by changing market conditions, reduced access to borrowing lines, or increased collateral pledge requirements imposed by lenders. The Bank has implemented a plan to address these risks and strengthen its liquidity position. To accomplish the goals of this liquidity plan, the Bank will maintain cash liquidity at a minimum of 4% of total outstanding deposits and borrowings. In addition to cash liquidity, the Bank will also maintain a minimum of 15% off balance sheet liquidity. These objectives have been established by extensive contingency funding stress testing and analytics that indicate these target minimum levels of liquidity to be appropriate and prudent.

Comprehensive weekly and quarterly liquidity analyses serve management as vital decision-making tools by providing summaries of anticipated changes in loans, investments, core deposits, and wholesale funds. These internal funding reports provide management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan and securities paydowns and maturities. These liquidity analyses act as a cash forecasting tool and are subject to certain assumptions based on past market and customer trends. Through consideration of the information provided in these reports, management is better able to effectively monitor the Bank’s liquidity position.

To better manage our liquidity position, management also stress tests our liquidity position on a semi-annual basis under two scenarios: short-term crisis and a longer-term crisis. In the short term crisis, we would be cut off from our normal funding along with the market in general. In this scenario, the Bank would replenish our funding through the most likely sources of funding that would exist in the order of price efficiency. In the longer term crisis, we may be cut off from several of our normal sources of funding as our Bank’s financial situation deteriorated. In such a case, we would utilize our unpledged securities to raise funds in the reverse repurchase market or borrow from the FHLB. On a quarterly basis, management monitors the market value of our securities portfolio to ensure its ability to be pledged if liquidity needs should arise.

We believe our liquidity sources are adequate to meet our needs for at least the next 12 months.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

IMPACT OF OFF-BALANCE SHEET INSTRUMENTS

The Company is a 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 consist of commitments to extend credit and standby letters of credit. Commitments to extend credit are legally binding agreements to lend to a customer at predetermined interest rates 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. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the instrument is represented by the contractual notional amount of the instrument. Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued to guarantee a customer’s performance to a third party and have essentially the same credit risk as other lending facilities. Standby letters of credit often expire without being used. Management believes that through various sources of liquidity, the Company has the necessary resources to meet obligations arising from these financial instruments.

The Company uses the same credit underwriting procedures for commitments to extend credit and standby letters of credit as for on-balance-sheet instruments. The credit worthiness of each borrower is evaluated and the amount of collateral, if deemed necessary, is based on the credit evaluation. Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties, as well as liquid assets such as time deposit accounts, brokerage accounts, and cash value of life insurance.

The Company is not involved in off-balance sheet contractual relationships, other than those disclosed in this report, which it believes could result in liquidity needs or other commitments or that could significantly impact earnings.

As of March 31, 2017, commitments to extend credit totaled $32.3 million and standby letters of credit totaled $1.2 million.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2017, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. As of the date of this report, except as noted below we do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

· On or about October 4, 2012, the United States Attorney for the District of South Carolina served the Company and the Bank with a subpoena requesting the production of documents related to the Company’s offering and sale of subordinated debt notes. The Company and the Bank have provided all documents and information requested by the government to date. By letter dated December 28, 2015, the office of the United States Attorney advised the Company and Bank that it was declining to prosecute and was closing its file. After this investigation was concluded, the office of SIGTARP, which had been working with the United States Attorney for South Carolina, notified the Company and the Bank that it would be requesting some additional documents needed for review. On March 1, 2016, the office of SIGTARP issued a subpoena for certain documents to the Company and Bank and a second subpoena was issued on November 18, 2016. The Company and Bank fully and timely responded to these subpoenas and are continuing to work with SIGTARP on its follow-up requests.

Item 1A. Risk Factors

Under the filer category of “smaller reporting company”, as defined in Rule 12b-2 of the Exchange Act, the Company is not required to provide information requested by Part II, Item 1A of its Form 10-Q.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits

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

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

SIGNATURES

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

Date:  May 5, 2017	By:	/s/ JAN H. HOLLAR
		Jan H. Hollar
		Chief Executive Officer
		(Principal Executive Officer)
Date:  May 5, 2017	By:	/s/ JENNIFER W. HARRIS
		Jennifer W. Harris
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

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HCSB FINANCIAL CORPORATION AND SUBSIDIARY

EXHIBIT INDEX

Exhibit Number	Description
10.1	Amended and Restated Employment Agreement, dated as of March 21, 2017, between the Company, the Bank, and Janet H. Hollar (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on March 24, 2017).
10.2	Amended and Restated Employment Agreement, dated as of March 21, 2017, between the Bank and J. Ricky Patterson (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on March 24, 2017).
10.3	Amended and Restated Employment Agreement, dated as of March 21, 2017, between the Bank and W. Jack McElveen, Jr. (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed on March 24, 2017).
10.4	Amended and Restated Employment Agreement, dated as of March 21, 2017, between the Company, the Bank, and Jennifer W. Harris (incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed on March 24, 2017).
31.1	Rule 13a-14(a) Certification of Principal Executive Officer.
31.2	Rule 13a-14(a) Certification of the Principal Financial Officer.
32	Section 1350 Certifications.
101	The following materials from the Quarterly Report on Form 10-Q of HCSB Financial Corporation for the quarter ended March 31, 2017, formatted in eXtensible Business Reporting Language (XBRL): (i) Condensed Consolidated Balance Sheets, (ii) Condensed Consolidated Statements of Operations, (iii) Condensed Consolidated Statements of Comprehensive Income, (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity, (v) Condensed Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Condensed Consolidated Financial Statements.

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