Carolina Financial (CARO) 10-Q 2017 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 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 number001-10897

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

Delaware	57-1039673
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
288 Meeting Street, Charleston, South Carolina	29401
(Address of principal executive offices)	(Zip Code)

843-723-7700
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address, and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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, a 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 filero	Accelerated filer                   x
Non-accelerated filer  o (Do not check if a smaller reporting company)	Smaller reporting company  o
	Emerging growth company  x

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: 21,060,395 shares of common stock, par value $0.01 per share, were issued and outstanding as of November 8, 2017.

TABLE OF CONTENTS

		Page
PART 1 –	FINANCIAL INFORMATION
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	50
Item 3.	Quantitative and Qualitative Disclosure about Market Risk	78
Item 4.	Controls and Procedures	78
PART II -	OTHER INFORMATION	79
Item 1.	Legal Proceedings	79
Item 1A.	Risk Factors	79
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	79
Item 3.	Defaults Upon Senior Securities	79
Item 4.	Mine Safety Disclosures	79
Item 5.	Other Information	79
Item 6.	Exhibits	79

2

PART 1 - FINANCIAL INFORMATION
Item 1 - Financial Statements
CAROLINA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
	September 30, 2017		December 31, 2016
	(Unaudited)		(Audited)
	(In thousands, except share data)
ASSETS
Cash and due from banks	$	14,046		9,761
Interest-bearing cash		31,198		14,591
Cash and cash equivalents		45,244		24,352
Securities available-for-sale (cost of $518,214 at September 30, 2017 and $338,214 at December 31, 2016)		523,744		335,352
Federal Home Loan Bank stock, at cost		10,970		11,072
Other investments		2,139		1,768
Derivative assets		2,332		2,219
Loans held for sale		26,786		31,569
Loans receivable, net of allowance for loan losses of $10,662 at September 30, 2017 and $10,688 at December 31, 2016		1,473,799		1,167,578
Premises and equipment, net		46,430		37,054
Accrued interest receivable		7,320		5,373
Real estate acquired through foreclosure, net		1,640		1,179
Deferred tax assets, net		7,668		8,341
Mortgage servicing rights		17,444		15,032
Cash value life insurance		38,317		28,984
Core deposit intangible		7,666		3,658
Goodwill		37,287		4,266
Other assets		7,953		5,939
Total assets	$	2,256,739		1,683,736
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Noninterest-bearing deposits	$	333,267		229,905
Interest-bearing deposits		1,374,387		1,028,355
Total deposits		1,707,654		1,258,260
Short-term borrowed funds		180,000		203,000
Long-term debt		54,351		38,465
Derivative liabilities		201		342
Drafts outstanding		5,630		6,223
Advances from borrowers for insurance and taxes		3,163		1,058
Accrued interest payable		1,053		327
Reserve for mortgage repurchase losses		2,129		2,880
Dividends payable to stockholders		646		502
Accrued expenses and other liabilities		11,688		9,489
Total liabilities		1,966,515		1,520,546
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $.01; 1,000,000 shares authorized at September 30, 2017 and December 31, 2016; no shares issued or outstanding		—		—
Common stock, par value $.01; 25,000,000 shares authorized at September 30, 2017 and December 31, 2016; 16,159,309 and 12,548,328 issued and outstanding at September 30, 2017 and December 31, 2016, respectively		162		125
Additional paid-in capital		168,919		66,156
Retained earnings		117,488		98,451
Accumulated other comprehensive income (loss), net of tax		3,655		(1,542	)
Total stockholders’ equity		290,224		163,190
Total liabilities and stockholders’ equity	$	2,256,739		1,683,736
See accompanying notes to consolidated financial statements.

3

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	For the Three Months							For the Nine Months
	Ended September 30,							Ended September 30,
	2017				2016			2017			2016
	(In thousands, except share data)
Interest income
Loans	$	18,960				13,826			52,207			36,791
Investment securities		3,761				2,264			9,975			6,835
Dividends from Federal Home Loan Bank stock		135				83			351			288
Federal funds sold		—				3			7			5
Other interest income		70				32			178			92
Total interest income		22,926				16,208			62,718			44,011
Interest expense
Deposits		2,422				1,570			6,212			4,449
Short-term borrowed funds		441				124			1,225			320
Long-term debt		514				558			1,364			1,743
Total interest expense		3,377				2,252			8,801			6,512
Net interest income		19,549				13,956			53,917			37,499
Provision for loan losses		—				—			—			—
Net interest income after provision for loan losses		19,549				13,956			53,917			37,499
Noninterest income
Mortgage banking income		3,625				5,605			11,522			12,967
Deposit service charges		1,072				953			2,928			2,712
Net loss on extinguishment of debt		—				(118	)		—			(174	)
Net gain on sale of securities		368				111			1,174			641
Fair value adjustments on interest rate swaps		90				99			(37	)		(408	)
Net increase in cash value life insurance		267				226			759			684
Mortgage loan servicing income		1,652				1,437			4,822			4,238
Other		801				560			2,742			1,728
Total noninterest income		7,875				8,873			23,910			22,388
Noninterest expense
Salaries and employee benefits		8,623				8,481			26,487			23,306
Occupancy and equipment		2,508				2,067			7,129			5,836
Marketing and public relations		385				374			1,182			1,144
FDIC insurance		205				180			380			527
Recovery of mortgage loan repurchase losses		(225	)			(250	)		(675	)		(750	)
Legal expense		157				80			373			185
Other real estate (income) expense, net		(5	)			(96	)		40			(37	)
Mortgage subservicing expense		494				462			1,485			1,353
Amortization of mortgage servicing rights		748				586			2,083			1,659
Merger related expenses		311				—			1,910			2,985
Other		2,255				2,006			6,538			5,759
Total noninterest expense		15,456				13,890			46,932			41,967
Income before income taxes		11,968				8,939			30,895			17,920
Income tax expense		3,975				2,998			8,659			5,500
Net income	$	7,993				5,941			22,236			12,420
Earnings per common share:
Basic	$	0.50				0.48			1.48			1.04
Diluted	$	0.49				0.47			1.47			1.02
Dividends per common share	$	0.04		��		0.03			0.12			0.09
Weighted average common shares outstanding:
Basic		16,029,332				12,327,921			14,980,349			11,995,477
Diluted		16,187,869				12,535,551			15,146,972			12,201,721
See accompanying notes to consolidated financial statements.

4

CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
	For the Three Months						For the Nine Months
	September 30,						September 30,
	2017			2016			2017			2016
	(In thousands)
Net income	$	7,993			5,941			22,236			12,420
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities		1,387			(1,021	)		9,511			1,678
Tax effect		(499	)		368			(3,424	)		(604	)
Reclassification adjustment for gains included in earnings		(368	)		(111	)		(1,174	)		(641	)
Tax effect		132			40			423			231
Unrealized gain (loss) on interest rate swaps designated as cash flow hedges		34			288			(217	)		(1,963	)
Tax effect		(12	)		(104	)		78			707
Transfer from held-to-maturity to available-for-sale securities		—			—			—			1,023
Tax effect		—			—			—			(368	)
Other comprehensive income, net of tax		674			(540	)		5,197			63
Comprehensive income	$	8,667			5,401			27,433			12,483
See accompanying notes to consolidated financial statements.

5

CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016
(Unaudited)
														Accumulated
								Additional						Other
	Common Stock							Paid-in			Retained			Comprehensive
	Shares			Amount				Capital			Earnings			Income (Loss)			Total
	(In thousands, except share data)
Balance, December 31, 2015		12,023,557		$	120		��		56,418			82,859			462			139,859
Stock awards		36,056			1				—			—			—			1
Vested stock awards surrendered in cashless exercise		(25,663	)		(1	)			(112	)		(346	)		—			(459	)
Stock options exercised		3,360			—				27			—			—			27
Stock issued - Congaree Bancshares, Inc. merger		508,910			5				8,545			—			—			8,550
Excess tax benefit in connection with equity awards		—			—				15			—			—			15
Stock-based compensation expense, net		—			—				969			—			—			969
Net income		—			—				—			12,420			—			12,420
Dividends declared to stockholders		—			—				—			(1,114	)		—			(1,114	)
Other comprehensive income, net of tax		—			—				—			—			63			63
Balance, September 30, 2016		12,546,220		$	125				65,862			93,819			525			160,331
Balance, December 31, 2016		12,548,328		$	125				66,156			98,451			(1,542	)		163,190
Issuance of common stock, net of offering expenses		1,807,143			18				47,653			—			—			47,671
Stock issued - Greer Bancshares Incorporated acquisition		1,789,523			18				54,205			—			—			54,223
Stock awards		71,385			1				108			—			—			109
Vested stock awards surrendered in cashless exercise		(57,670	)		—				(383	)		(1,330	)		—			(1,713	)
Stock options exercised		600			—				10			—			—			10
Stock-based compensation expense, net		—			—				1,170			—			—			1,170
Net income		—			—				—			22,236			—			22,236
Dividends declared to stockholders		—			—				—			(1,869	)		—			(1,869	)
Other comprehensive income, net of tax		—			—				—			—			5,197			5,197
Balance,September 30, 2017		16,159,309		$	162				168,919			117,488			3,655			290,224
See accompanying notes to consolidated financial statements.

6

CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
	For the Nine Months
	Ended September 30,
	2017			2016
	(In thousands)
Cash flows from operating activities:
Net income	$	22,236			12,420
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of unearned discount/premiums on investments, net		2,726			2,723
Accretion of deferred loan fees		(917	)		(484	)
Accretion of acquired loans		(2,052	)		(471	)
Amortization of core deposit intangibles		472			294
Gain on sale of available-for-sale securities, net		(1,174	)		(641	)
Mortgage banking income		(11,522	)		(12,967	)
Originations of loans held for sale		(671,103	)		(713,675	)
Proceeds from sale of loans held for sale		687,513			731,730
Loss on extinguishment of debt		—			174
Amortization of fair value adjustments on subordinated debentures		55			—
Recovery of mortgage loan repurchase losses		(675	)		(750	)
Mortgage repurchase loan losses paid, net of recoveries		(76	)		4
Fair value adjustments on interest rate swaps		37			408
Stock-based compensation		1,170			969
Increase in cash surrender value of bank owned life insurance		(759	)		(709	)
Depreciation		1,881			1,457
Loss (gain) on disposals of premises and equipment		3			(1	)
Gain on sale of real estate acquired through foreclosure		(33	)		(48	)
Originations of mortgage servicing rights		(4,495	)		(3,782	)
Amortization of mortgage servicing rights		2,083			1,659
Increase in:
Accrued interest receivable		(764	)		(194	)
Other assets		(2,868	)		(2,375	)
Increase (decrease) in:
Accrued interest payable		468			(9	)
Dividends payable to stockholders		144			15
Accrued expenses and other liabilities		(5,461	)		4,373
Cash flows provided by operating activities		16,889			20,120
					Continued

7

CAROLINA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Unaudited)
	For the Nine Months
	Ended September 30,
	2017			2016
	(In thousands)
Cash flows from investing activities:
Activity in available-for-sale securities:
Purchases	$	(202,321	)		(115,990	)
Maturities, payments and calls		37,097			41,735
Proceeds from sales		103,451			69,896
Increase in other investments		(21	)		(21	)
Decrease in Federal Home Loan Bank stock		1,697			2,830
Increase in loans receivable, net		(109,649	)		(135,637	)
Purchase of premises and equipment		(3,101	)		(1,231	)
Proceeds from disposals of premises and equipment		—			1
Proceeds from sale of real estate acquired through foreclosure		661			1,925
Net cash received for acquisitions		37,764			3,668
Cash flows used in investing activities		(134,422	)		(132,824	)
Cash flows from financing activities:
Net increase in deposit accounts		138,328			191,423
Net decrease in Federal Home Loan Bank advances		(43,500	)		(70,174	)
Principal repayment of subordinated debt		(3,871	)		—
Net (decrease) increase in drafts outstanding		(593	)		1,811
Net increase in advances from borrowers for insurance and taxes		2,105			1,973
Cash dividends paid on common stock		(1,725	)		(1,083	)
Proceeds from issuance of common stock		47,671			—
Net increase in excess tax benefit in connection with equity awards		—			421
Proceeds from exercise of stock options		10			27
Cash flows provided by financing activities		138,425			124,398
Net increase in cash and cash equivalents		20,892			11,694
Cash and cash equivalents, beginning of period		24,352			26,627
Cash and cash equivalents, end of period	$	45,244			38,321
Supplemental disclosure:
Cash paid for:
Interest on deposits and borrowed funds	$	8,075			6,499
Income taxes paid, net of refunds		7,889			3,795
Noncash investing activities:
Transfer of loans receivable to real estate acquired through foreclosure	$	1,047			886
Transfer of held-to-maturity securities to available-for-sale securities		—			16,955
Acquisitions:
Fair value of tangible assets acquired	$	380,011			103,117
Other intangible assets acquired		4,480			1,104
Liabilities assumed		358,866			92,203
Net identifiable assets acquired over liabilities assumed		25,625			12,018
Common stock issued in acquisition		54,223			8,557
Goodwill		33,020			4,266
See accompanying notes to consolidated financial statements.

8

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Carolina Financial Corporation (“Carolina Financial” or the “Company”), incorporated under the laws of the State of Delaware, is a financial holding company with one wholly-owned subsidiary, CresCom Bank (the “Bank”). In June 2017, the Company applied, and was approved by the Federal Reserve Bank of Richmond, to be a financial holding company from a bank holding company. CresCom Bank operates two wholly-owned subsidiaries, Crescent Mortgage Company and Carolina Services Corporation of Charleston (“Carolina Services”). The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. In consolidation, all material intercompany accounts and transactions have been eliminated. The results of operations of the businesses acquired in transactions accounted for as purchases are included only from the dates of acquisition. All majority-owned subsidiaries are consolidated unless control is temporary or does not rest with the Company.

At September 30, 2017, statutory business trusts (“Trusts”) created or acquired by the Company had outstanding trust preferred securities with a balance of $23.3 million. The principal assets of the Trusts are the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $806,000 of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 as filed with the Securities and Exchange Commission (the “SEC”) on March 10, 2017. There have been no significant changes to the accounting policies as disclosed in the Company’s Form 10-K.

Management’s Estimates

The financial statements are prepared in accordance with GAAP, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, including valuation for impaired loans, the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans, the valuation of securities, the valuation of derivative instruments, the valuation of assets acquired and liabilities assumed in business combinations, the valuation of mortgage servicing rights, the determination of the reserve for mortgage loan repurchase losses, asserted and unasserted legal claims and deferred tax assets or liabilities. In connection with the determination of the allowance for loan losses and foreclosed real estate, management obtains independent appraisals for significant properties. Management must also make estimates in determining the estimated useful lives and methods for depreciating premises and equipment.

9

Management uses available information to recognize losses on loans and foreclosed real estate. However, 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 Bank’s allowance for loan losses and foreclosed real estate. Such agencies may require the Bank to recognize additions to the allowance 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 allowance for loan losses and valuation of foreclosed real estate may change materially in the near term.

Earnings Per Share

Basic earnings per share (“EPS”) represents income available to common stockholders divided by the weighted-average number of shares outstanding during the period. Diluted earnings per share reflects additional shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate solely to outstanding stock options, restricted stock (non-vested shares), restricted stock units (“RSUs”) and warrants, and are determined using the treasury stock method. Under the treasury stock method, the number of incremental shares is determined by assuming the issuance of stock for the outstanding stock options, unvested restricted stock and RSUs, and warrants, reduced by the number of shares assumed to be repurchased from the issuance proceeds, using the average market price for the period of the Company’s stock.

Subsequent Events

Subsequent events are material 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. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the statement of financial condition but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and no subsequent events occurred requiring accrual or disclosure except as follows:

On October 18, 2017 the Company declared a $0.05 dividend per common share, payable on January 5, 2018, to stockholders of record on December 14, 2017.

Pursuant to an Agreement and Plan of Merger and Reorganization, dated as of June 9, 2017, by and between the Company and First South Bancorp, Inc. (“First South”), on November 1, 2017 First South merged with and into the Company, with the Company as the surviving corporation. Immediately thereafter, First South Bank, a wholly owned subsidiary of First South, merged with and into the Bank, with the Bank as the surviving Bank. Pursuant to the merger agreement, holders of First South common stock received 0.5064 shares of the common stock of the Company for each share of First South common stock held immediately prior to the effective time of the merger. The Company issued 4.8 million shares of common stock to the former shareholders of First South in the transaction.

Reclassification

Certain reclassifications of accounts reported for previous periods have been made in these consolidated financial statements. Such reclassifications had no effect on stockholders’ equity or the net income as previously reported.

Recently Issued Accounting Pronouncements

In August 2017, the FASB issued ASU No. 2017-12,Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 amends the requirements of the Derivatives and Hedging Topic of the Accounting Standards Codification to improve the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. 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. 

In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09,Compensation-Stock Compensation (Topic 718) (“ASU 2017-09”). ASU 2017-09 provides clarity when applying guidance to a change to the terms or conditions of a share-based payment award. The amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period for public business entities for which financial statements have not yet been issued. The amendments should be applied prospectively to an award modified on or after the adoption date. The Company has determined that this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

10

In March 2017, the FASB issued ASU No. 2017-08,Receivables-Nonrefundable Fees and Other Cost (Subtopic 310-20):  Premium Amortization on Purchased Callable Debt Securities (“ASU 2017-08”).  ASU 2017-08 shortens the amortization period of the premium for certain callable debt securities, from the contractual maturity date to the earliest call date. The amendments do not require an accounting change for securities held at a discount; an entity will continue to amortize to the contractual maturity date the discount related to callable debt securities. The amendments apply to the amortization of premiums on callable debt securities with explicit, non-contingent call features that are callable at fixed prices on preset dates.  For public business entities, ASU 2017-08 is effective in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted for all entities, including in an interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the amendments are adopted.  The Company has determined that this guidance will not have a material impact on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-04,Intangible-Goodwill and other (Topic 350):  Simplifying the Test for Goodwill Impairment(“ASU 2017-04”). ASU 2017-04 simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in today’s two-step impairment test under Accounting Standards Codification ASC 350 and eliminating Step 2 from the goodwill impairment test.  As amended, the goodwill impairment test will consist of one step comparing the fair value of a reporting unit with its carrying amount.  An entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value.  The guidance is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those years. The amendments should be adopted prospectively and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.  The Company has determined that this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2016, the FASB ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326):  Measurement of Credit Losses on Financial Instruments  (“ASU 2016-13”).  ASU 2016-13 requires an entity to utilize a new impairment model known as the current expected credit loss (“CECL”) model to estimate its lifetime “expected credit loss” and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset.  The CECL model is expected to result in earlier recognition of credit losses.  ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities.  The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years.  Early adoption is permitted.  Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted.   The Company is assessing the impact that this new guidance will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09,Compensation – Stock Compensation (Topic 718):  Improvements to Employee Share – Based Payment Accounting(“ASU 2016-09”).  ASU 2016-09 introduces targeted amendments intended to simplify the accounting for stock compensation. Specifically, ASU 2016-09 requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity also should recognize excess tax benefits, and assess the need for a valuation allowance, regardless of whether the benefit reduces taxes payable in the current period. That is, off balance sheet accounting for net operating losses stemming from excess tax benefits would no longer be required and instead such net operating losses would be recognized when they arise. Existing net operating losses that are currently tracked off balance sheet would be recognized, net of a valuation allowance if required, through an adjustment to opening retained earnings in the period of adoption. Entities will no longer need to maintain and track an “APIC pool.”  For public business entities, ASU 2016-09 became effective for interim and annual periods beginning after December 15, 2016, with early adoption permitted. The Company adopted the guidance in the second quarter of 2016.  These amendments did not have a material impact on the Company’s financial statements.

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In March 2016, the FASB issued ASU No. 2016-08,Revenue from Contracts with Customers (Topic 606): Principal versus Agent considerations (Reporting Revenue Gross versus Net)(“ASU 2016-08”).  ASU 2016-08 updates the new revenue standard by clarifying the principal versus agent implementation guidance, but does not change the core principle of the new standard. The updates to the principal versus agent guidance:  (i) require an entity to determine whether it is a principal or an agent for each distinct good or service (or a distinct bundle of goods or services) to be provided to the customer; (ii) illustrate how an entity that is a principal might apply the control principle to goods, services, or rights to services, when another party is involved in providing goods or services to a customer and (iii) clarify that the purpose of certain specific control indicators is to support or assist in the assessment of whether an entity controls a good or service before it is transferred to the customer, provide more specific guidance on how the indicators should be considered, and clarify that their relevance will vary depending on the facts and circumstances.  Forbusiness entities, the effective date and transition requirements for these amendments are the same as the effective date and transition requirements of ASU 2014-09 which is effective for interim and annual periods beginning after December 15, 2017. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this new guidance recognized at the date of initial application.  The Company’s revenue is primarily comprised of net interest income on financial assets and financial liabilities, which is explicitly excluded from the scope of ASU 2014-09, and non-interest income. The Company has evaluated ASU 2016-08 and 2014-09 and determined that this guidance is not expected to have a significant impact on its financial statements.

In March 2016, the FASB issued ASU No. 2016-05,Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships (“ASU 2016-05”).  ASU 2016-05 requires an entity to discontinue a designated hedging relationship in certain circumstances, including termination of the derivative hedging instrument or if the entity wishes to change any of the critical terms of the hedging relationship. ASU 2016-05 amends Topic 815 to clarify that novation of a derivative (replacing one of the parties to a derivative instrument with a new party) designated as the hedging instrument would not, in and of itself, be considered a termination of the derivative instrument or a change in critical terms requiring discontinuation of the designated hedging relationship. For public business entities, the amendments in ASU 2016-05 are effective for interim and annual periods beginning after December 15, 2016.  An entity has an option to apply the amendments in ASU 2016-05 on either a prospective basis or a modified retrospective basis.  ASU 2016-05 became effective for the Company on January 1, 2017 and did not have a significant impact on the Company’s consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02,Leases (Topic 842) (“ASU 2016-02”).  ASU 2016-02 applies a right-of-use (“ROU”) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset and a liability to make lease payments. For leases with a term of 12 months or less, a practical expedient is available whereby a lessee may elect, by class of underlying asset, not to recognize an ROU asset or lease liability. At inception, lessees must classify all leases as either finance or operating based on five criteria. Balance sheet recognition of finance and operating leases is similar, but the pattern of expense recognition in the income statement, as well as the effect on the statement of cash flows, differs depending on the lease classification.  For public business entities, the amendments in ASU 2016-02 are effective for interim and annual periods beginning after December 15, 2018.   In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach which includes a number of optional practical expedients that entities may elect to apply.   The Company is currently evaluating the provisions of ASU 2016-02 in relation to its outstanding leases to determine the potential impact the new standard will have to the Company’s financial statements.

In January 2016, the FASB issued ASU No. 2016-01,Financial Instruments – Overall (Subtopic 825-10); Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”).  This update is intended to improve the recognition and measurement of financial instruments and it requires an entity to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in OCI the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price; and (v) assess a valuation allowance on deferred tax assets related to unrealized losses of AFS debt securities in combination with other deferred tax assets. ASU 2016-01 also provides anelection to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes and requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements.  For public business entities, the amendments in ASU 2016-01 are effective for interim and annual periods beginning after December 15, 2017.  An entity should apply the amendments 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 (including disclosure requirements) should be applied prospectively to equity investments that exist as of the date of adoption of the ASU 2016-01.  Management is currently evaluating the provisions of ASU 2016-01 on the Company, however, management does not expect these changes to have a significant impact on the Company’s 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.

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NOTE 2 – BUSINESS COMBINATIONS

Acquisition of Greer Bancshares Incorporated

On March 18, 2017, the Company completed its acquisition of Greer Bancshares Incorporated (“Greer”), the holding company for Greer State Bank, pursuant to the Agreement and Plan of Merger, dated as of November 7, 2016. Under the terms of the merger agreement, each share of Greer common stock was converted into the right to receive $18.00 in cash or 0.782 shares of the Company’s common stock, or a combination thereof, subject to certain limitations.

The following table presents a summary of total consideration paid by the Company at the acquisition date (dollars in thousand).

Common stock issued (1,789,523 shares at $30.30 per share)	$	54,223
Cash payments to common stockholders		4,422
Total consideration paid	$	58,645

The assets acquired and liabilities assumed from Greer were recorded at their fair value as of the closing date of the merger. Fair values were preliminary and subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values became available. Goodwill of $33.0 million was recorded at the time of the acquisition. The following table summarizes the consideration paid by the Company in the merger with Greer and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date.

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March 18, 2017	As Reported by Greer			Fair Value Adjustments			As Recorded by the Company
	(In thousands)
Assets
Cash and cash equivalents	$	42,187			—			42,187
Securities available for sale		121,374			—			121,374
Loans held for sale		105			—			105
Loans receivable		205,209			(10,559	)(a)		194,650
Allowance for loan losses		(3,198	)		3,198	(b)		—
Premises and equipment		3,928			4,202	(c)		8,130
Foreclosed assets		42			—			42
Core deposit intangible		—			4,480	(d)		4,480
Deferred tax asset, net		3,831			(1,434	)(e)		2,397
Other assets		11,367			(241	)(f)		11,126
Total assets acquired	$	384,845			(354	)		384,491
Liabilities
Deposits	$	310,866			200	(g)		311,066
Borrowings		43,712			(3,510	)(h)		40,202
Other liabilities		7,086			512	(i)		7,598
Total liabilities assumed	$	361,664			(2,798	)		358,866
Net identifiable assets acquired over liabilities assumed								25,625
Total consideration paid								58,645
Goodwill							$	33,020

Explanation of fair value adjustments:
(a)	Adjustment represents the amount necessary to adjust loans to their fair value due to interest rate and credit factors.
(b)	Adjustment reflects the elimination of Greer’s historical allowance for loan losses.
(c)	Adjustment reflects fair value adjustments on acquired branch and administrative offices based on third party appraisals.
(d)	Adjustment reflects the fair value adjustment to record the estimated core deposit intangible based on the Company’s third party valuation report.
(e)	Adjustment reflects the tax impact of acquisition accounting fair value adjustments.
(f)	Adjustment reflects the fair value adjustment based on the Company’s evaluation of acquired other assets.
(g)	Adjustment represents the fair value adjustment due to interest rate factors.
(h)	Adjustment represents the fair value adjustment due to interest rate factors.
(i)	Adjustment reflects the fair value adjustment based on the Company’s evaluation of acquired other liabilities.

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The following table presents additional information related to the purchased credit impaired (“PCI”) acquired loan portfolio at March 18, 2017 (in thousands):

Contractual principal and interest at acquisition	$	37,683
Nonaccretable difference		7,248
Expected cash flows at acquisition		30,435
Accretable yield		4,995
Basis in PCI loans at acquisition - estimated fair value	$	25,440

Acquisition of Congaree Bancshares, Inc.

On June 11, 2016, the Company completed its acquisition of Congaree Bancshares, Inc. (“Congaree”), the holding company for Congaree State Bank, pursuant to the Agreement and Plan of Merger, dated as of January 5, 2016. Under the terms of the merger agreement, each share of Congaree common stock was converted into the right to receive $8.10 in cash or 0.4806 shares of the Company’s common stock, or a combination thereof, subject to certain limitations.

The following table presents a summary of total consideration paid by the Company at the acquisition date (dollars in thousands).

Common stock issued (509,370 shares at $16.80 per share)	$	8,557
Cash payments to common stockholders		5,724
Preferred shares assumed and redeemed at par		1,564
Fair value of Congaree stock options assumed - paid out in cash		439
Total consideration paid	$	16,284

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The following table presents the Congaree assets acquired and liabilities assumed as of June 11, 2016 as well as the related fair value adjustments and determination of goodwill. There have been no adjustments to initial fair values recorded by the Company for the Congaree acquisition to date.

	As Reported by Congaree			Fair Value Adjustments			As Recorded by the Company
Assets	(In thousands)
Cash and cash equivalents	$	11,394			—			11,394
Securities		9,453			(59	)(a)		9,394
Loans receivable		78,712			(4,111	)(b)		74,601
Allowance for loan losses		(1,112	)		1,112	(c)		—
Premises and equipment		2,712			38	(d)		2,750
Foreclosed assets		1,710			(250	)(e)		1,460
Core deposit intangible		—			1,104	(f)		1,104
Deferred tax asset, net		1,813			915	(g)		2,728
Other assets		942			(152	)(h)		790
Total assets acquired	$	105,624			(1,403	)		104,221
Liabilities
Deposits	$	89,227			98	(i)		89,325
Borrowings		2,500			—			2,500
Other liabilities		378			—			378
Total liabilities assumed	$	92,105			98			92,203
Net identifiable assets acquired over liabilities assumed								12,018
Total consideration paid								16,284
Goodwill							$	4,266

Explanation of fair value adjustments:

(a) Adjustment reflects opening fair value of securities portfolio, which was established as the new book basis of the portfolio.

(b) Adjustment represents the amount necessary to adjust loans to their fair value due to interest rate and credit factors.

(c) Adjustment reflects the elimination of Congaree’s historical allowance for loan losses.

(d) Adjustment reflects fair value adjustments on acquired branch and administrative offices based on third party appraisals.

(e) Adjustment reflects the fair value adjustment based on the Company’s evaluation of the foreclosed assets.

(f) Adjustment reflects the fair value adjustment to record the estimated core deposit intangible based on the Company’s third party valuation report.

(g) Adjustment reflects the tax impact of acquisition accounting fair value adjustments.

(h) Adjustment reflects the fair value adjustment based on the Company’s evaluation of acquired other assets.

(i) Adjustment reflects the fair value adjustment based on the Company’s third party evaluation report on deposits assumed.

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NOTE 3 – SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of securities available-for-sale at September 30, 2017 and December 31, 2016 follows:

	September 30, 2017									December 31, 2016
			Gross		Gross							Gross		Gross
	Amortized		Unrealized		Unrealized			Fair		Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value		Cost		Gains		Losses			Value
Securities available-for-sale:	(In thousands)
Municipal securities	$	161,446		5,436		(275	)		166,607		92,792		1,475		(1,055	)		93,212
US government agencies		10,301		53		—			10,354		3,438		—		(52	)		3,386
Collateralized loan obligations		111,478		681		(33	)		112,126		76,202		138		(91	)		76,249
Corporate securities		476		18		—			494		474		17		—			491
Mortgage-backed securities:
Agency		166,451		1,725		(285	)		167,891		90,477		995		(486	)		90,986
Non-agency		56,862		592		(125	)		57,329		63,628		424		(188	)		63,864
Total mortgage-backed securities		223,313		2,317		(410	)		225,220		154,105		1,419		(674	)		154,850
Trust preferred securities		11,200		1,019		(3,276	)		8,943		11,203		545		(4,584	)		7,164
Total	$	518,214		9,524		(3,994	)		523,744		338,214		3,594		(6,456	)		335,352

The Company had no held-to-maturity securities as of September 30, 2017 or December 31, 2016. During the second quarter of 2016, the Company tainted its securities held-to-maturity portfolio as a result of a change in the intent to hold these securities until maturity to provide opportunities to maximize its asset utilization. As a result, the securities were moved to available-for-sale resulting in an increase to accumulated other comprehensive income of $655,000.

The amortized cost and fair value of debt securities by contractual maturity at September 30, 2017 follows:

	At September 30, 2017
	Amortized		Fair
	Cost		Value
	(In thousands)
Securities available-for-sale:
Less than one year	$	298		299
One to five years		1,320		1,328
Six to ten years		108,513		109,913
After ten years		408,083		412,204
Total	$	518,214		523,744

The contractual maturity dates of the securities were used for mortgage-backed securities and asset-backed securities. No estimates were made to anticipate principal repayments. 

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The following table summarizes the gross realized gains and losses from sales of investment securities available-for-sale for the periods indicated.

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2017		2016		2017			2016
	(In thousands)
Proceeds	$	22,430		19,024		103,451			69,896
Realized gains	$	368		111		1,388			758
Realized losses		—		—		(214	)		(117	)
Total investment securities gains, net	$	368		111		1,174			641

At September 30, 2017, the Company had pledged securities with a market value of $6.7 million for Federal Home Loan Bank (“FHLB”) advances.

At September 30, 2017, the Company has pledged $79.6 million of securities to secure public agency funds.

The following tables summarize gross unrealized losses on investment securities and the fair market value of the related securities at September 30, 2017 and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

	At September 30, 2017
	Less than 12 Months							12 Months or Greater							Total
	Amortized		Fair		Unrealized			Amortized		Fair		Unrealized			Amortized		Fair		Unrealized
	Cost		Value		Losses			Cost		Value		Losses			Cost		Value		Losses
	(In thousands)
Available-for-sale:
Municipal securities	$	8,436		8,382		(54	)		6,849		6,628		(221	)		15,285		15,010		(275	)
Collateralized loanobligations		21,000		20,968		(32	)		5,000		4,999		(1	)		26,000		25,967		(33	)
Mortgage-backed securities:
Agency		22,605		22,445		(160	)		16,627		16,502		(125	)		39,232		38,947		(285	)
Non-agency		3,083		3,057		(26	)		10,585		10,486		(99	)		13,668		13,543		(125	)
Total mortgage-backedsecurities		25,688		25,502		(186	)		27,212		26,988		(224	)		52,900		52,490		(410	)
Trust preferred securities		—		—		—			8,550		5,274		(3,276	)		8,550		5,274		(3,276	)
Total	$	55,124		54,852		(272	)		47,611		43,889		(3,722	)		102,735		98,741		(3,994	)

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	At December 31, 2016
	Less than 12 Months							12 Months or Greater							Total
	Amortized		Fair		Unrealized			Amortized		Fair		Unrealized			Amortized		Fair		Unrealized
	Cost		Value		Losses			Cost		Value		Losses			Cost		Value		Losses
	(In thousands)
Available-for-sale:
Municipal securities	$	40,479		39,424		(1,055	)		—		—		—			40,479		39,424		(1,055	)
US government agencies		3,438		3,386		(52	)		—		—		—			3,438		3,386		(52	)
Collateralized loan obligations		16,792		16,748		(44	)		8,500		8,453		(47	)		25,292		25,201		(91	)
Mortgage-backed securities:
Agency		33,323		32,960		(363	)		10,125		10,002		(123	)		43,448		42,962		(486	)
Non-agency		9,357		9,240		(117	)		8,801		8,730		(71	)		18,158		17,970		(188	)
Total mortgage-backed securities		42,680		42,200		(480	)		18,926		18,732		(194	)		61,606		60,932		(674	)
Trust preferred securities		1,362		1,112		(250	)		8,667		4,333		(4,334	)		10,029		5,445		(4,584	)
Total	$	104,751		102,870		(1,881	)		36,093		31,518		(4,575	)		140,844		134,388		(6,456	)

The Company reviews its investment securities portfolio at least quarterly and more frequently when economic conditions warrant, assessing whether there is any indication of other-than-temporary impairment (“OTTI”). Factors considered in the review include estimated future cash flows, length of time and extent to which market value has been less than cost, the financial condition and near term prospect of the issuer, and our intent and ability to retain the security to allow for an anticipated recovery in market value. If the review determines that there is OTTI, then an impairment loss is recognized in earnings equal to the difference between the investment’s cost and its fair value at the balance sheet date of the reporting period for which the assessment is made, or a portion may be recognized in other comprehensive income. The fair value of investments on which OTTI is recognized then becomes the new cost basis of the investment.

As of September 30, 2017, trust preferred securities had an amortized cost of $11.2 million and a fair value of $8.9 million. For each trust preferred security, impairment testing is performed on a quarterly basis using a detailed cash flow analysis. The major assumptions used during the quarterly impairment testing are described in the subsequent paragraph.

In 2009, the Company adopted a four year “burst” scenario for its modeled default rates (2010 - 2013) that replicated the default rates for the banking industry from the four peak years of the savings and loan crisis, which then reduced to 0.25% annually. The elevated default rate ended in 2013, and the constant default rate used by the Company is now 0.25% annually. All issuers that are currently in deferral were presumed to be in default. Additionally, all defaults are assumed to have a 15% recovery after two years and 1% of the pool is presumed to prepay annually. If this analysis results in a present value of expected cash flows that is less than the book value of a security (that is, a credit loss exists), OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis management performed used discount rates equal to the credit spread at the time of purchase for each security and then added the current three-month LIBOR forward interest rate curve.

Based on the cash flow analysis performed at period end, management believes that there are no additional securities other-than-temporarily impaired at September 30, 2017.

The underlying issuers in the pools were primarily financial institutions and to a lesser extent, insurance companies and real estate investment trusts. The Company owns both senior and mezzanine tranches in pooled trust preferred securities; however, the Company does not own any income notes. The senior and mezzanine tranches of trust preferred collateralized debt obligations generally have some protection from defaults in the form of over-collateralization and excess spread revenues, along with waterfall structures that redirect cash flows in the event certain coverage test requirements are failed. Generally, senior tranches have the greatest protection, with mezzanine tranches subordinated to the senior tranches, and income notes subordinated to the mezzanine tranches.

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At September 30, 2017 and December 31, 2016, the Company had 46 and 81, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in US government-sponsored agencies, municipal securities, mortgage-backed securities (agency and non-agency), and trust preferred securities summarized above were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows testing as needed, and determined that no OTTI expense was necessary during 2017 or 2016.

Management believes that there are no additional securities other-than-temporarily impaired at September 30, 2017. The Company does not currently 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. Management continues to monitor these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of the securities may be sold or are other-than-temporarily impaired, which would require a charge to earnings in such periods.

NOTE 4 – DERIVATIVES

In the ordinary course of business, the Company enters into various types of derivative transactions. The Company’s primary uses of derivative instruments are related to the mortgage banking activities. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements.

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The derivative positions of the Company at September 30, 2017 and December 31, 2016 are as follows:

	At September 30,				At December 31,
	2017				2016
	Fair		Notional		Fair		Notional
	Value		Value		Value		Value
	(In thousands)
Derivative assets:
Cash flow hedges:
Interest rate swaps	$	205		30,000		421		30,000
Non-hedging derivatives:
Interest rate swaps		613		45,000		532		20,000
Mortgage loan interest rate lock commitments		913		121,805		1,113		117,439
Mortgage loan forward sales commitments		245		17,882		153		94,001
Mortgage-backed securities forward sales commitments		356		89,000		—		—
Total derivative assets	$	2,332		303,687		2,219		261,440
Derivative liabilities:
Cash flow hedges:
Interest rate swaps	$	1		15,000		—		—
Non-hedging derivatives:
Interest rate swaps		200		10,000		195		10,000
Mortgage-backed securities forward sales commitments		—		—		147		22,784
Total derivative liabilities	$	201		25,000		342		32,784

Non-Designated Hedges

Derivative Loan Commitments and Forward Sales Commitments

The Company enters into mortgage loan commitments that are also referred to as derivative loan commitments, if the loan that will result from exercise of the commitment will be held for sale upon funding. The Company enters into commitments to fund residential mortgage loans at specified rates and times in the future, with the intention that these loans will subsequently be sold in the secondary market.

Outstanding derivative loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might decline from inception of the rate lock to funding of the loan due to increases in mortgage interest rates. If interest rates increase, the value of these loan commitments typically decreases. Conversely, if interest rates decrease, the value of these loan commitments typically increases.

To protect against the price risk inherent in derivative loan commitments, the Company utilizes both “mandatory delivery” and “best efforts” forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments.

21

With a “mandatory delivery” contract, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a “pair-off” fee, based on then-current market prices, to the investor to compensate the investor for the shortfall.

With a “best efforts” contract, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, the price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). The Company expects that these forward loan sale commitments will experience changes in fair value opposite to the change in fair value of derivative loan commitments.

Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability on the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in “mortgage banking income” within noninterest income in the consolidated statements of operations.

Interest Rate Swaps

The Company enters into interest rate swaps that do not meet the hedge accounting requirements and are recorded at fair value as a derivative asset or liability. Interest rate swaps that are not designated as hedges are primarily used to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches. Fair value changes are recognized in noninterest income as “fair value adjustments on interest rate swaps.”

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using certain interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

The Company has entered into interest rate swaps to reduce the exposure to variability in interest-related cash outflows attributable to changes in forecasted LIBOR-based FHLB borrowings. These derivative instruments are designated as cash flow hedges. The hedged item is the LIBOR portion of the series of future adjustable rate borrowings over the term of the interest rate swap. Accordingly, changes to the amount of interest payment cash flows for the hedged transactions attributable to a change in credit risk are excluded from our assessment of hedge effectiveness. The Company tests for hedging effectiveness on a quarterly basis. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company has not recorded any hedge ineffectiveness since inception.

Risk Management Objective of Using Derivatives

When using derivatives to hedge fair value and cash flow risks, the Company exposes itself to potential credit risk from the counterparty to the hedging instrument. This credit risk is normally a small percentage of the notional amount and fluctuates as interest rates change. The Company analyzes and approves credit risk for all potential derivative counterparties prior to execution of any derivative transaction. The Company seeks to minimize credit risk by dealing with highly rated counterparties and by obtaining collateralization for exposures above certain predetermined limits. If significant counterparty risk is determined, the Company would adjust the fair value of the derivative recorded asset balance to consider such risk.

22

NOTE 5 - LOANS RECEIVABLE, NET

We emphasize a range of lending services, including commercial and residential real estate mortgage loans, real estate construction loans, commercial and industrial loans and consumer loans. Our customers are generally individuals and small to medium-sized businesses and professional firms that are located in or conduct a substantial portion of their business in our market areas. We have focused our lending activities primarily on the professional market, including doctors, dentists, small business to medium-sized owners and commercial real estate developers.

Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer lending limits, with approval processes for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds the maximum senior officer’s lending authority, the loan request will be considered by the management loan committee, or MLC, which is comprised of four members, all of whom are part of the senior management team of the Bank. The MLC meets weekly to approve loans with total loan commitment relationships generally exceeding $1.5 million. The loan authority of the MLC is equal to two-thirds of the legal lending limit of the Bank which is equivalent to the in-house loan limit. Total credit exposure above the in-house limit requires approval by the majority of the board of directors. We do not make any loans to any director, executive officer of the Bank, or the related interests of each, unless the loan is approved by the full Board of Directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.

The following is a description of the risk characteristics of the material loan portfolio segments:

Residential Mortgage Loans and Home Equity Loans. We generally originate and hold short-term and long-term first mortgages and traditional second mortgage residential real estate loans. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We also offer a variety of lot loan options to consumers to purchase the lot on which they intend to build their home. The options available depend on whether the borrower intends to begin building within 12 months of the lot purchase or at an undetermined future date. We also offer traditional home equity loans and lines of credit. Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity loans typically have terms of 10 years or less. We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.

Commercial Real Estate. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, generally does not exceed 80%. We also generally require that a borrower’s cash flow exceed 120% of monthly debt service obligations. In order to ensure secondary sources of payment and liquidity to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.

Real Estate Construction and Development Loans.We offer fixed and adjustable rate residential and commercial construction loan financing to builders and developers and to consumers who wish to build their own home. The term of construction and development loans generally is limited to 18 months, although payments may be structured on a longer amortization basis. Most loans will mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the subsequent sale of the property. We attempt to reduce risk associated with construction and development loans by obtaining personal guarantees and by keeping the maximum loan-to-value ratio at or below 65%-80% of the lesser of cost or appraised value, depending on the project type.

Commercial Business Loans.We make loans for commercial purposes in various lines of businesses, including the manufacturing industry, service industry, and professional service areas. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate. Equipment loans typically will be made for a term of 10 years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 75% of cost. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.

23

The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company purchases nationally syndicated commercial and industrial loans. These loans typically have terms of seven years and are generally tied to a floating rate index such as LIBOR or prime. To effectively manage this line of business, the Company has an experienced senior lending executive with relevant experience to manage this area of this segment of the loan portfolio. In addition, the Company engaged a consulting firm that specializes in syndicated loans to assist in monitoring performance analytics. As of September 30, 2017 and December 31, 2016, there were approximately $83.5 million and $91.5 million in syndicated loans outstanding. Syndicated loans are grouped within commercial business loans below.

Consumer Loans.We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit. Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral. Consumer rates are both fixed and variable, with negotiable terms. Our installment loans typically amortize over periods up to 72 months. Although we typically require monthly payments of interest and a portion of the principal on our loan products, we will offer consumer loans with a single maturity date when a specific source of repayment is available. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.

Loans receivable, net at September 30, 2017 and December 31, 2016 are summarized by category as follows:

	At September 30,					At December 31,
	2017					2016
			% of Total					% of Total
All Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	475,949		32.06	%	$	411,399		34.91	%
Home equity		46,162		3.11	%		36,026		3.06	%
Commercial real estate		575,200		38.75	%		445,344		37.80	%
Construction and development		175,799		11.84	%		115,682		9.82	%
Consumer loans		9,010		0.61	%		5,714		0.48	%
Commercial business loans		202,341		13.63	%		164,101		13.93	%
Total gross loans receivable		1,484,461		100.00	%		1,178,266		100.00	%
Less:
Allowance for loan losses		10,662					10,688
Total loans receivable, net	$	1,473,799				$	1,167,578

24

Loans receivable, net at September 30, 2017 and December 31, 2016 for acquired non-credit impaired loans and nonacquired loans are summarized by category as follows:

	At September 30,					At December 31,
	2017					2016
Acquired Non-Credit Impaired Loans			% of Total					% of Total
(ASC 310-20) and Nonacquired Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	470,357		32.13	%	$	411,399		34.91	%
Home equity		46,111		3.15	%		36,026		3.06	%
Commercial real estate		563,996		38.53	%		445,344		37.80	%
Construction and development		172,983		11.82	%		115,682		9.82	%
Consumer loans		8,973		0.61	%		5,714		0.48	%
Commercial business loans		201,454		13.76	%		164,101		13.93	%
Total gross loans receivable		1,463,874		100.00	%		1,178,266		100.00	%
Less:
Allowance for loan losses		10,662					10,688
Total loans receivable, net	$	1,453,212				$	1,167,578

Loans receivable, net at September 30, 2017 for acquired credit impaired loans are summarized by category below. There were no acquired credit impaired loans at December 31, 2016.

	At September 30,
	2017
Acquired Credit Impaired			% of Total
Loans (ASC 310-30):	Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	5,592		27.16	%
Home equity		51		0.25	%
Commercial real estate		11,204		54.42	%
Construction and development		2,816		13.68	%
Consumer loans		37		0.18	%
Commercial business loans		887		4.31	%
Total gross loans receivable		20,587		100.00	%
Less:
Allowance for loan losses		—
Total loans receivable, net	$	20,587

Included in the loan totals, net of purchase discount, were $252.8 million and $111.4 million in loans acquired through acquisitions at September 30, 2017 and December 31, 2016, respectively. At September 30, 2017 and December 31, 2016, the purchase discount on acquired non-credit impaired loans was $5.3 million and $3.2 million, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

25

There are two methods to account for acquired loans as part of a business combination. Acquired loans that contain evidence of credit deterioration on the date of purchase are carried at the net present value of expected future proceeds in accordance with ASC 310-30 and are considered purchased credit impaired (“PCI”) loans. All other acquired loans are recorded at their initial fair value, adjusted for subsequent advances, pay downs, amortization or accretion of any premium or discount on purchase, charge-offs and any other adjustment to carrying value in accordance with ASC 310-20.

PCI loans are aggregated into pools of loans based on common risk characteristics such as the type of loan, payment status, or collateral type. The Company estimates the amount and timing of expected cash flows for each purchased loan pool and the expected cash flows in excess of the amount paid are recorded as interest income over the remaining life of the pool (accretable yield). The excess of the pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

Over the life of the loan pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

At September 30, 2017, the outstanding balance and recorded investment of PCI loans was $27.5 million and $20.6 million, respectively. The Company had no PCI loans prior to 2017.

The following table presents changes in the value of PCI loans receivable for the three and nine months ended September 30, 2017:

	For the Three Months			For the Nine Months
	Ended September 30, 2017			Ended September 30, 2017
	(In thousands)			(In thousands)
Balance at beginning of period	$	23,993		$	—
Fair value of acquired loans		—			25,439
Net reductions for payments, foreclosures, and accretion		(3,406	)		(4,852	)
Change in the allowance for loan losses on acquired loans		—			—
Balance at end of period, net of allowance for loan losses on acquired loans	$	20,587		$	20,587

26

The following table presents changes in the value of the accretable yield for PCI loans for the three and nine months ended September 30, 2017 (in thousands):

	For the Three Months			For the Nine Months
	Ended September 30, 2017			Ended September 30, 2017
	(In thousands)			(In thousands)
Accretable yield, beginning of period	$	4,542		$	—
Additions		—			4,995
Accretion		(322	)		(775	)
Reclassification from nonaccretable balance, net		—			—
Other changes, net		—			—
Accretable yield, end of period	$	4,220		$	4,220

The composition of gross loans outstanding, net of undisbursed amounts, by rate type is as follows:

	At September 30,				At December 31,
	2017				2016
	(Dollars in thousands)
Variable rate loans	$	579,895	39.06	%	$	455,589	38.67	%
Fixed rate loans		904,566	60.94	%		722,677	61.33	%
Total loans outstanding	$	1,484,461	100.00	%	$	1,178,266	100.00	%

27

The following table presents activity in the allowance for loan losses for the period indicated. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

Allowance for loan losses:	For the Three Months Ended September 30, 2017
	Loans Secured by Real Estate
	One-to-					Commercial		Construction
	four			Home		real		and						Commercial
	family			equity		estate		development			Consumer			business			Unallocated		Total
	(In thousands)
Balance, beginning of period	$	2,725			218		3,331		948			101			2,901			526		10,750
Provision for loan losses		(125	)		18		243		181			(36	)		(342	)		61		—
Charge-offs		(127	)		—		—		—			(5	)		—			—		(132	)
Recoveries		2			—		—		—			16			26			—		44
Balance, end of period	$	2,475			236		3,574		1,129			76			2,585			587		10,662
		For the Three Months Ended September 30, 2016
		Loans Secured by Real Estate
		One-to-					Commercial		Construction
		four			Home		real		and						Commercial
		family			equity		estate		development			Consumer			business			Unallocated		Total
		(In thousands)
Balance, beginning of period	$	2,706			167		3,393		1,210			30			2,423			368		10,297
Provision for loan losses		(174	)		21		189		(140	)		(1	)		43			62		—
Charge-offs		—			—		—		—			(2	)		(2	)		—		(4	)
Recoveries		9			—		—		4			8			26			—		47
Balance, end of period	$	2,541			188		3,582		1,074			35			2,490			430		10,340
Allowance for loan losses:		For the Nine Months Ended September 30, 2017
		Loans Secured by Real Estate
		One-to-					Commercial		Construction
		four			Home		real		and						Commercial
		family			equity		estate		development			Consumer			business			Unallocated		Total
		(In thousands)
Balance, beginning of period	$	2,636			197		3,344		1,132			80			2,805			494		10,688
Provision for loan losses		(2	)		39		204		(5	)		(16	)		(313	)		93		—
Charge-offs		(162	)		—		—		—			(16	)		—			—		(178	)
Recoveries		3			—		26		2			28			93			—		152
Balance, end of period	$	2,475			236		3,574		1,129			76			2,585			587		10,662
		For the Nine Months Ended September 30, 2016
		Loans Secured by Real Estate
		One-to-					Commercial		Construction
		four			Home		real		and						Commercial				��
		family			equity		estate		development			Consumer			business			Unallocated		Total
		(In thousands)
Balance, beginning of period	$	2,903			151		3,402		1,138			27			2,100			420		10,141
Provision for loan losses		(465	)		37		180		(74	)		16			296			10		—
Charge-offs		(45	)		—		—		—			(31	)		(121	)		—		(197	)
Recoveries		148			—		—		10			23			215			—		396
Balance, end of period	$	2,541			188		3,582		1,074			35			2,490			430		10,340

28

The following table disaggregates our allowance for loan losses and recorded investment in loans by impairment methodology.

	Loans Secured by Real Estate
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
	family		equity		estate		development		Consumer		business		Unallocated		Total
	(In thousands)
At September 30, 2017:
Allowance for loan losses ending balances:
Individually evaluated for impairment	$	98		54		—		—		—		15		—		167
Collectively evaluated for impairment		2,377		182		3,574		1,129		76		2,570		587		10,495
	$	2,475		236		3,574		1,129		76		2,585		587		10,662
Loans receivable ending balances:
Individually evaluated for impairment	$	4,145		623		4,805		391		16		206		—		10,186
Collectively evaluated for impairment		466,212		45,488		559,191		172,592		8,957		201,248		—		1,453,688
Purchased Credit-Impaired Loans		5,592		51		11,204		2,816		37		887		—		20,587
Total loans receivable	$	475,949		46,162		575,200		175,799		9,010		202,341		—		1,484,461
At December 31, 2016:
Allowance for loan losses ending balances:
Individually evaluated for impairment	$	27		29		92		—		—		9		—		157
Collectively evaluated for impairment		2,609		168		3,252		1,132		80		2,796		494		10,531
	$	2,636		197		3,344		1,132		80		2,805		494		10,688
Loans receivable ending balances:
Individually evaluated for impairment	$	4,668		108		5,247		507		24		267		—		10,821
Collectively evaluated for impairment		406,731		35,918		440,097		115,175		5,690		163,834		—		1,167,445
Total loans receivable	$	411,399		36,026		445,344		115,682		5,714		164,101		—		1,178,266

29

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of September 30, 2017 and December 31, 2016. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

	At September 30, 2017						At December 31, 2016
			Unpaid						Unpaid
	Recorded		Principal		Related		Recorded		Principal		Related
	Investment		Balance		Allowance		Investment		Balance		Allowance
	(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family	$	3,295		3,416		—		4,125		4,366		—
Home equity		353		353		—		—		—		—
Commercial real estate		3,350		3,350		—		4,011		4,011		—
Construction and development		391		391		—		507		507		—
Consumer loans		16		16		—		24		24		—
Commercial business loans		23		24		—		258		258		—
		7,428		7,550		—		8,925		9,166		—
With an allowance recorded:
Loans secured by real estate:
One-to-four family		850		850		98		543		543		27
Home equity		270		270		54		108		108		29
Commercial real estate		1,455		1,455		—		1,236		1,236		92
Construction and development		—		—		—		—		—		—
Consumer loans		—		—		—		—		—		—
Commercial business loans		183		183		16		9		9		9
		2,758		2,758		168		1,896		1,896		157
Total:
Loans secured by real estate:
One-to-four family		4,145		4,266		98		4,668		4,909		27
Home equity		623		623		54		108		108		29
Commercial real estate		4,805		4,805		—		5,247		5,247		92
Construction and development		391		391		—		507		507		—
Consumer loans		16		16		—		24		24		—
Commercial business loans		206		207		15		267		267		9
	$	10,186		10,308		167		10,821		11,062		157

30

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three and nine months ended September 30, 2017 and 2016.

	For the Three Months Ended September 30,									For the Nine Months Ended September 30,
	2017					2016				2017					2016
	Average		Interest			Average		Interest		Average		Interest			Average		Interest
	Recorded		Income			Recorded		Income		Recorded		Income			Recorded		Income
	Investment		Recognized			Investment		Recognized		Investment		Recognized			Investment		Recognized
	(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family	$	2,686		13			2,218		9		2,757		34			2,445		32
Home equity		347		6			111		4		290		18			37		5
Commercial real estate		3,552		(13	)		3,889		61		3,543		85			7,411		289
Construction and development		158		6			503		1		182		14			501		1
Consumer loans		19		—			20		9		19		—			29		8
Commercial business loans		32		—			286		4		32		1			465		56
		6,794		12			7,027		88		6,823		152			10,888		391
With an allowance recorded:
Loans secured by real estate:
One-to-four family		775		6			550		4		748		14			555		14
Home equity		274		—			55		2		246		(1	)		18		2
Commercial real estate		1,472		62			1,256		—		1,472		62			1,274		—
Construction and development		—		—			—		—		—		—			—		—
Consumer loans		—		—			—		—		—		—			—		—
Commercial business loans		193		2			9		—		192		8			9		—
		2,714		70			1,870		6		2,658		83			1,856		16
Total:
Loans secured by real estate:
One-to-four family		3,461		19			2,768		13		3,505		48			3,000		46
Home equity		621		6			166		6		536		17			55		7
Commercial real estate		5,024		49			5,145		61		5,015		147			8,685		289
Construction and development		158		6			503		1		182		14			501		1
Consumer loans		19		—			20		9		19		—			29		8
Commercial business loans		225		2			295		4		224		9			474		56
	$	9,508		82			8,897		94		9,481		235			12,744		407

31

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of September 30, 2017 and December 31, 2016.

	At September 30, 2017
Acquired Non-Credit	Real Estate Loans
Impaired Loans	One-to-					Commercial		Construction
(ASC 310-20) and	four		Home			real		and				Commercial
Nonacquired Loans:	family		equity			estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	251		543			980		70		208		190		2,242
60-89 days past due		503		35	��		1,086		—		21		23		1,668
90 days or more past due		1,551		108			—		90		5		5		1,759
Total past due		2,305		686			2,066		160		234		218		5,669
Current		468,052		45,425			561,930		172,823		8,739		201,236		1,458,205
Total loans receivable	$	470,357		46,111			563,996		172,983		8,973		201,454		1,463,874

	At September 30, 2017
	Real Estate Loans
	One-to-				Commercial		Construction
Acquired Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	298		—		—		—		—		—		298
60-89 days past due		25		—		—		—		—		—		25
90 days or more past due		427		—		—		1,261		—		—		1,688
Total past due		750		—		—		1,261		—		—		2,011
Current		4,842		51		11,204		1,555		37		887		18,576
Total loans receivable	$	5,592		51		11,204		2,816		37		887		20,587

32

	At December 31, 2016
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
	family		equity		estate		development		Consumer		business		Total
	(In thousands)
30-59 days past due	$	3,864		379		206		62		55		136		4,702
60-89 days past due		635		497		—		—		3		—		1,135
90 days or more past due		3,170		108		334		507		26		16		4,161
Total past due		7,669		984		540		569		84		152		9,998
Current		403,730		35,042		444,804		115,113		5,630		163,949		1,168,268
Total loans receivable	$	411,399		36,026		445,344		115,682		5,714		164,101		1,178,266

Loans are generally placed in nonaccrual status when the collection of principal and interest is 90 days or more past due, unless the obligation is both well-secured and in the process of collection. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest payments received while the loan is on nonaccrual are applied to the principal balance. No interest income was recognized on impaired loans subsequent to the nonaccrual status designation. A loan is returned to accrual status when the borrower makes consistent payments according to contractual terms and future payments are reasonably assured.

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at September 30, 2017 and December 31, 2016.

	At September 30,		At December 31,
	2017		2016
Loans secured by real estate:	(In thousands)
One-to-four family	$	2,974		3,256
Home equity		270		108
Commercial real estate		1,360		1,703
Construction and development		124		507
Consumer loans		22		27
Commercial business loans		174		24
	$	4,924		5,625

The Company uses several metrics as credit quality indicators of current or potential risks as part of the ongoing monitoring of credit quality of its loan portfolio. The credit quality indicators are periodically reviewed and updated on a case-by-case basis. The Company uses the following definitions for the internal risk rating grades, listed from the least risk to the highest risk.

Pass:These loans range from minimal credit risk to average, however, still acceptable credit risk.

Special mention: A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the institution’s credit position at some future date.

Substandard:A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that may jeopardize the liquidation of the debt. A substandard loan is characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

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Doubtful:A doubtful loan has all of the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of the currently existing facts, conditions and values, highly questionable and improbable.

The Company uses the following definitions in the tables below: 

Nonperforming:Loans on nonaccrual status plus loans greater than 90 days past due still accruing interest.

Performing:All current accrual loans plus loans less than 90 days past due. 

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of September 30, 2017 and December 31, 2016.

	At September 30, 2017
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
Total Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	472,354		45,469		571,745		173,594		8,992		200,490		1,472,644
Special Mention		483		—		2,095		138		—		1,851		4,567
Substandard		3,112		693		1,360		2,067		18		—		7,250
Total loans receivable	$	475,949		46,162		575,200		175,799		9,010		202,341		1,484,461
Performing	$	472,548		45,892		573,840		174,414		8,988		202,167		1,477,849
Nonperforming:
90 days past due still accruing		427		—		—		1,261		—		—		1,688
Nonaccrual		2,974		270		1,360		124		22		174		4,924
Total nonperforming		3,401		270		1,360		1,385		22		174		6,612
Total loans receivable	$	475,949		46,162		575,200		175,799		9,010		202,341		1,484,461

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	At September 30, 2017
Acquired Non-Credit	Real Estate Loans
Impaired Loans	One-to-				Commercial		Construction
(ASC 310-20) and	four		Home		real		and				Commercial
Nonacquired Loans:	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	467,245		45,418		561,387		172,439		8,955		199,854		1,455,298
Special Mention		188		—		1,249		74		—		1,600		3,111
Substandard		2,924		693		1,360		470		18		—		5,465
Total loans receivable	$	470,357		46,111		563,996		172,983		8,973		201,454		1,463,874
Performing	$	467,383		45,841		562,636		172,859		8,951		201,280		1,458,950
Nonperforming:
90 days past due still accruing		—		—		—		—		—		—		—
Nonaccrual		2,974		270		1,360		124		22		174		4,924
Total nonperforming		2,974		270		1,360		124		22		174		4,924
Total loans receivable	$	470,357		46,111		563,996		172,983		8,973		201,454		1,463,874

	At September 30, 2017
	Real Estate Loans
	One-to-				Commercial		Construction
Acquired Credit Impaired	four		Home		real		and				Commercial
Loans (ASC 310-30):	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	5,109		51		10,358		1,155		37		636		17,346
Special Mention		295		—		846		64		—		251		1,456
Substandard		188		—		—		1,597		—		—		1,785
Total loans receivable	$	5,592		51		11,204		2,816		37		887		20,587
Performing	$	5,165		51		11,204		1,555		37		887		18,899
Nonperforming:
90 days past due still accruing		427		—		—		1,261		—		—		1,688
Nonaccrual		—		—		—		—		—		—		—
Total nonperforming		427		—		—		1,261		—		—		1,688
Total loans receivable	$	5,592		51		11,204		2,816		37		887		20,587

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	At December 31, 2016
	Real Estate Loans
	One-to-				Commercial		Construction
	four		Home		real		and				Commercial
	family		equity		estate		development		Consumer		business		Total
	(In thousands)
Internal Risk Rating Grades:
Pass	$	407,612		35,903		442,323		114,751		5,683		162,235		1,168,507
Special Mention		438		15		1,318		424		19		1,849		4,063
Substandard		3,349		108		1,703		507		12		17		5,696
Total loans receivable	$	411,399		36,026		445,344		115,682		5,714		164,101		1,178,266
Performing	$	408,143		35,918		443,641		115,175		5,687		164,077		1,172,641
Nonperforming:
Nonaccrual		3,256		108		1,703		507		27		24		5,625
Total nonperforming		3,256		108		1,703		507		27		24		5,625
Total loans receivable	$	411,399		36,026		445,344		115,682		5,714		164,101		1,178,266

There were no loans 90 days or more past due and still accruing at December 31, 2016. 

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

Troubled Debt Restructurings 

At September 30, 2017, there were $6.5 million in loans designated as troubled debt restructurings of which $5.5 million were accruing. At September 30, 2016, there were $6.3 million in loans designated as troubled debt restructurings of which $4.9 million were accruing. At December 31, 2016, there were $6.4 million in loans designated as troubled debt restructurings of which $5.2 million were accruing.

There were no loans identified as a troubled debt restructuring during the three months ended September 30, 2016 or 2017.

No loans previously restructured in the twelve months prior to September 30, 2017 and 2016 went into default during the three and nine months ended September 30, 2017 and 2016. 

NOTE 6 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in real estate acquired through foreclosure for the periods ended September 30, 2017 and December 31, 2016:

	September 30,			December 31,
	2017			2016
	(In thousands)
Balance at beginning of period	$	1,179			2,374
Additions		1,089			2,630
Sales		(628	)		(3,810	)
Write downs		—			(15	)
Balance at end of period	$	1,640			1,179

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A summary of the composition of real estate acquired through foreclosure follows:

	At September 30,		At December 31,
	2017		2016
	(In thousands)
Real estate loans:
One-to-four family	$	291		—
Construction and development		1,349		1,179
	$	1,640		1,179

NOTE 7 - DEPOSITS

Deposits outstanding by type of account at September 30, 2017 and December 31, 2016 are summarized as follows:

	At September 30,		At December 31,
	2017		2016
	(In thousands)
Noninterest-bearing demand accounts	$	333,267		229,905
Interest-bearing demand accounts		309,241		191,851
Savings accounts		69,552		48,648
Money market accounts		377,754		292,639
Certificates of deposit:
Less than $250,000		567,483		467,937
$250,000 or more		50,357		27,280
Total certificates of deposit		617,840		495,217
Total deposits	$	1,707,654		1,258,260

The aggregate amount of brokered certificates of deposit was $112.0 million and $98.3 million at September 30, 2017 and December 31, 2016, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $250,000. The aggregate amount of institutional certificates of deposit was $43.7 million and $44.3 million at September 30, 2017 and December 31, 2016, respectively. 

NOTE 8 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

Current accounting literature requires disclosures about the fair value of all financial instruments whether or not recognized in the balance sheet, for which it is practicable to estimate the value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument. Certain items are specifically excluded from disclosure requirements, including the Company’s stock, premises and equipment, accrued interest receivable and payable and other assets and liabilities.

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The fair value of a financial instrument is an amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced sale. Fair values are estimated at a specific point in time based on relevant market information and information about the financial instruments. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.

The Company has used management’s best estimate of fair value based on the above assumptions. Thus the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses that would be incurred in an actual sale or settlement are not taken into consideration in the fair values presented. 

The Company determines the fair value of its financial instruments based on the fair value hierarchy established under ASC 820-10, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the financial instrument’s fair value measurement in its entirety. There are three levels of inputs that may be used to measure fair value. The three levels of inputs of the valuation hierarchy are defined below:

Level 1 Quoted prices (unadjusted) in active markets for identical assets and liabilities for the instrument or security to be valued. Level 1 assets include marketable equity securities as well as U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2 Observable inputs other than Level 1 quoted prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices in markets that are not active, or model-based valuation techniques for which all significant assumptions are derived principally from or corroborated by observable market data. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined by using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. U.S. Government sponsored agency securities, mortgage-backed securities issued by U.S. Government sponsored enterprises and agencies, obligations of states and municipalities, collateralized mortgage obligations issued by U.S. Government sponsored enterprises, and mortgage loans held-for-sale are generally included in this category. Certain private equity investments that invest in publicly traded companies are also considered Level 2 assets.

Level 3 Unobservable inputs that are supported by little, if any, market activity for the asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow models and similar techniques, and may also include the use of market prices of assets or liabilities that are not directly comparable to the subject asset or liability. These methods of valuation may result in a significant portion of the fair value being derived from unobservable assumptions that reflect The Company’s own estimates for assumptions that market participants would use in pricing the asset or liability. This category primarily includes collateral-dependent impaired loans, other real estate, certain equity investments, and certain private equity investments.

Cash and due from banks - The carrying amounts of these financial instruments approximate fair value. All mature within 90 days and present no anticipated credit concerns. 

Interest-bearing cash - The carrying amount of these financial instruments approximates fair value. 

Securities available-for-sale and securities held to maturity – Fair values for investment securities available-for-sale and securities held to maturity are based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

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FHLB stock and other non-marketable equity securities - The carrying amount of these financial instruments approximates fair value.

Mortgage loans held for sale – Mortgage loans held for sale are recorded at either fair value, if elected, or the lower of cost or fair value on an individual loan basis. Origination fees and costs for loans held for sale recorded at lower of cost or market are capitalized in the basis of the loan and are included in the calculation of realized gains and losses upon sale. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is derived from observable current market prices, when available, and includes loan servicing value. When observable market prices are not available, the Company uses judgment and estimates fair value using internal models, in which the Company uses its best estimates of assumptions it believes would be used by market participants in estimating fair value. Mortgage loans held for sale are classified within Level 2 of the valuation hierarchy.

Loans receivable - 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 borrowers with similar credit ratings and for the same remaining maturities. Further adjustments are made to reflect current market conditions. There is no discount for liquidity included in the expected cash flow assumptions. Loans receivable are classified within Level 3 of the valuation hierarchy.

Accrued interest receivable - The carrying value approximates the fair value. 

Mortgage servicing rights - The Company initially measures servicing assets and liabilities retained related to the sale of residential loans held for sale (“mortgage servicing rights”) at fair value, if practicable. For subsequent measurement purposes, the Company measures servicing assets and liabilities based on the lower of cost or market.

Deposits - The estimated fair value of demand deposits, savings accounts, and money market accounts is the amount payable on demand at the reporting date. The estimated fair value of fixed maturity certificates of deposits is estimated by discounting the future cash flows using rates currently offered for deposits of similar remaining maturities. 

Short-term borrowed funds - The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Estimated fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. 

Long-term debt - The estimated fair values of the Company’s long-term debt are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

39

Other Investments – The carrying value approximates the fair value. 

Derivative assets and liabilities – The primary use of derivative instruments are related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, The Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. Management also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate hedge ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

Derivative instruments not related to mortgage banking activities interest rate swap agreements - Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices are recurring Level 1.

Commitments to extend credit – The carrying amounts of these commitments are considered to be a reasonable estimate of fair value because the commitments underlying interest rates are based upon current market rates.

Accrued interest payable - The fair value approximates the carrying value.

Off-balance sheet financial instruments – Contract values and fair values for off-balance sheet, credit-related financial instruments are based on estimated fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and counterparties’ credit standing.

40

The carrying amount and estimated fair value of the Company’s financial instruments at September 30, 2017 and December 31, 2016 are as follows:

	At September 30, 2017
	Carrying		Fair Value
	Amount		Total		Level 1		Level 2		Level 3
Financial assets:	(In thousands)
Cash and due from banks	$	14,046		14,046		14,046		—		—
Interest-bearing cash		31,198		31,198		31,198		—		—
Securities available-for-sale		523,744		523,744		—		514,801		8,943
Federal Home Loan Bank stock		10,970		10,970		—		—		10,970
Other investments		2,139		2,139		—		—		2,139
Derivative assets		2,332		2,332		818		1,514		—
Loans held for sale		26,786		26,786		—		26,786		—
Loans receivable, net		1,473,799		1,472,666		—		—		1,472,666
Accrued interest receivable		7,320		7,320		—		7,320		—
Mortgage servicing rights		17,444		22,764		—		—		22,764
Cash value life insurance		38,317		38,317		—		38,317		—
Financial liabilities:
Deposits		1,707,654		1,705,605		—		1,705,605		—
Short-term borrowed funds		180,000		179,775		—		179,775		—
Long-term debt		54,351		54,165		—		54,165		—
Derivative liabilities		201		201		201		—		—
Accrued interest payable		1,053		1,053		—		1,053		—

	At December 31, 2016
	Carrying		Fair Value
	Amount		Total		Level 1		Level 2		Level 3
Financial assets:	(In thousands)
Cash and due from banks	$	9,761		9,761		9,761		—		—
Interest-bearing cash		14,591		14,591		14,591		—		—
Securities available-for-sale		335,352		335,352		—		328,188		7,164
Federal Home Loan Bank stock		11,072		11,072		—		—		11,072
Other investments		1,768		1,768		—		—		1,768
Derivative assets		2,219		2,219		953		1,266		—
Loans held for sale		31,569		31,569		—		31,569		—
Loans receivable, net		1,167,578		1,173,118		—		—		1,173,118
Cash value life insurance		28,984		28,984		—		28,984		—
Accrued interest receivable		5,373		5,373		—		5,373		—
Mortgage servicing rights		15,032		20,961		—		—		20,961
Financial liabilities:
Deposits		1,258,260		1,256,119		—		1,256,119		—
Short-term borrowed funds		203,000		202,455		—		202,455		—
Long-term debt		38,465		38,442		—		38,442		—
Derivative liabilities		342		342		195		147		—
Accrued interest payable		327		327		—		327		—

41

	At September 30, 2017				At December 31, 2016
	Notional		Estimated		Notional		Estimated
	Amount		Fair Value		Amount		Fair Value
Off-Balance Sheet Financial Instruments:	(In thousands)
Commitments to extend credit	$	209,319		—		111,446		—
Standby letters of credit		3,272		—		2,248		—

In determining appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to fair value disclosures. At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3.

Following is a description of valuation methodologies used for assets recorded at fair value on a recurring and non-recurring basis.

Securities Available-for-Sale 

Measurement is on a recurring basis upon quoted market prices, if available. If quoted market 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 prepayment assumptions, projected credit losses, and liquidity. At September 30, 2017 and December 31, 2016, the Company’s investment securities available-for-sale are recurring Level 2 except for trust preferred securities which are determined to be Level 3.

Mortgage Loans Held for Sale

Mortgage loans held for sale are recorded at either fair value, if elected, or the lower of cost or fair value on an individual loan basis. Origination fees and costs for loans held for sale recorded at lower of cost or market are capitalized in the basis of the loan and are included in the calculation of realized gains and losses upon sale. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is derived from observable current market prices, when available, and includes loan servicing value. When observable market prices are not available, the Company uses judgment and estimates fair value using internal models, in which the Company uses its best estimates of assumptions it believes would be used by market participants in estimating fair value. Mortgage loans held for sale are classified within Level 2 of the valuation hierarchy.

Derivative Assets and Liabilities 

The primary use of derivative instruments is related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, the Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. The Company also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate hedge ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

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Derivative instruments not related to mortgage banking activities include interest rate swap agreements. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices in an active market are recurring Level 1. 

Impaired Loans

Loans that are considered impaired are recorded at fair value on a nonrecurring basis. Once a loan is considered impaired, the fair value is measured using one of several methods, including collateral liquidation value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific charge against the allowance represent loans for which the fair value of the expected repayments or collateral meet or exceed the recorded investment in the loan. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair value of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 3 inputs. 

Other Real Estate Owned (“OREO”)

OREO is carried at the lower of carrying value or fair value on a nonrecurring basis.  Fair value is based upon independent appraisals or management’s estimation of the collateral and is considered a Level 3 measurement.  When the OREO value is based upon a current appraisal or when a current appraisal is not available or there is estimated further impairment, the measurement is considered a Level 3 measurement.

Mortgage Servicing Rights 

A mortgage servicing right asset represents the amount by which the present value of the estimated future net cash flows to be received from servicing loans are expected to more than adequately compensate the Company for performing the servicing. The Company initially measures servicing assets and liabilities retained related to the sale of residential loans held for sale (“mortgage servicing rights”) at fair value, if practicable. For subsequent measurement purposes, the Company measures servicing assets and liabilities based on the lower of cost or market on a quarterly basis. The quarterly determination of fair value of servicing rights is provided by a third party and is estimated using a present value cash flow model. The most important assumptions used in the valuation model are the anticipated rate of the loan prepayments and discount rates. Although some assumptions in determining fair value are based on standards used by market participants, some are based on unobservable inputs and therefore are classified in Level 3 of the valuation hierarchy.

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Assets and liabilities measured at fair value on a recurring basis are as follows as of September 30, 2017 and December 31, 2016:

	Quoted market		Significant other		Significant other
	price in active markets		observable inputs		unobservable inputs
	(Level 1)		(Level 2)		(Level 3)
	(In thousands)
September 30, 2017
Available-for-sale investment securities:
Municipal securities	$	—		166,607		—
US government agencies		—		10,354		—
Collateralized loan obligations		—		112,126		—
Corporate securities		—		494		—
Mortgage-backed securities:
Agency		—		167,891		—
Non-agency		—		57,329		—
Trust Preferred Securities		—		—		8,943
Loans held for sale		—		26,786		—
Derivative assets:
Cash flow hedges:
Interest rate swaps		205		—		—
Non-hedging derivatives:
Interest rate swaps		613		—		—
Mortgage loan interest rate lock commitments		—		913		—
Mortgage loan forward sales commitments		—		245		—
Mortgage-backed securities forward sales commitments		—		356		—
Derivative liabilities:
Cash flow hedges:
Interest rate swaps		1		—		—
Non-hedging derivatives:
Interest rate swaps		200		—		—
Total	$	1,019		543,101		8,943
December 31, 2016
Available-for-sale investment securities:
Municipal securities	$	—		93,212		—
US government agencies		—		3,386		—
Collateralized loan obligations		—		76,249		—
Corporate securities		—		491		—
Mortgage-backed securities:
Agency		—		90,986		—
Non-agency		—		63,864		—
Trust preferred securities		—		—		7,164
Loans held for sale		—		31,569		—
Derivative assets:
Cash flow hedges:
Interest rate swaps		421		—		—
Non-hedging derivatives:
Interest rate swaps		532		—		—
Mortgage loan interest rate lock commitments		—		1,113		—
Mortgage loan forward sales commitments		—		153		��
Derivative liabilities:
Non-hedging derivatives:
Interest rate swaps		195		—		—
Mortgage-backed securities forward sales commitments		—		147		—
Total	$	1,148		361,170		7,164

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Assets measured at fair value on a nonrecurring basis are as follows as of September 30, 2017 and December 31, 2016:

	Quoted market		Significant other		Significant other
	price in active markets		observable inputs		unobservable inputs
	(Level 1)		(Level 2)		(Level 3)
	(In thousands)
September 30, 2017
Impaired loans:
Loans secured by real estate:
One-to-four family	$	—		—		4,047
Home equity		—		—		569
Commercial real estate		—		—		4,805
Construction and development		—		—		391
Consumer loans		—		—		16
Commercial business loans		—		—		191
Real estate owned:
One-to-four family		—		—		291
Construction and development		—		—		1,349
Mortgage servicing rights		—		—		22,764
Total	$	—		—		34,423
December 31, 2016
Impaired loans:
Loans secured by real estate:
One-to-four family	$	—		—		4,641
Home equity		—		—		79
Commercial real estate		—		—		5,155
Construction and development		—		—		507
Consumer loans		—		—		24
Commercial business loans		—		—		258
Real estate owned:
Construction and development		—		—		1,179
Mortgage servicing rights		—		—		20,961
Total	$	—		—		32,804

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For Level 3 assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2017 and December 31, 2016, the significant unobservable inputs used in the fair value measurements were as follows:

	September 30, 2017 and December 31, 2016
		Significant	Significant Unobservable
	Valuation Technique	Observable Inputs	Inputs
Impaired Loans	Appraisal Value	Appraisals and or sales of	Appraisals discounted 10% to 20% for
		comparable properties	sales commissions and other holding costs
Real estate owned	Appraisal Value/	Appraisals and or sales of	Appraisals discounted 10% to 20% for
	Comparison Sales	comparable properties	sales commissions and other holding costs
Mortgage Servicing Rights	Discounted cash flows	Comparable sales	Discount rates averaging 12% - 13%
			in each period presented
			Prepayment rates averaging 7% - 8% - 2016
			Prepayment rates averaging 9% -10% -2017

NOTE 9 - EARNINGS PER SHARE

Basic earnings per share (“EPS”) represents income available to common stockholders divided by the weighted-average number of shares outstanding during the period. Diluted earnings per share reflects additional shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate solely to outstanding stock options, restricted stock (non-vested shares), restricted stock units (“RSUs”) and warrants, and are determined using the treasury stock method. Under the treasury stock method, the number of incremental shares is determined by assuming the issuance of stock for the outstanding stock options, unvested restricted stock and RSUs, and warrants, reduced by the number of shares assumed to be repurchased from the issuance proceeds, using the average market price for the period of the Company’s stock.

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The following is a summary of the reconciliation of weighted average shares outstanding for the three and nine months ended September 30, 2017 and 2016:

	For the Three Months Ended September 30,
	2017				2016
	Basic		Diluted		Basic		Diluted
Weighted average shares outstanding		16,029,332		16,029,332		12,327,921		12,327,921
Effect of dilutive securities		—		158,537		—		207,630
Weighted average shares outstanding		16,029,332		16,187,869		12,327,921		12,535,551
	For the Nine Months Ended September 30,
	2017				2016
	Basic		Diluted		Basic		Diluted
Weighted average shares outstanding		14,980,349		14,980,349		11,995,477		11,995,477
Effect of dilutive securities		—		166,623		—		206,244
Weighted average shares outstanding		14,980,349		15,146,972		11,995,477		12,201,721

The following is a summary of the reconciliation of shares issued and outstanding and unvested restricted stock awards as of September 30, 2017 and 2016 used to calculate book value per share:

	As of September 30,
	2017			2016
Issued and outstanding shares		16,159,309			12,546,220
Less nonvested restricted stock awards		(99,639	)		(216,828	)
Period end dilutive shares		16,059,670			12,329,392

NOTE 10 – SUPPLEMENTAL SEGMENT INFORMATION

The Company has three reportable segments: community banking, wholesale mortgage banking (“mortgage banking”) and other. The community banking segment includes traditional banking services offered through the Bank as well as the managerial and operational support provided by Carolina Services. The mortgage banking segment provides wholesale mortgage loan origination and servicing offered through Crescent Mortgage Company. The other segment includes parent company financial information and represents an overhead function rather than an operating segment. The parent company’s most significant assets are its net investments in its subsidiaries.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on net income.

The Company accounts for intersegment revenues and expenses as if the revenue/expense transactions were generated to third parties, that is, at current market prices.

The Company’s reportable segments are strategic business units that offer different products and services. They are managed separately because each segment has different types and levels of credit and interest rate risk.

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The following tables present selected financial information for the Company’s reportable business segments for the three and nine months ended September 30, 2017 and 2016:

	Community		Mortgage
For the Three Months Ended September 30, 2017	Banking		Banking		Other			Eliminations			Total
	(In thousands)
Interest income	$	22,460		480		8			(22	)		22,926
Interest expense		3,086		65		291			(65	)		3,377
Net interest income (expense)		19,374		415		(283	)		43			19,549
Provision for loan losses		—		—		—			—			—
Noninterest income from external customers		3,097		4,778		—			—			7,875
Intersegment noninterest income		242		—		—			(242	)		—
Noninterest expense		10,999		4,234		223			—			15,456
Intersegment noninterest expense		—		240		2			(242	)		—
Income (loss) before income taxes		11,714		719		(508	)		43			11,968
Income tax expense (benefit)		3,877		270		(188	)		16			3,975
Net income (loss)	$	7,837		449		(320	)		27			7,993

	Community			Mortgage
For the Three Months Ended September 30, 2016	Banking			Banking			Other			Eliminations			Total
	(In thousands)
Interest income	$	15,760			435			4			9			16,208
Interest expense		2,102			33			151			(34	)		2,252
Net interest income (expense)		13,658			402			(147	)		43			13,956
Provision for loan losses		(12	)		12			—			—			—
Noninterest income from external customers		2,512			6,361			—			—			8,873
Intersegment noninterest income		242			(9	)		—			(233	)		—
Noninterest expense		9,448			4,254			188			—			13,890
Intersegment noninterest expense		—			240			2			(242	)		—
Income (loss) before income taxes		6,976			2,248			(337	)		52			8,939
Income tax expense (benefit)		2,242			846			(109	)		19			2,998
Net income (loss)	$	4,734			1,402			(228	)		33			5,941

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	Community		Mortgage
For the Nine Months Ended September 30, 2017	Banking		Banking		Other			Eliminations			Total
	(In thousands)
Interest income	$	61,409		1,302		21			(14	)		62,718
Interest expense		8,051		119		750			(119	)		8,801
Net interest income (expense)		53,358		1,183		(729	)		105			53,917
Provision for loan losses		—		—		—			—			—
Noninterest income from external customers		9,011		14,899		—			—			23,910
Intersegment noninterest income		725		64		—			(789	)		—
Noninterest expense		33,773		12,448		711			—			46,932
Intersegment noninterest expense		—		720		5			(725	)		—
Income (loss) before income taxes		29,321		2,978		(1,445	)		41			30,895
Income tax expense (benefit)		8,533		645		(535	)		16			8,659
Net income (loss)	$	20,788		2,333		(910	)		25			22,236

	Community			Mortgage
For the Nine Months September 30, 2016	Banking			Banking		Other			Eliminations			Total
	(In thousands)
Interest income	$	42,790			1,133		13			75			44,011
Interest expense		6,066			42		447			(43	)		6,512
Net interest income (expense)		36,724			1,091		(434	)		118			37,499
Provision for loan losses		(12	)		12		—			—			—
Noninterest income from external customers		6,773			15,615		—			—			22,388
Intersegment noninterest income		727			25		—			(752	)		—
Noninterest expense		29,523			11,825		619			—			41,967
Intersegment noninterest expense		—			721		6			(727	)		—
Income (loss) before income taxes		14,713			4,173		(1,059	)		93			17,920
Income tax expense (benefit)		4,404			1,451		(390	)		35			5,500
Net income (loss)	$	10,309			2,722		(669	)		58			12,420

The following tables present selected financial information for the Company’s reportable business segments for September 30, 2017 and December 31, 2016:

	Community		Mortgage
At September 30, 2017	Banking		Banking		Other		Eliminations			Total
	(In thousands)
Assets	$	2,255,640		76,579		310,281		(385,761	)		2,256,739
Loans receivable, net		1,457,942		25,549		—		(9,692	)		1,473,799
Loans held for sale		1,658		25,128		—		—			26,786
Deposits		1,715,798		—		—		(8,144	)		1,707,654
Borrowed funds		211,000		9,163		23,351		(9,163	)		234,351

	Community		Mortgage
At December 31, 2016	Banking		Banking		Other		Eliminations			Total
	(In thousands)
Assets	$	1,678,541		78,315		179,681		(252,801	)		1,683,736
Loans receivable, net		1,151,704		27,433		—		(11,559	)		1,167,578
Loans held for sale		2,159		29,410		—		—			31,569
Deposits		1,263,030		—		—		(4,770	)		1,258,260
Borrowed funds		226,000		10,990		15,465		(10,990	)		241,465

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion reviews our results of operations for the three and nine months ended September 30, 2017 as compared to the three and nine months ended September 30, 2016 and assesses our financial condition as of September 30, 2017 as compared to December 31, 2016. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2016 included in our Form 10-K for that period. Results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 or any future period.

Cautionary Warning Regarding Forward-Looking Statements

This report, including information included or incorporated by reference in this report, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, the following:

· our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;

· examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;

· changes in economic conditions, either nationally or regionally and especially in our primary market areas, resulting in, among other things, a deterioration in credit quality;

· changes in interest rates, or changes in regulatory environment resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;

· greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;

· greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

· changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, eastern North Carolina and national real estate markets;

· the rate of delinquencies and amount of loans charged-off;

· the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;

· the rate of loan growth in recent or future years;

· our ability to attract and retain key personnel;

· our ability to retain our existing customers, including our deposit relationships;

· significant increases in competitive pressure in the banking and financial services industries;

· adverse changes in asset quality and resulting credit risk-related losses and expenses;

· changes in the interest rate environment which could reduce anticipated or actual margins;

· changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking, mortgage banking, and financial service industries;

· changes occurring in business conditions and inflation;

· increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;

· our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;

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· changes in deposit flows;

· changes in technology;

· changes in monetary and tax policies;

· changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the FASB;

· loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;

· our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;

· our anticipated capital expenditures and our estimates regarding our capital requirements;

· our liquidity and working capital requirements;

· competitive pressures among depository and other financial institutions;

· the growth rates of the markets in which we compete;

· our anticipated strategies for growth and sources of new operating revenues;

· our current and future products, services, applications and functionality and plans to promote them;

· anticipated trends and challenges in our business and in the markets in which we operate;

· the evolution of technology affecting our products, services and markets;

· our ability to retain and hire necessary employees and to staff our operations appropriately;

· management compensation and the methodology for its determination;

· our ability to compete in our industry and innovation by our competitors;

· increased cybersecurity risk, including potential business disruptions or financial losses;

· acquisition integration risks, including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related matters, and the inability to identify and successfully negotiate and complete additional combinations with potential merger or acquisition partners or to successfully integrate such businesses into the Company, including the ability to realize the benefits and cost savings from, and limit any unexpected liabilities associated with, any such business combinations;

· our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business; and

· estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices and stock-based compensation.

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements prove to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2016. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q and our other reports filed pursuant to the Securities Exchange Act of 1934. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

Company Overview

 Carolina Financial Corporation is a Delaware corporation and a financial holding company registered under the Bank Holding Company Act of 1956, as amended. Its primary business is to serve as the holding company to CresCom Bank, a South Carolina state-chartered bank. CresCom Bank operates Crescent Mortgage Company and Carolina Service Corporation of Charleston as wholly-owned subsidiaries of CresCom Bank. Except where the context otherwise requires, the “Company”, “we”, “us” and “our” refer to Carolina Financial Corporation and its consolidated subsidiaries and the “Bank” refers to CresCom Bank.

CresCom Bank provides a full range of commercial and retail banking financial services designed to meet the financial needs of our customers through its branch network in South Carolina and North Carolina. Crescent Mortgage Company, headquartered in Atlanta, Georgia, is a wholesale mortgage company licensed to provide mortgage banking services in 48 states and partners with community banks, credit unions and mortgage brokers. 

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Like most community banks, we derive a significant portion of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, both interest-bearing and noninterest-bearing. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowed funds. In order to maximize our net interest income, we must not only manage the volume of these balance sheet items, but also the yields that we earn on our interest-earning assets and the rates that we pay on interest-bearing liabilities. 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings.

In addition to earning interest on our loans and investments, we derive a portion of our income from Crescent Mortgage Company through mortgage banking income as well as servicing income. We also earn income through fees that we charge to our customers. Likewise, we incur other operating expenses as well.

Economic conditions, competition, and the monetary and fiscal policies of the federal government significantly affect most financial institutions, including the Bank. Lending and deposit activities and fee income generation are influenced by levels of business spending and investment, consumer income, consumer spending and savings, capital market activities, and competition among financial institutions as well as client preferences, interest rate conditions and prevailing market rates on competing products in our market areas.

Recent Events

On January 25, 2017, the Company closed a public offering of 1.8 million shares of its common stock with net proceeds of approximately $47.7 million.

On March 18, 2017, the Company closed its acquisition of Greer Bancshares Incorporated, the holding company for Greer State Bank (“Greer”) ,with the operational conversion completed in April 2017.

Pursuant to an Agreement and Plan of Merger and Reorganization, dated as of June 9, 2017, by and between the Company and First South Bancorp, Inc. (“First South”), on November 1, 2017 First South merged with and into the Company, with the Company as the surviving corporation. Immediately thereafter, First South Bank, a wholly owned subsidiary of First South, merged with and into the Bank, with the Bank as the surviving Bank. Pursuant to the merger agreement, holders of First South common stock received 0.5064 shares of the common stock of the Company for each share of First South common stock held immediately prior to the effective time of the merger. The Company issued 4.8 million shares of common stock to the former shareholders of First South in the transaction.

Executive Summary of Operating Results

The following is a summary of the Company’s financial highlights and significant events in third quarter of 2017:

· Net income for the third quarter 2017 increased 34.5% to $8.0 million, or $0.49 per diluted share, from $5.9 million, or $0.47 per diluted share for the third quarter of 2016. Included in earnings are pretax merger related expenses of $0.3 million for the third quarter of 2017. There were no merger related expenses in the third quarter of 2016.

· Operating earnings for the third quarter of 2017, which excludes certain non-operating income and expenses, increased 34.3% to $7.9 million, or $0.49 per diluted share, from $5.9 million, or $0.47 per diluted share, from the third quarter of 2016.

· Performance ratios third quarter of 2017 compared to third quarter of 2016:

o Return on average assets was 1.43% compared to 1.46%.

o Operating return on average assets was 1.42% compared to 1.45%.

o Return on average tangible equity was 13.24% compared to 15.93%.

o Operating return on average tangible equity was 13.08% compared to 15.76%.

o Average stockholders’ equity to average assets increased to 12.85% compared to 9.67%.

52

· Loans receivable, excluding Greer loans acquired, grew at an annualized rate of 12.6%, or $111.5 million, since December 31, 2016.

· Nonperforming assets to total assets were 0.29% at September 30, 2017 compared to 0.40% at December 31, 2016.

· Total deposits, excluding Greer deposits acquired, increased $138.3 million since December 31, 2016. Core deposits, excluding Greer core deposits acquired, increased $78.0 million since December 31, 2016.

Non-GAAP Financial Measures

Statements included in this management’s discussion and analysis include non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The Company’s management uses these non-GAAP financial measures, including: (i) operating earnings; (ii) operating earnings per common share (iii) operating return on average assets, (iv) operating return on average tangible equity, (v) core deposits, (vi) tangible book value and (vii) allowance for loan losses to non-acquired loans.

Management believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company without regard to transactional activities. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under GAAP, and investors should consider the Company’s performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the Company’s results or financial condition as reported under GAAP.

The following is a summary of the Company’s performance measures:

	At or for the Three						At or for the Nine
	Months Ended						Months Ended
	September 30,			September 30,			September 30,			September 30,
	2017			2016			2017			2016
Performance Ratios (annualized):
Return on average equity		11.16	%		15.11	%		11.49	%		11.18	%
Return on average assets		1.43	%		1.46	%		1.44	%		1.10	%
Return on average tangible equity (Non-GAAP)		13.24	%		15.93	%		13.25	%		11.41	%
Average earning assets to average total assets		91.09	%		92.94	%		91.18	%		93.63	%
Average loans receivable to average deposits		85.59	%		84.68	%		87.53	%		85.65	%
Average stockholders’ equity to average assets		12.85	%		9.67	%		12.56	%		9.87	%
Net interest margin-tax equivalent (1)		3.94	%		3.75	%		3.97	%		3.67	%
Net charge-offs (recovery) to average loans receivable		0.02	%		(0.02	)%		0.00	%		(0.03	)%
Nonperforming assets to period end loans receivable		0.44	%		0.62	%		0.44	%		0.62	%
Nonperforming assets to total assets		0.29	%		0.42	%		0.29	%		0.42	%
Nonperforming loans to total loans		0.33	%		0.37	%		0.33	%		0.37	%
Allowance for loan losses as a percentage of  loans receivable (end of period)		0.72	%		0.91	%		0.72	%		0.91	%
Allowance for loan losses as a percentage of non-acquired loans receivable (Non-GAAP)		0.87	%		1.03	%		0.87	%		1.03	%
Allowance for loan losses as a percentage of nonperforming loans		216.53	%		247.72	%		216.53	%		247.72	%

 (1) Net interest margin-tax equivalent reflects tax-exempt income on a tax-equivalent basis.

53

The following table presents a reconciliation of Non-GAAP performance measures for consolidated operating earnings and corresponding ratios:

Carolina Financial Corporation
Reconciliation of Non-GAAP Financial Measures - Consolidated
(Unaudited)
(In thousands, except share data)
	For the Three Months Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
Operating Earnings and Performance Ratios:	2017			2017			2017			2016			2016
Income before income taxes	$	11,968			12,013			6,915			7,498			8,939
Gain on sale of securities		(368	)		(621	)		(185	)		(65	)		(111	)
Net loss on extinguishment of debt		—			—			—			1,694			118
Fair value adjustments on interest rate swaps		(90	)		69			58			(998	)		(99	)
Merger related expenses		311			279			1,319			260			—
Operating earnings before income taxes		11,821			11,740			8,107			8,389			8,847
Tax expense (1)		3,926			2,612			2,358			2,627			2,967
Operating earnings (Non-GAAP)	$	7,895			9,128			5,749			5,762			5,880
Average equity	$	286,524			277,708			210,071			160,991			157,311
Average assets	$	2,230,586			2,166,803			1,768,323			1,651,653			1,626,717
Average Equity	$	286,524			277,708			210,071			160,991			157,311
Less average intangible assets		(45,035	)		(44,452	)		(13,510	)		(7,979	)		(8,092	)
Average tangible common equity (Non-GAAP)	$	241,489			233,256			196,561			153,012			149,219
Operating return on average assets (Non-GAAP)		1.42	%		1.69	%		1.30	%		1.40	%		1.45	%
Operating return on average equity (Non-GAAP)		11.02	%		13.15	%		10.95	%		14.32	%		14.95	%
Operating return on average tangible equity (Non-GAAP)		13.08	%		15.65	%		11.70	%		15.06	%		15.76	%
Weighted average common shares outstanding:
Basic		16,029,332			16,029,332			13,919,711			12,336,420			12,327,921
Diluted		16,187,869			16,180,171			14,139,241			12,585,518			12,535,551
Operating earnings per common share:
Basic (Non-GAAP)	$	0.49			0.57			0.41			0.47			0.48
Diluted (Non-GAAP)	$	0.49			0.56			0.41			0.46			0.47
As Reported:
Income before income taxes	$	11,968			12,013			6,915			7,498			8,939
Tax expense		3,975			2,673			2,011			2,348			2,998
Net Income	$	7,993			9,340			4,904			5,150			5,941
Average equity	$	286,524			277,708			210,071			160,991			157,311
Average tangible equity (Non-GAAP)	$	241,489			233,256			196,561			153,012			149,219
Average assets	$	2,230,586			2,166,803			1,768,323			1,651,653			1,626,717
Return on average assets		1.43	%		1.72	%		1.11	%		1.25	%		1.46	%
Return on average equity		11.16	%		13.45	%		9.34	%		12.80	%		15.11	%
Return on average tangible equity (Non-GAAP)		13.24	%		16.02	%		9.98	%		13.46	%		15.93	%
Weighted average common shares outstanding:
Basic		16,029,332			16,029,332			13,919,711			12,336,420			12,327,921
Diluted		16,187,869			16,180,171			14,139,241			12,585,518			12,535,551
Earnings per common share:
Basic	$	0.50			0.58			0.35			0.42			0.48
Diluted	$	0.49			0.58			0.35			0.41			0.47
(1) Tax expense is determined using the effective tax rate reflected in the accompanying income statement for the applicable reporting period.

54

Carolina Financial Corporation
Reconciliation of Non-GAAP Financial Measures - Consolidated
(Unaudited)
(In thousands, except share data)
	At the Month Ended
	September 30,		June 30,		March 31,		December 31,		September 30,
	2017		2017		2017		2016		2016
Core deposits:
Noninterest-bearing demand accounts	$	333,267	$	330,641		298,365		229,905		267,892
Interest-bearing demand accounts		309,241		298,123		309,961		191,851		195,792
Savings accounts		69,552		70,336		66,506		48,648		47,035
Money market accounts		377,754		380,108		363,600		292,639		299,960
Total core deposits (Non-GAAP)		1,089,814		1,079,208		1,038,432		763,043		810,679
Certificates of deposit:
Less than $250,000		567,483		539,177		524,836		467,937		476,744
$250,000 or more		50,357		45,344		44,452		27,280		24,853
Total certificates of deposit		617,840		584,521		569,288		495,217		501,597
Total deposits	$	1,707,654	$	1,663,729		1,607,720		1,258,260		1,312,276

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	At the Month Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
	2017			2017			2017			2016			2016
Tangible book value per share:
Total stockholders’ equity	$	290,224			281,818			271,454			163,190			160,331
Less intangible assets		(44,953	)		(45,123	)		(45,292	)		(7,924	)		(8,037	)
Tangible common equity (Non-GAAP)	$	245,271			236,695			226,162			155,266			152,294
Issued and outstanding shares		16,159,309			16,156,943			16,185,408			12,548,328			12,546,220
Less nonvested restricted stock awards		(99,639	)		(101,489	)		(227,439	)		(211,908	)		(216,828	)
Period end dilutive shares		16,059,670			16,055,454			15,957,969			12,336,420			12,329,392
Total stockholders equity	$	290,224			281,818			271,454			163,190			160,331
Divided by period end dilutive shares		16,059,670			16,055,454			15,957,969			12,336,420			12,329,392
Common book value per share	$	18.07			17.55			17.01			13.23			13.00
Tangible common equity (Non-GAAP)	$	245,271			236,695			226,162			155,266			152,294
Divided by period end dilutive shares		16,059,670			16,055,454			15,957,969			12,336,420			12,329,392
Tangible common book value per share (Non-GAAP)	$	15.27			14.74			14.17			12.59			12.35
		At the Month Ended
		September 30,			June 30,			March 31,			December 31,			September 30,
		2017			2017			2017			2016			2016
Acquired and non-acquired loans:
Acquired loans receivable	$	257,461		$	278,275			303,244			119,422			129,505
Non-acquired loans receivable		1,227,000			1,157,145			1,113,766			1,058,844			1,003,724
Total loans receivable	$	1,484,461		$	1,435,420			1,417,010			1,178,266			1,133,229
% Acquired		17.34	%		19.39	%		21.40	%		10.14	%		11.43	%
Non-acquired loans	$	1,227,000		$	1,157,145			1,113,766			1,058,844			1,003,724
Allowance for loan losses		10,662			10,750			10,715			10,688			10,340
Allowance for loan losses to non-acquired loans (Non-GAAP)		0.87	%		0.93	%		0.96	%		1.01	%		1.03	%
Total loans receivable	$	1,484,461		$	1,435,420			1,417,010			1,178,266			1,133,229
Allowance for loan losses		10,662			10,750			10,715			10,688			10,340
Allowance for loan losses to total loans receivable		0.72	%		0.75	%		0.76	%		0.91	%		0.91	%

Critical Accounting Policies 

There have been no significant changes to our critical accounting policies from those disclosed in our 2016 Annual Report on Form 10-K. Refer to the notes to our consolidated financial statements in our 2016 Annual Report on Form 10-K for a full disclosure of all critical accounting policies.

Results of Operations

Summary

The Company reported an increase in net income for the three months ended September 30, 2017 to $8.0 million, or $0.49 per diluted share, as compared to $5.9 million, or $0.47 per diluted share, for the three months ended September 30, 2016. Included in net income for the three months ended September 30, 2017 were pretax merger related expenses of $0.3 million. There were no merger related expenses for the three months ended September 30, 2016. The Company reported increased net income for the nine months ended September 30, 2017 of $22.2 million, or $1.47 per diluted share, as compared to $12.4 million, or $1.02 per diluted share, for the nine months ended September 30, 2016. Included in net income for the nine months ended September 30, 2017 and 2016 were pretax merger related expenses of $1.9 million and $3.0 million, respectively.

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Net Interest Income and Margin

Net interest income is a significant component of our net income. Net interest income is the difference between income earned on interest-earning assets and interest paid on interest-bearing liabilities. Net interest income is determined by the yields earned on interest-earning assets, rates paid on interest-bearing liabilities, the relative balances of interest-earning assets and interest-bearing liabilities, the degree of mismatch, and the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities.

Net interest income increased to $19.5 million for the three months ended September 30, 2017 from $14.0 million for the three months ended September 30, 2016. Net interest income increased to $53.9 million for the nine months ended September 30, 2017 from $37.5 million for the nine months ended September 30, 2016. The increase in net interest income is a result of the increase in average interest-earning assets balances, as well as an increase in the net interest margin on a tax equivalent yield basis of 19 basis points over the comparable prior year quarter. The increase in average earnings assets for the three months ended September 30, 2017 is primarily the result of increased balances of securities available for sale and loans receivable.

The growth in loan balances was primarily the result of the following:

· On June 11, 2016, the Company acquired approximately $74.6 million of loans, net of purchase accounting adjustments, as part of the acquisition of Congaree Bancshares, Inc. (“Congaree”). The recorded investment in loans acquired from the Congaree acquisition were $55.8 million as of September 30, 2017.

· On March 18, 2017, the Company acquired approximately $194.7 million of loans, net of purchase accounting adjustments, as part of the acquisition of Greer. The recorded investment in loans acquired from the Greer acquisition were $159.5 million as of September 30, 2017. Loans that have been refinanced are not included below. The recorded investment as of September 30, 2017 for loans acquired in the acquisition of Greer are presented in the following table:

	At September 30, 2017
			% of Total
	Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	42,006		26.33	%
Home equity		14,484		9.08	%
Commercial real estate		62,588		39.24	%
Construction and development		17,542		11.00	%
Consumer loans		3,128		1.96	%
Commercial business loans		19,769		12.39	%
Total loans receivable, net		159,517		100.00	%

· Residential mortgage – In addition to selling a portion of its production, the Company has retained a portion of its mortgage production. Due to management’s emphasis on growing the Company’s residential mortgage portfolio, loans receivable within the one-to-four family portfolio has increased $75.4 million since September 30, 2016. This growth includes loans acquired in the acquisition of Greer.

· Commercial lending – The Company continues to expand its commercial lending team throughout its markets. As a result, gross loans receivable within commercial real estate and construction and development increased $204.5 million since September 30, 2016. This growth includes loans acquired in the acquisition of Greer.

57

The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the periods indicated (dollars in thousands). We derived these yields or costs by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments were owned at an original maturity of over one year. Nonaccrual loans are included in earning assets in the following tables. Loan yields reflect the negative impact on our earnings of loans on nonaccrual status. The net capitalized loan costs and fees, which are considered immaterial, are amortized into interest income on loans.

	For The Three Months Ended September 30,
	2017								2016
				Interest		Average						Interest		Average
	Average			Earned/		Yield/			Average			Earned/		Yield/
	Balance			Paid		Rate			Balance			Paid		Rate
Interest-earning assets:
Loans held for sale	$	27,282			269		3.91	%		32,196			282		3.48	%
Loans receivable, net (1)		1,463,771			18,691		5.07	%		1,093,669			13,544		4.93	%
Interest-bearing cash		16,533			52		1.25	%		29,989			19		0.25	%
Securities available for sale		511,564			3,757		2.87	%		345,385			2,264		2.57	%
Dividends from non-equitable securities		10,005			135		5.35	%		7,477			83		4.42	%
Other investments		2,629			22		3.32	%		3,201			16		1.96	%
Total interest-earning assets		2,031,784			22,926		4.48	%		1,511,917			16,208		4.26	%
Non-earning assets		198,802								114,800
Total assets	$	2,230,586								1,626,717
Interest-bearing liabilities:
Demand accounts		297,163			228		0.30	%		175,484			64		0.15	%
Money market accounts		381,711			500		0.52	%		298,961			233		0.31	%
Savings accounts		69,233			36		0.21	%		46,875			15		0.13	%
Certificates of deposit		607,532			1,658		1.08	%		504,492			1,258		0.99	%
Short-term borrowed funds		146,670			441		1.19	%		88,452			124		0.56	%
Long-term debt		64,855			514		3.14	%		68,282			558		3.25	%
Total interest-bearing liabilities		1,567,164			3,377		0.85	%		1,182,546			2,252		0.76	%
Noninterest-bearing deposits		354,624								265,755
Other liabilities		22,274								21,105
Stockholders’ equity		286,524								157,311
Total liabilities and
Stockholders’ equity	$	2,230,586								1,626,717
Net interest spread							3.63	%							3.50	%
Net interest margin		3.82	%							3.67	%
Net interest margin (tax-equivalent) (2)		3.94	%							3.75	%
Net interest income				$	19,549								13,956
(1) Average balances of loans include nonaccrual loans.
(2) The tax-equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.

Our net interest margin was 3.82%, or 3.94% on a tax-equivalent basis, for the three months ended September 30, 2017 compared to 3.67%, or 3.75% on a tax equivalent basis, for the three months ended September 30, 2016. The increase in margin from period to period is the result of an increase in yield on securities available for sale and loans receivable. The yield on loans receivable during the quarter ended September 30, 2017 and 2016 reflects accretion income of $601,000 and $399,000 respectively.

Our net interest spread, which is not on a tax-equivalent basis, was 3.63% for the three months ended September 30, 2017 as compared to 3.50% for the same period in 2016. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 13 basis point increase in net interest spread is a result of the 22 basis point increase in yield on interest-earning assets net of a 9 basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing as a result of the increases in the prime rate and the impact of accretion income from acquired loans.

58

	For The Nine Months Ended September 30,
	2017								2016
				Interest		Average						Interest		Average
	Average			Earned/		Yield/			Average			Earned/		Yield/
	Balance			Paid		Rate			Balance			Paid		Rate
Interest-earning assets:
Loans held for sale	$	22,507			657		3.90	%		27,388			717		3.50	%
Loans receivable, net (1)		1,363,830			51,550		5.05	%		1,000,780			36,074		4.81	%
Interest-bearing cash		15,160			117		1.03	%		29,222			55		0.25	%
Securities available for sale		458,266			9,966		2.87	%		327,860			6,618		2.65	%
Securities held to maturity		—			—		—			9,452			217		3.02	%
Dividends from non-equitable securities		10,342			351		4.54	%		7,740			288		4.97	%
Other investments		3,855			77		2.63	%		2,772			42		1.99	%
Total interest-earning assets		1,873,960			62,718		4.47	%		1,405,214			44,011		4.18	%
Non-earning assets		181,277								95,605
Total assets	$	2,055,237								1,500,819
Interest-bearing liabilities:
Demand accounts		253,735			540		0.28	%		140,092			157		0.15	%
Money market accounts		355,049			1,202		0.45	%		266,000			574		0.29	%
Savings accounts		63,678			91		0.19	%		43,602			43		0.13	%
Certificates of deposit		563,688			4,379		1.04	%		484,581			3,675		1.01	%
Short-term borrowed funds		165,610			1,225		0.99	%		84,590			320		0.51	%
Long-term debt		52,108			1,364		3.51	%		82,586			1,743		2.82	%
Total interest-bearing liabilities		1,453,868			8,801		0.81	%		1,101,451			6,512		0.79	%
Noninterest-bearing deposits		321,894								234,243
Other liabilities		21,374								16,991
Stockholders’ equity		258,101								148,134
Total liabilities and
Stockholders’ equity	$	2,055,237								1,500,819
Net interest spread							3.66	%							3.39	%
Net interest margin		3.85	%							3.59	%
Net interest margin (tax-equivalent) (2)		3.97	%							3.67	%
Net interest income					53,917								37,499
(1) Average balances of loans include nonaccrual loans.
(2) The tax-equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.

Our net interest margin was 3.85%, or 3.97% on a tax-equivalent basis, for the nine months ended September 30, 2017 compared to 3.59%, or 3.67% on a tax equivalent basis, for the nine months ended September 30, 2016. The increase in margin from period to period is the result of a shift to higher yielding earning assets as well as an increase in yield on securities available for sale and loans receivable. Average loans receivable comprised 72.8% of earnings assets for the nine months ended September 30, 2017 compared to 71.2% for the nine months ended September 30, 2016. The yield on loans receivable during the nine months ended September 30, 2017 and 2016 reflects accretion income of $2.1 million and $471,000, respectively.

59

Our net interest spread, which is not on a tax-equivalent basis, was 3.66% for the nine months ended September 30, 2017 as compared to 3.39% for the same period in 2016. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 27 basis point increase in net interest spread is a result of the 29 basis point increase in yield on interest-earning assets as well as a two basis point increase in rates paid on interest-bearing liabilities. The increase in the rate realized on loans is primarily the result of variable rate loans repricing as a result of the increases in the prime rate and the impact of accretion income from acquired loans.

Provision for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of operations. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under “Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Following is a summary of the activity in the allowance for loan losses during the periods ended September 30, 2017 and 2016.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Balance, beginning of period	$	10,750			10,297			10,688			10,141
Provision for loan losses		—			—			—			—
Loan charge-offs		(132	)		(4	)		(178	)		(197	)
Loan recoveries		44			47			152			396
Balance, end of period	$	10,662			10,340			10,662			10,340

The Company experienced net charge-offs of $88,000 for the three months ended September 30, 2017 and net recoveries of $43,000 for the three months ended September 30, 2016. The Company experienced net charge-offs of $26,000 for the nine months ended September 30, 2017 and net recoveries of $199,000 for the nine months ended September 30, 2016. Asset quality has remained relatively consistent since December 31, 2016, with nonperforming assets to total assets decreasing to 0.29% as of September 30, 2017 as compared to 0.40% as of December 31, 2016. No provision expense for loan losses was recorded during the first nine months of 2017 or the year 2016 primarily due to the net recoveries experienced and asset quality.

Provision expense is recorded based on our assessment of general loan loss risk as well as asset quality. The allowance for loan losses is management’s estimate of probable credit losses inherent in the loan portfolio at the balance sheet date. Management determines the allowance based on an ongoing evaluation. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. For further discussion regarding the calculation of the allowance, see the “Allowance for Loan Losses” discussion below.

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Noninterest Income and Expense

Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three and nine months ended September 30, 2017 and 2016 are presented below:

	For the Three Months					For the Nine Months
	Ended September 30,					Ended September 30,
	2017		2016			2017			2016
	(In thousands)
Noninterest income:
Mortgage banking income	$	3,625		5,605			11,522			12,967
Deposit service charges		1,072		953			2,928			2,712
Net loss on extinguishment of debt		—		(118	)		—			(174	)
Net gain on sale of securities		368		111			1,174			641
Fair value adjustments on interest rate swaps		90		99			(37	)		(408	)
Net increase in cash value life insurance		267		226			759			684
Mortgage loan servicing income		1,652		1,437			4,822			4,238
Other		801		560			2,742			1,728
Total noninterest income	$	7,875		8,873			23,910			22,388

Noninterest income decreased $1.0 million to $7.9 million for the three months ended September 30, 2017 from $8.9 million for the three months ended September 30, 2016. Noninterest income increased $1.5 million to $23.9 million for the nine months ended September 30, 2017 from $22.4 million for the nine months ended September 30, 2016. The decrease in noninterest income for the three months ended September 30, 2017 primarily relates to a decrease in mortgage banking income. The increase in noninterest income for the nine months ended September 30, 2017 primarily relates to net gain on sale of securities, mortgage loan servicing income related to an increase in loans service for third parties and other noninterest income.

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The following table provides a break out of mortgage banking income from our Bank’s retail mortgage team “Community banking” and Crescent Mortgage Company “Wholesale mortgage banking”.

	For the Three Months Ended September 30,
	Loan Originations				Mortgage Banking Income				Margin
	2017		2016		2017		2016		2017			2016
Additional segment information:
Community banking	$	20,342		25,633		500		680		2.46	%		2.65	%
Wholesale mortgage banking		217,014		253,485		3,125		4,925		1.44	%		1.94	%
Total	$	237,356		279,118		3,625		5,605		1.53	%		2.01	%
	For the Nine Months Ended September 30,
	Loan Originations				Mortgage Banking Income				Margin
	2017		2016		2017		2016		2017			2016
Additional segment information:
Community banking	$	59,511		68,263		1,441		1,586		2.42	%		2.32	%
Wholesale mortgage banking		611,597		645,412		10,081		11,381		1.65	%		1.76	%
Total	$	671,108		713,675		11,522		12,967		1.72	%		1.82	%

During the three months ended September 30, 2017 and 2016, the Company recognized net gains on sale of available-for-sale securities of $368,000 and $111,000 respectively. During the nine months ended September 30, 2017 and 2016, the Company recognized net gains on sale of available-for-sale securities of $1.2 million and $641,000 respectively.

The fair value adjustment on interest rate swaps increased noninterest income by $90,000 for the three months ended September 30, 2017 compared to an increase in noninterest income of $99,000 for three months ended September 30, 2016. The fair value adjustment on interest rate swaps decreased noninterest income by $37,000 for the nine months ended September 30, 2017 compared to a reduction in noninterest income of $408,000 for nine months ended September 30, 2016. The change in fair value adjustment on interest rate swaps relates to the change in interest rates from period to period. The Company uses standalone interest rate swaps to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches. 

The following table sets forth for the periods indicated the primary components of noninterest expense:

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Noninterest expense:
Salaries and employee benefits	$	8,623			8,481			26,487			23,306
Occupancy and equipment		2,508			2,067			7,129			5,836
Marketing and public relations		385			374			1,182			1,144
FDIC insurance		205			180			380			527
Recovery of mortgage loan repurchase losses		(225	)		(250	)		(675	)		(750	)
Legal expense		157			80			373			185
Other real estate expense, net		(5	)		(96	)		40			(37	)
Mortgage subservicing expense		494			462			1,485			1,353
Amortization of mortgage servicing rights		748			586			2,083			1,659
Merger related expenses		311			—			1,910			2,985
Other		2,255			2,006			6,538			5,759
Total noninterest expense	$	15,456			13,890			46,932			41,967

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Noninterest expense represents the largest expense category for the Company. Noninterest expense increased to $15.5 million for the three months ended September 30, 2017 from $13.9 million for the three months ended September 30, 2016. Noninterest expense increased to $46.9 million for the nine months ended September 30, 2017 from $42.0 million for the nine months ended September 30, 2016. The increase in noninterest expense is primarily the result of an increase in salaries and employee benefits and occupancy and equipment as well as merger related expense related to the acquisition of Greer during the first quarter of 2017. Merger related expenses totaled $0.3 million for the three months ended September 30, 2017. There were no merger related expenses for the three months ended September 30, 2016. Merger related expenses totaled $1.9 million for the nine months ended September 30, 2017 as compared to $3.0 million for the nine months ended September 30, 2016.

Income Tax Expense

Our effective tax rate was 33.2% for three month period ended September 30, 2017, compared to 33.5% for the three month period ended September 30, 2016. Our effective tax rate was 28.0% for nine month period ended September 30, 2017, compared to 30.7% for the nine month period ended September 30, 2016. The decrease in the effective tax rate from period to period reflects an increase in interest income on municipal securities during 2017 and tax benefits related to excess stock-based compensation. Tax preferenced municipal securities interest comprised 5.3% and 3.7% of interest income for the quarter ended September 30, 2017 and 2016, respectively. Municipal securities interest comprised 5.1% and 4.0% of interest income for the nine months ended September 30, 2017 and 2016, respectively. In addition, the Company recognized tax benefits related to excess stock-based compensation of approximately $1.2 million and $400,000 for the nine months ended September 30, 2017 and 2016, respectively. The impact of tax benefits related to excess stock-based compensation for the three months ended September 30, 2017 and 2016 was not significant. 

Balance Sheet Review

Securities

Our primary objective in managing the investment portfolio is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns. We are required under federal regulations to maintain adequate liquidity to ensure safe and sound operations. We maintain investment balances based on a continuing assessment of cash flows, the level of current and expected loan production, current interest rate risk strategies and the assessment of the potential future direction of market interest rate changes. Investment securities differ in terms of default, interest rate, liquidity and expected rate of return risk.

At September 30, 2017, our securities portfolio, excluding FHLB stock and other investments, was $523.7 million or approximately 23.2% of our assets. Our available-for-sale securities portfolio included US agency securities, municipal securities, collateralized loan obligations, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $523.7 million and an amortized cost of $518.2 million resulting in a net unrealized gain of $5.5 million.

As securities are purchased, they are designated as held-to-maturity or available-for-sale based upon our intent, which incorporates liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements. We do not currently hold, nor have we ever held, any securities that are designated as trading securities.

The increase in securities from period to period is attributable to the securities acquired with the acquisition of Greer on March 18, 2017. Securities acquired in the acquisition of Greer were approximately $121.4 million on March 18, 2017. For additional information, see note 2 “Business Combinations” in the accompanying financial statements. 

Loans by Type

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Gross loans receivable at September 30, 2017 and December 2016 were $1.5 billion and $1.2 billion, respectively.

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Our loan portfolio consists primarily of loans secured by real estate mortgages. As of September 30, 2017, our loan portfolio included $1.3 billion, or 85.8%, of gross loans secured by real estate. As of December 31, 2016, our loan portfolio included $1.0 billion, or 85.6%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, gross loans receivable increased $306.2 million since December 31, 2016. The increase in loans receivable primarily relates to the loans acquired in the acquisition of Greer well as the Bank’s focus on growing residential mortgage and commercial lending. The recorded investment in loans acquired in the acquisition of Greer was $159.5 million as of September 30, 2017. For additional information, see the net interest margin discussion above as well as Note 2 “Business Combinations” in the accompanying financial statements. For additional information regarding acquired loans, see Note 5, “Loans Receivable, Net”. 

The following table summarizes loans by type and percent of total at the end of the periods indicated:

	At September 30,					At December 31,
	2017					2016
			% of Total					% of Total
All Loans:	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Loans secured by real estate:
One-to-four family	$	475,949		32.06	%	$	411,399		34.91	%
Home equity		46,162		3.11	%		36,026		3.06	%
Commercial real estate		575,200		38.75	%		445,344		37.80	%
Construction and development		175,799		11.84	%		115,682		9.82	%
Consumer loans		9,010		0.61	%		5,714		0.48	%
Commercial business loans		202,341		13.63	%		164,101		13.93	%
Total gross loans receivable		1,484,461		100.00	%		1,178,266		100.00	%
Less:
Allowance for loan losses		10,662					10,688
Total loans receivable, net	$	1,473,799				$	1,167,578

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

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The following table summarizes the loan maturity distribution by type and related interest rate characteristics. 

	At September 30, 2017
			After one
	One Year		but within		After five
	or Less		five years		years		Total
	(In thousands)
Loans secured by real estate:
One-to-four family	$	19,256		57,015		399,678		475,949
Home equity		4,638		5,298		36,226		46,162
Commercial real estate		64,409		391,500		119,291		575,200
Construction and development		58,440		93,527		23,832		175,799
Consumer loans		1,459		6,085		1,466		9,010
Commercial business loans		28,535		83,557		90,249		202,341
Total gross loans receivable	$	176,737		636,982		670,742		1,484,461
Loans maturing - after one year:
Variable rate loans							$	479,706
Fixed rate loans								828,018
							$	1,307,724

Nonperforming and Problem Assets

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of nine consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of September 30, 2017, the Company had $1.7 million of PCI loans that were 90 days past due and accruing. At December 31 2016, we had no loans 90 days past due and still accruing.

Troubled Debt Restructurings (“TDRs”)

The Company designates loan modifications as TDRs when, for economic or legal reasons related to the borrower’s financial difficulties, it grants a concession to the borrower that it would not otherwise consider. Loans on nonaccrual status at the date of modification are initially classified as nonaccrual TDRs. Loans on accruing status at the date of modification are initially classified as accruing TDRs at the date of modification, if the note is reasonably assured of repayment and performance is in accordance with its modified terms. Such loans may be designated as nonaccrual loans subsequent to the modification date if reasonable doubt exists as to the collection of interest or principal under the restructuring agreement. Nonaccrual TDRs are returned to accrual status when there is economic substance to the restructuring, there is well documented credit evaluation of the borrower’s financial condition, the remaining balance is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated repayment performance in accordance with the modified terms for a reasonable period of time, generally a minimum of nine months.

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The following table summarizes nonperforming and problem assets at the end of the periods indicated.

	At September 30,		At December 31,
	2017		2016
	(In thousands)
Loans receivable:
Nonaccrual loans-renegotiated loans	$	1,001		1,227
Nonaccrual loans-other		3,923		4,398
Real estate acquired through foreclosure, net		1,640		1,179
Total Non-Performing Assets	$	6,564		6,804
Problem Assets not included in Non-Performing Assets-
Accruing renegotiated loans outstanding	$	5,488		5,216

At September 30, 2017, nonperforming assets were $6.6 million, or 0.29% of total assets. Comparatively, nonperforming assets were $6.8 million, or 0.40% of total assets, at December 31, 2016. Nonperforming loans were 0.33% and 0.48% of gross loans receivable at September 30, 2017 and December 31, 2016, respectively.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $5.5 million at September 30, 2017, compared to $5.2 million at December 31, 2016. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at September 30, 2017 and December 31, 2016 are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on loans greater than $100,000 on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.

Credit quality indicators continue to show improvement as the Company experienced reduced loan migrations to nonaccrual status, and lower loss severity on individual problem asset. The Company believes this general trend in reduced loans migrating into nonaccrual status is an indication of improving credit quality in the Company’s overall loan portfolio and a leading indicator of reduced credit losses going forward. Nevertheless, the Company can make no assurances that nonperforming assets will continue to improve in future periods. The Company continues to monitor the loan portfolio and foreclosed assets carefully and is continually working to reduce its problem assets.

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of probable credit losses inherent in the loan portfolio at the balance sheet date. Management determines the allowance based on an ongoing evaluation. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The allowance consists of specific and general components.

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The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by major loan category and is based on the actual loss history trends for the previous 20 quarters. The actual loss experience is supplemented with internal and external qualitative factors as considered necessary at each period and given the facts at the time. These qualitative factors adjust the 20 quarter historical loss rate to recognize the most recent loss results and changes in the economic conditions to ensure the estimated losses in the portfolio are recognized in the period incurred and that the allowance at each balance sheet date is adequate and appropriate in accordance with GAAP. Qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent twelve quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. Impaired loans are evaluated for impairment using the discounted cash flow methodology or based on the net realizable value of the underlying collateral. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. See additional discussion in section “Nonperforming and Problem Assets.”

While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates. To the extent actual outcomes differ from management’s estimates, additional provisions for loan losses could be required that could adversely affect the Bank’s earnings or financial position in future periods.

The allowance for loan losses was $10.7 million, or 0.87% of non-acquired loans, at September 30, 2017, compared to $10.7 million, or 1.01% of total non-acquired loans, at December 31, 2016. Loans acquired in business combinations were $257.3 million and $119.4 million at September 30, 2017 and December 31, 2016, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. At September 30, 2017 and December 31, 2016, acquired non-credit impaired loans had a purchase discount remaining of $5.3 million and $3.2 million, respectively.

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The table below shows a reconciliation of acquired and non-acquired loans and allowance for loan losses to non-acquired loans:

	At the Month Ended
	September 30,			June 30,			March 31,			December 31,			September 30,
	2017			2017			2017			2016			2016
Acquired and non-acquired loans:
Acquired loans receivable	$	257,461		$	278,275			303,244			119,422			129,505
Non-acquired loans receivable		1,227,000			1,157,145			1,113,766			1,058,844			1,003,724
Total loans receivable	$	1,484,461		$	1,435,420			1,417,010			1,178,266			1,133,229
% Acquired		17.34	%		19.39	%		21.40	%		10.14	%		11.43	%
Non-acquired loans	$	1,227,000		$	1,157,145			1,113,766			1,058,844			1,003,724
Allowance for loan losses		10,662			10,750			10,715			10,688			10,340
Allowance for loan losses to non-acquired loans (Non-GAAP)		0.87	%		0.93	%		0.96	%		1.01	%		1.03	%
Total loans receivable	$	1,484,461		$	1,435,420			1,417,010			1,178,266			1,133,229
Allowance for loan losses		10,662			10,750			10,715			10,688			10,340
Allowance for loan losses to total loans receivable		0.72	%		0.75	%		0.76	%		0.91	%		0.91	%

The Company experienced net charge-offs of $88,000 for the three months ended September 30, 2017 and net recoveries of $43,000 for the three months ended September 30, 2016. The Company experienced net charge-offs of $26,000 for the nine months ended September 30, 2017 and net recoveries of $199,000 for the nine months ended September 30, 2016. Asset quality has remained relatively consistent since year end, with nonperforming assets to total assets slightly decreasing to 0.29% as of September 30, 2017 as compared to 0.40% as of December 31, 2016.

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The following table summarizes the activity related to our allowance for loan losses for the three and nine months ended September 30, 2017 and 2016.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(Dollars in thousands)
Balance, beginning of period	$	10,750			10,297			10,688			10,141
Provision for loan losses		—			—			—			—
Loan charge-offs:
Loans secured by real estate:
One-to-four family		(127	)		—			(162	)		(45	)
Consumer loans		(5	)		(2	)		(16	)		(31	)
Commercial business loans		—			(2	)		—			(121	)
Total loan charge-offs		(132	)		(4	)		(178	)		(197	)
Loan recoveries:
Loans secured by real estate:
One-to-four family		2			9			3			148
Commercial real estate		—			—			26			—
Construction and development		—			4			2			10
Consumer loans		16			8			28			23
Commercial business loans		26			26			93			215
Total loan recoveries		44			47			152			396
Net loan recoveries		(88	)		43			(26	)		199
Balance, end of period	$	10,662			10,340			10,662			10,340
Allowance for loan losses as a percentage of loans receivable (end of period)		0.72	%		0.91	%		0.72	%		0.91	%
Net charge-offs (recoveries) to averageloans receivable (annualized)		0.02	%		(0.02	)%		0.00	%		(0.04	)%

Mortgage Operations

Mortgage Activities and Servicing

Our wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans and is included in mortgage banking income in the accompanying consolidated statements of operations. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations is provided in “Results of Operations – Noninterest Income and Expense”. Additional segment information is provided in Note 10 “Supplemental Segment Information” in the accompanying financial statements. 

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Loan Servicing

We retain the rights to service a portion of the loans we sell on the secondary market, as part of our mortgage banking activities, for which we receive service fee income. These rights are known as mortgage servicing rights, or MSRs, where the owner of the MSR acts on behalf of the mortgage loan owner and has the contractual right to receive a stream of cash flows in exchange for performing specified mortgage servicing functions. These duties typically include, but are not limited to, performing loan administration, collection, and default activities, including the collection and remittance of loan payments, responding to customer inquiries, accounting for principal and interest, holding custodial (impound) funds for the payment of property taxes and insurance premiums, counseling delinquent mortgagors, modifying loans and supervising foreclosures and property dispositions. We subservice the duties and responsibilities obligated to the owner of the MSR to a third party provider for which we pay a fee.

We recognize the rights to service mortgage loans for others as an asset. We initially record the MSR at fair value and subsequently account for the asset at lower of cost or market using the amortization method. Servicing assets are amortized in proportion to, and over the period of, the estimated net servicing income and are carried at amortized cost. A valuation is performed by an independent third party on a quarterly basis to assess the servicing assets for impairment based on the fair value at each reporting date. The fair value of servicing assets is determined by calculating the present value of the estimated net future cash flows consistent with contractually specified servicing fees. This valuation is performed on a disaggregated basis, based on loan type and year of production. Generally, loan servicing becomes more valuable when interest rates rise (as prepayments typically decrease) and less valuable when interest rates decline (as prepayments typically increase). As discussed in detail in notes to the consolidated financial statements, we use an appropriate weighted average constant prepayment rate, discount rate, and other defined assumptions to model the respective cash flows and determine the fair value of the servicing asset at each reporting date.

The Company was servicing $2.5 billion loans for others at September 30, 2017 and $2.2 billion at December 31, 2016. Mortgage servicing rights asset had a balance of $17.4 million and $15.0 million at September 30, 2017 and December 31, 2016, respectively. The economic estimated fair value of the mortgage servicing rights was $22.8 million and $21.0 million at September 30, 2017 and December 31, 2016, respectively. Amortization expense related to the mortgage servicing rights was $748,000 and $586,000 during the three months ended September 30, 2017 and 2016, respectively. Amortization expense related to the mortgage servicing rights was $2.1 million and $1.7 million during the nine months ended September 30, 2017 and 2016, respectively.

Below is a roll-forward of activity in the balance of the servicing assets for the three months ended September 30, 2017 and 2016.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(In thousands)
MSR beginning balance	$	16,692			12,400			15,032			11,433
Amount capitalized		1,500			1,743			4,495			3,782
Amount amortized		(748	)		(587	)		(2,083	)		(1,659	)
MSR ending balance	$	17,444			13,556			17,444			13,556

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Reserve For Mortgage Repurchase Losses

Loans held for sale have primarily been fixed-rate single-family residential mortgage loans under contracts to be sold in the secondary market. In most cases, loans in this category are sold within 30 days of closing. Buyers generally have recourse to return a purchased loan to the Company under limited circumstances. An estimation of mortgage repurchase losses is reviewed on a quarterly basis.  The representations and warranties in our loan sale agreements provide that we repurchase or indemnify the investors for losses or costs on loans we sell under certain limited conditions.  Some of these conditions include underwriting errors or omissions, fraud or material misstatements by the borrower in the loan application or invalid market value on the collateral property due to deficiencies in the appraisal.  In addition to these representations and warranties, our loan sale contracts define a condition in which the borrower defaults during a short period of time, typically 120 days to one year, as an early payment default, or EPD.  In the event of an EPD, we are required to return the premium paid by the investor for the loan as well as certain administrative fees, and in some cases repurchase the loan or indemnify the investor.  Because the level of mortgage loan repurchase losses depends upon economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment.

The following table demonstrates the activity for the reserve for mortgage repurchase losses for the three and nine months ended September 30, 2017 and 2016.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Beginning Balance	$	2,354			3,355			2,880			3,876
Losses paid		—			—			(76	)		(21	)
Recoveries		—			25			—			25
Provision for mortgage repurchase losses		(225	)		(250	)		(675	)		(750	)
Ending balance	$	2,129			3,130			2,129			3,130

For the three months ended September 30, 2017 and 2016, the Company recorded a recovery of mortgage repurchase losses of $225,000 and $250,000, respectively. For the nine months ended September 30, 2017 and 2016, the Company recorded a recovery of mortgage repurchase losses of $675,000 and $750,000, respectively. The decline in the provision for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. Prior to 2012, there was no expiration date related to representations and warranties as long as the loan sold to the investor was outstanding. As a result, the Company received loan repurchase requests years after the loan was originated and sold to various third parties. In the latter part of 2012, the regulatory framework for certain GSEs changed where, under certain circumstances, the loan repurchase risk was limited for production beginning in January 2013. In addition, in May 2014, additional regulatory changes further limited loan repurchase risk.

As a result, the Company performed an analysis of its reserve for mortgage loan repurchase losses and, based on management’s judgment and interpretation of such regulatory changes, reduced the reserve accordingly. Management will continue to monitor how the GSEs implement the regulatory changes and trends. If such trends continue to be favorable, there is a possibility that additional reductions in this reserve could occur in future periods.

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At September 30, 2017, deposits totaled $1.7 billion, an increase of $449.4 million from deposits of $1.3 billion at December 31, 2016. The increase in deposits since December 31, 2016 primarily relates to the $311.1 million in deposits assumed with the completion of the acquisition of Greer on March 18, 2017 as well as continued efforts to increase our core deposits through business development. 

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The following table shows the average balance amounts and the average rates paid on deposits held by us.

	For the Nine Months
	Ended September 30,
	2017					2016
	Average		Average			Average		Average
	Balance		Rate			Balance		Rate
	(Dollars in thousands)
Interest-bearing demand accounts	$	253,735		0.28	%		140,092		0.15	%
Money market accounts		355,049		0.45	%		266,000		0.29	%
Savings accounts		63,678		0.19	%		43,602		0.13	%
Certificates of deposit less than $100,000		291,856		0.94	%		268,385		0.95	%
Certificates of deposit of $100,000 or more		271,832		1.14	%		216,196		1.09	%
Total interest-bearing average deposits		1,236,150					934,275
Noninterest-bearing deposits		321,894					234,243
Total average deposits	$	1,558,044					1,168,518

The maturity distribution of our time deposits of $100,000 or more is as follows:

	At September 30, 2017
	(In thousands)
Three months or less	$	52,139
Over three through six months		33,455
Over six through twelve months		97,555
Over twelve months		113,668
Total certificates of deposits	$	296,817

Borrowings

The followings table outlines our various sources of short-term borrowed funds during the three and nine months ended September 30, 2017 and 2016 and the amounts outstanding at the end of each period, the maximum amount for each component during the periods, the average amounts for each period, and the average interest rate that we paid for each borrowings source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the periods shown.

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						Maximum		Average for the
			Contractual			Month		Period including
	Ending		Period End			End		Fair Value Amortization
	Balance		Rate			Balance		Balance		Rate
At or for the three months ended September 30, 2017	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	180,000		0.83% - 2.70	%		180,000		146,670		1.19	%
Long-term borrowed funds
Long-term FHLB advances, due 2018 through 2020		31,000		1.20% - 1.22	%		52,000		41,516		2.14	%
Subordinated debentures, due 2032 through 2037		23,351		3.04% - 4.75	%		23,355		23,339		4.98	%

						Maximum		Average for the
			Contractual			Month		Period including
	Ending		Period End			End		Fair Value Amortization
	Balance		Rate			Balance		Balance		Rate
At or for the three months ended September 30, 2016	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	87,500		0.36% - 0.95	%		117,500		88,452		0.56	%
Long-term borrowed funds
Long-term FHLB advances, due 2017 through 2021		53,000		0.83% - 4.00	%		53,000		52,817		3.09	%
Subordinated debentures, due 2032 through 2034		15,465		3.73% - 4.00	%		15,465		15,465		3.87	%

						Maximum		Average for the
			Contractual			Month		Period including
	Ending		Period End			End		Fair Value Amortization
	Balance		Rate			Balance		Balance		Rate
At or for the nine months ended September 30, 2017	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	180,000		0.83% - 2.70	%		214,500		165,610		0.99	%
Long-term borrowed funds
Long-term FHLB advances, due 2018 through 2020		31,000		1.20% - 1.22	%		52,000		31,008		2.64	%
Subordinated debentures, due 2032 through 2037		23,351		3.04% - 4.75	%		23,355		21,100		4.74	%

						Maximum		Average for the
			Contractual			Month		Period including
	Ending		Period End			End		Fair Value Amortization
	Balance		Rate			Balance		Balance		Rate
At or for the nine months ended September 30, 2016	(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances	$	87,500		0.36% - 0.95	%		117,500		84,590		0.51	%
Long-term borrowed funds
Long-term FHLB advances, due 2017 through 2021		53,000		0.83% - 4.00	%		88,000		67,121		2.58	%
Subordinated debentures, due 2032 through 2034		15,465		3.73% - 4.00	%		15,465		15,465		3.83	%

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Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

The Company utilizes borrowing facilities in order to maintain adequate liquidity including: the FHLB of Atlanta, the Federal Reserve Bank (“FRB”), and federal funds purchased. The Company also uses wholesale deposit products, including brokered deposits as well as national certificate of deposit services. Additionally, the Company has certain investment securities classified as available-for-sale that are carried at market value with changes in market value, net of tax, recorded through stockholders’ equity.

Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At September 30, 2017, the Company had FHLB advances of $211 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $281.3 million.

Lines of credit with the FRB are based on collateral pledged. At September 30, 2017 the Company had lines available with the FRB for $196.3 million. At September 30, 2017 the Company had no FRB advances outstanding.

Capital Resources  

The Company and the Bank are subject to various federal and state regulatory requirements, including regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions that if undertaken could have a direct material effect on the Company’s and the Bank’s financial statements.

Effective January 2, 2015, the Company and Bank became subject to the regulatory risk-based capital rules adopted by the federal banking agencies implementing Basel III. Under the new capital guidelines, applicable regulatory capital components consist of (1) common equity Tier 1 capital (common stock, including related surplus, and retained earnings, plus limited amounts of minority interest in the form of common stock, net of goodwill and other intangibles (other than mortgage servicing assets), deferred tax assets arising from net operating loss and tax credit carry forwards above certain levels, mortgage servicing rights above certain levels, gain on sale of securitization exposures and certain investments in the capital of unconsolidated financial institutions, and adjusted by unrealized gains or losses on cash flow hedges and accumulated other comprehensive income items (subject to the ability of a non-advanced approaches institution to make a one-time irrevocable election to exclude from regulatory capital most components of AOCI), (2) additional Tier 1 capital (qualifying non-cumulative perpetual preferred stock, including related surplus, plus qualifying Tier 1 minority interest and, in the case of holding companies with less than $15 billion in consolidated assets at December 31, 2009, certain grandfathered trust preferred securities and cumulative perpetual preferred stock in limited amounts, net of mortgage servicing rights, deferred tax assets related to temporary timing differences, and certain investments in financial institutions) and (3) Tier 2 capital (the allowance for loan and lease losses in an amount not exceeding 1.25% of standardized risk-weighted assets, plus qualifying preferred stock, qualifying subordinated debt and qualifying total capital minority interest, net of Tier 2 investments in financial institutions). Total Tier 1 capital, plus Tier 2 capital, constitutes total risk-based capital.

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The required minimum ratios are as follows:

· Common equity Tier 1 capital ratio (common equity Tier 1 capital to total risk-weighted assets) of 4.5%

· Tier 1 Capital Ratio (Tier 1 capital to total risk-weighted assets) of 6%

· Total capital ratio (total capital to total risk-weighted assets) of 8%; and

· Leverage ratio (Tier 1 capital to average total consolidated assets) of 4%

The new capital guidelines also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity Tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. The phase-in of the capital conservation buffer requirement began on January 1, 2016.

The final regulatory capital rules also incorporate these changes in regulatory capital into the prompt corrective action framework, under which the thresholds for “adequately capitalized” banking organizations are equal to the new minimum capital requirements. Under this framework, in order to be considered “well capitalized”, insured depository institutions are required to maintain a Tier 1 leverage ratio of 5%, a common equity Tier 1 risk-based capital measure of 6.5%, a Tier 1 risked-based capital ratio of 8% and a total risk-based capital ratio of 10%.

The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at September 30, 2017 and December 31, 2016 are as follows:

																To Be Well
						Minimum Capital					Minimum Capital					Capitalized Under
						Required - Basel III					Required - Basel III					Prompt Corrective
	Actual					Phase-In Schedule					Fully Phased-In					Action Regulations
	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
September 30, 2017
Carolina Financial Corporation
CET1 capital (to risk weighted assets)	$	243,149		14.93	%		83,446		5.125	%		113,975		7.000	%		N/A		N/A
Tier 1 capital (to risk weighted assets)		265,694		16.32	%		107,869		6.625	%		138,398		8.500	%		N/A		N/A
Total capital (to risk weighted assets)		276,356		16.97	%		140,433		8.625	%		170,962		10.500	%		N/A		N/A
Tier 1 capital (to total average assets)		265,694		12.13	%		87,334		4.000	%		87,334		4.000	%		N/A		N/A
CresCom Bank
CET1 capital (to risk weighted assets)		261,395		16.05	%		83,445		5.125	%		113,974		7.000	%		105,833		6.50	%
Tier 1 capital (to risk weighted assets)		261,395		16.05	%		107,868		6.625	%		138,397		8.500	%		130,256		8.00	%
Total capital (to risk weighted assets)		272,057		16.71	%		140,433		8.625	%		170,961		10.500	%		162,820		10.00	%
Tier 1 capital (to total average assets)		261,395		11.93	%		87,639		4.000	%		87,639		4.000	%		109,549		5.00	%
December 31, 2016
Carolina Financial Corporation
CET1 capital (to risk weighted assets)	$	157,876		12.87	%		62,859		5.125	%		85,857		7.000	%		N/A		N/A
Tier 1 capital (to risk weighted assets)		172,876		14.09	%		81,257		6.625	%		104,254		8.500	%		N/A		N/A
Total capital (to risk weighted assets)		183,564		14.97	%		105,788		8.625	%		128,785		10.500	%		N/A		N/A
Tier 1 capital (to total average assets)		172,876		10.49	%		65,911		4.000	%		65,911		4.000	%		N/A		N/A
CresCom Bank
CET1 capital (to risk weighted assets)		169,222		13.81	%		62,811		5.125	%		85,791		7.000	%		79,663		6.50	%
Tier 1 capital (to risk weighted assets)		169,222		13.81	%		81,195		6.625	%		104,174		8.500	%		98,046		8.00	%
Total capital (to risk weighted assets)		179,910		14.68	%		105,706		8.625	%		128,686		10.500	%		122,558		10.00	%
Tier 1 capital (to total average assets)		169,222		10.30	%		65,701		4.000	%		65,701		4.000	%		82,126		5.00	%

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The following table provides the amount of dividends and dividend payout ratios (dividends declared divided by net income) for the three and nine months ended September 30, 2017 and 2016.

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Dividends declared	$	646			376			1,869			1,114
Dividend payout ratios		8.08	%		6.33	%		8.41	%		8.97	%

Off Balance Sheet Arrangements

Through the operations of our Bank, we have made contractual commitments to extend credit in the ordinary course of our business activities. These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, commercial and residential real estate. We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

At September 30, 2017, we had issued commitments to extend credit and standby letters of credit of approximately $212.6 million through various types of lending arrangements.  There were 39 standby letters of credit included in the commitments for $3.3 million. Total fixed rate commitments were $59.0 million and variable rate commitments were $153.6 million.

Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. A significant portion of the unfunded commitments relate to consumer equity lines of credit and commercial lines of credit. Based on historical experience, we anticipate that a portion of these lines of credit will not be funded.

Except as disclosed in this report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.

Market Risk Management and Interest Rate Risk

The effective management of market risk is essential to achieving the Company’s objectives. As a financial institution, the Company’s most significant market risk exposure is interest rate risk. The primary objective of managing interest rate risk is to minimize the effect that changes in interest rates have on net income. This is accomplished through active asset and liability management, which requires the strategic pricing of asset and liability accounts and management of appropriate maturity mixes of assets and liabilities. The expected result of these strategies is the development of appropriate maturity and re-pricing opportunities in those accounts to produce consistent net income during periods of changing interest rates. The Bank’s asset/liability management committee, or ALCO, monitors loan, investment and liability portfolios to ensure comprehensive management of interest rate risk. These portfolios are analyzed for proper fixed-rate and variable-rate mixes under various interest rate scenarios. The asset/liability management process is designed to achieve relatively stable net interest margins and assure liquidity by coordinating the volumes, maturities or re-pricing opportunities of interest-earning assets, deposits and borrowed funds. It is the responsibility of the ALCO to determine and achieve the most appropriate volume and mix of interest-earning assets and interest-bearing liabilities, as well as ensure an adequate level of liquidity and capital, within the context of corporate performance goals. The ALCO meets regularly to review the Company’s interest rate risk and liquidity positions in relation to present and prospective market and business conditions, and adopts funding and balance sheet management strategies that are intended to ensure that the potential impact on earnings and liquidity as a result of fluctuations in interest rates is within acceptable standards. The Board of Directors also sets policy guidelines and establishes long-term strategies with respect to interest rate risk exposure and liquidity.

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The Company uses interest rate sensitivity analysis to measure the sensitivity of projected net interest income to changes in interest rates. Management monitors the Company’s interest sensitivity by means of a computer model that incorporates current volumes, average rates earned and paid, and scheduled maturities, payments of asset and liability portfolios, together with multiple scenarios of prepayments, repricing opportunities and anticipated volume growth. Interest rate sensitivity analysis shows the effect that the indicated changes in interest rates would have on net interest income as projected for the next 12 months under the current interest rate environment. The resulting change in net interest income reflects the level of sensitivity that net interest income has in relation to changing interest rates.

As of September 30, 2017, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market condition.

				Annualized Hypothetical
Interest Rate Scenario				Percentage Change in
Change	Prime Rate			Net Interest Income
(1.00)%		3.25	%		(3.90	)%
0.00%		4.25	%		0.00	%
1.00%		5.25	%		0.20	%
2.00%		6.25	%		0.00	%
3.00%		7.25	%		(0.10	)%

The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings within the noninterest income of the consolidated statements of operations.

Derivative instruments not related to mortgage banking activities, including financial futures commitments and interest rate swap agreements that do not satisfy the hedge accounting requirements, are recorded at fair value and are classified with resultant changes in fair value being recognized in noninterest income in the consolidated statement of operations.

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When using derivatives to hedge fair value and cash flow risks, the Company exposes itself to potential credit risk from the counterparty to the hedging instrument. This credit risk is normally a small percentage of the notional amount and fluctuates as interest rates change. The Company analyzes and approves credit risk for all potential derivative counterparties prior to execution of any derivative transaction. The Company seeks to minimize credit risk by dealing with highly rated counterparties and by obtaining collateralization for exposures above certain predetermined limits. If significant counterparty risk is determined, the Company would adjust the fair value of the derivative recorded asset balance to consider such risk.

Accounting, Reporting, and Regulatory Matters

Information regarding recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of the financial information by the Company are included in Note 1 “Summary of Significant Accounting Polices” in the accompanying financial statements.

Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with GAAP.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

See Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk Management and Interest Rate Risk, and Liquidity.

Item 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

Management, including our President and Chief Executive Officer and Executive Vice President 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 President and Chief Executive Officer and Executive Vice President 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 President and Chief Executive Officer and Executive Vice President and 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 September 30, 2017, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

We are a party to claims and lawsuits arising in the ordinary course of business. Management is not aware of any material pending legal proceedings against the Company which, if determined adversely, would have a material adverse impact on the Company’s financial position, results of operations or cash flows.

Item 1A. RISK FACTORS.

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for fiscal years ended December 31, 2016, as well as cautionary statements contained in this Form 10-Q, including those under the caption “Cautionary Note Regarding Any Forward-Looking Statements” set forth in Part I, Item 2 of this Form 10-Q, risks and matters described elsewhere in this Form 10-Q and in our other filings with the SEC.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

Not applicable

Item 3. DEFAULTS UPON SENIOR SECURITIES.

Not applicable

Item 4. MINE SAFETY DISCLOSURES.

Not applicable

Item 5. OTHER INFORMATION.

Not applicable

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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 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.

	CAROLINA FINANCIAL CORPORATION
	Registrant
Date: November 9, 2017	/s/ Jerold L. Rexroad
	Jerold L. Rexroad
	President and Chief Executive Officer
	(Principal Executive Officer)
Date: November 9, 2017	/s/ William A. Gehman, III
	William A. Gehman III
	Executive Vice President and Chief Financial Officer
	(Principal Financial and Accounting Officer)

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 INDEX TO EXHIBITS

Exhibit Number	Description
2.1	Agreement and Plan of Merger by and between Carolina Financial Corporation, CBAC, Inc., and Congaree Bancshares, Inc. dated January 5, 2016.(1)
2.2	Agreement and Plan of Merger by and between Carolina Financial Corporation and Greer Bancshares Incorporated, dated November 7, 2016.(2)
2.3	Agreement and Plan of Merger and Reorganization by and between Carolina Financial Corporation and First South Bancorp, Inc. dated June 9, 2017.(3)
4.1	Restated Certificate of Incorporation.(4)
4.2	Amendment to the Restated Certificate of Incorporation.(5)
4.3	Amendment and Restated Bylaws.(6)
4.4	Specimen Common Stock Certificate.(7)
4.5	See Exhibits 4.1, 4.2, and 4.3 for provisions of the Restated Certificate of Incorporation and Amended and Restated Bylaws which define the rights of the stockholders.
31.1	Rule 13a-14(a) Certification of the 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 10Q of Carolina Financial Corporation for the quarter ended September 30, 2017, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statement of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.
(1)	Incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on January 11, 2016.
(2)	Incorporated by reference to Exhibit 2.2 of the Company’s Registration Statement on Form S-3 filed on December 23, 2016.
(3)	Incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on June 15, 2017.
(4)	Incorporated by reference to Exhibit 3.1 of the Company’s Registration Statement on Form S-3 filed on August 31, 2015.
(5)	Incorporated by reference to Exhibit A of the Company’s Definitive Proxy Statement on Schedule 14A filed on March 31, 2016.
(6)	Incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on May 5, 2016.
(7)	Incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form 10 filed on February 26, 2014.

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