Edgar Filing: Atlantic Coast Financial CORP

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2013

Commission file number: 001-35072

ATLANTIC COAST FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Maryland	65-1310069
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

10151 Deerwood Park Blvd Building 200, Suite 100 Jacksonville, Florida	32256
(Address of principal executive offices)	(Zip Code)

(800) 342-2824

(Registrant's telephone number, including area code)

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

YES x NO ¨.

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

YES x NO ¨.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer ¨

Accelerated Filer ¨

Non-Accelerated Filer ¨

Smaller Reporting Company x

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

YES ¨ NO x.

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

2,629,061 shares of common stock, $0.01 par value, outstanding as of August 5, 2013

ATLANTIC COAST FINANCIAL CORPORATION

Form 10-Q Quarterly Report

Table of Contents

		Page

	PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	60
Item 4.	Controls and Procedures	62

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	63
Item 1A.	Risk Factors	63
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	64
Item 3.	Defaults upon Senior Securities	64
Item 4.	Mine Safety Disclosures	64
Item 5.	Other Information	64
Item 6.	Exhibits	64

Form 10-Q	Signature Page	65

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ATLANTIC COAST FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands, Except Share Information)

(unaudited)

	June 30, 2013			December 31, 2012
ASSETS
Cash and due from financial institutions	$	3,758		$	7,490
Short-term interest-earning deposits		74,201			60,338
Total cash and cash equivalents		77,959			67,828
Securities available-for-sale		160,856			159,745
Portfolio loans, net of allowance of $10,029 in 2013 and $10,889 in 2012		386,285			421,201
Other loans:
Held-for-sale		2,217			4,089
Warehouse		60,653			68,479
Total other loans		62,870			72,568
Federal Home Loan Bank stock, at cost		5,879			7,260
Land, premises and equipment, net		14,279			14,584
Bank owned life insurance		15,960			15,764
Other real estate owned		12,861			8,065
Accrued interest receivable		1,971			2,035
Other assets		3,274			3,569
Total assets	$	742,194		$	772,619

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand	$	43,889		$	41,904
Interest-bearing demand		73,240			73,490
Savings and money market		174,777			181,708
Time		210,238			202,658
Total deposits		502,144			499,760
Securities sold under agreements to repurchase		92,800			92,800
Federal Home Loan Bank advances		110,000			135,000
Accrued expenses and other liabilities		6,085			4,799
Total liabilities		711,029			732,359

Commitments and contingent liabilities

Preferred stock: $0.01 par value; 25,000,000 shares authorized, none issued and outstanding at June 30, 2013 and December 31, 2012		-			-
Common stock: $0.01 par value; 100,000,000 shares authorized, 2,629,061 issued and outstanding at June 30, 2013 and December 31, 2012		26			26
Additional paid-in capital		56,093			56,132
Common stock held by:
Employee stock ownership plan shares of 83,832 at June 30, 2013 and 86,227 at December 31, 2012		(1,821	)		(1,873	)
Benefit plans		(326	)		(338	)
Retained deficit		(17,966	)		(14,373	)
Accumulated other comprehensive income (loss)		(4,841	)		686
Total stockholders’ equity		31,165			40,260
Total liabilities and stockholders’ equity	$	742,194		$	772,619

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

ATLANTIC COAST FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in Thousands, Except Share Information)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012

Interest and dividend income:
Loans, including fees	$	6,712		$	7,730		$	13,673		$	15,603
Securities and interest-earning deposits in other financial institutions		674			893			1,248			1,770
Total interest and dividend income		7,386			8,623			14,921			17,373
Interest expense:
Deposits		867			998			1,749			2,243
Federal Home Loan Bank advances		1,144			1,326			2,278			2,651
Securities sold under agreements to repurchase		1,196			1,195			2,378			2,392
Total interest expense		3,207			3,519			6,405			7,286
Net interest income		4,179			5,104			8,516			10,087
Provision for loan losses		1,219			3,741			2,453			7,216
Net interest income after provision for loan losses		2,960			1,363			6,063			2,871

Noninterest income:
Service charges and fees		750			786			1,497			1,570
Gain on sale of loans held-for-sale		299			381			633			1,118
Bank owned life insurance earnings		98			116			197			232
Interchange fees		404			408			799			812
Other		182			108			322			222
Total noninterest income		1,733			1,799			3,448			3,954

Noninterest expense:
Compensation and benefits		2,127			2,434			4,403			4,624
Occupancy and equipment		482			517			965			1,033
FDIC insurance premiums		442			272			882			547
Foreclosed assets, net		(171	)		79			(189	)		(74	)
Data processing		446			340			776			670
Outside professional services		1,070			694			1,958			1,468
Collection expense and repossessed asset losses		676			635			1,588			1,121
Other		1,175			1,037			2,721			1,991
Total noninterest expense		6,247			6,008			13,104			11,380

Loss before income tax expense (benefit)		(1,554	)		(2,846	)		(3,593	)		(4,555	)
Income tax expense (benefit)		-			150			-			150
Net loss	$	(1,554	)	$	(2,996	)	$	(3,593	)	$	(4,705	)

Loss per common share:
Basic	$	(0.62	)	$	(1.20	)	$	(1.43	)	$	(1.89	)
Diluted	$	(0.62	)	$	(1.20	)	$	(1.43	)	$	(1.89	)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

ATLANTIC COAST FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Dollars in Thousands, Except Share Information)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012

Net loss	$	(1,554	)	$	(2,996	)	$	(3,593	)	$	(4,705	)

Other comprehensive income (loss):
Change in securities available-for-sale:
Unrealized holding gains (losses) arising during the period		(4,641	)		1,647			(5,527	)		2,368
Less reclassification adjustments for (gains) losses recognized in income		-			-			-			-
Net unrealized gains (losses)		(4,641	)		1,647			(5,527	)		2,368
Income tax effect		-			-			-			-
Net of tax effect		(4,641	)		1,647			(5,527	)		2,368

Total other comprehensive income (loss)		(4,641	)		1,647			(5,527	)		2,368

Comprehensive loss	$	(6,195	)	$	(1,349	)	$	(9,120	)	$	(2,337	)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

ATLANTIC COAST FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars in Thousands, Except Share Information)

(unaudited)

	Common Stock		Additional Paid-In Capital			Employee Stock Ownership Plan Shares			Benefit Plans			Retained Earnings (Deficit)			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity

For the six months ended June 30, 2013:

Balance at December 31, 2012	$	26	$	56,132		$	(1,873	)	$	(338	)	$	(14,373	)	$	686		$	40,260
Employee stock ownership plan shares earned, 2,395 shares		-		(42	)		52			-			-			-			10
Management restricted stock expense		-		2			-			-			-			-			2
Stock options expense		-		13			-			-			-			-			13
Distribution from Rabbi Trust		-		(12	)		-			12			-			-			-
Net loss		-		-			-			-			(3,593	)		-			(3,593	)
Other comprehensive loss		-		-			-			-			-			(5,527	)		(5,527	)
Balance at June 30, 2013	$	26	$	56,093		$	(1,821	)	$	(326	)	$	(17,966	)	$	(4,841	)	$	31,165

For the six months ended June 30, 2012:

Balance at December 31, 2011	$	26	$	56,186		$	(1,977	)	$	(351	)	$	(7,706	)	$	116		$	46,294
Employee stock ownership plan shares earned, 2,395 shares		-		(47	)		52			-			-			-			5
Management restricted stock expense		-		16			-			-			-			-			16
Stock options expense		-		18			-			-			-			-			18
Distribution from Rabbi Trust		-		168			-			(174	)		-			-			(6	)
Net loss		-		-			-			-			(4,705	)		-			(4,705	)
Other comprehensive income		-		-			-			-			-			2,368			2,368
Balance at June 30, 2012	$	26	$	56,341		$	(1,925	)	$	(525	)	$	(12,411	)	$	2,484		$	43,990

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

ATLANTIC COAST FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars in Thousands, Except Share Information)

(unaudited)

	Six Months Ended June 30,
	2013			2012

Cash flows from operating activities:
Net loss	$	(3,593	)	$	(4,705	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Provision for loan losses		2,453			7,216
Gain on sale of loans held-for-sale		(633	)		(1,118	)
Originations of loans held-for-sale		(4,869	)		(28,201	)
Proceeds from sales of loans held-for-sale		7,374			26,182
Foreclosed assets, net		(189	)		(74	)
Loss on disposal of equipment		-			5
Employee stock ownership plan compensation expense		10			5
Share-based compensation expense		15			34
Amortization of premiums and deferred fees, net of accretion of discounts on securities and loans		772			313
Depreciation expense		328			395
Net change in accrued interest receivable		64			290
Net change in cash surrender value of bank owned life insurance		(196	)		(232	)
Net change in other assets		295			(454	)
Net change in accrued expenses and other liabilities		1,286			(199	)
Net cash provided by operating activities		3,117			(543	)

Cash flows from investing activities:
Proceeds from maturities and payments of securities available-for-sale		18,009			16,016
Purchase of securities available-for-sale		(25,582	)		(33,823	)
Funding of warehouse loans		(569,763	)		(378,755	)
Proceeds from repayments of warehouse loans		577,589			385,705
Net change in portfolio loans		23,378			37,724
Expenditures on premises and equipment		(23	)		(245	)
Proceeds from sale of other real estate owned		4,641			3,792
Redemption of Federal Home Loan Bank stock		1,381			1,819
Net cash provided by investing activities		29,630			32,233

Cash flows from financing activities:
Net increase (decrease) in deposits		2,384			(7,930	)
Repayment of Federal Home Loan Bank advances		(25,000	)		-
Shares purchased for and distributions from Rabbi Trust		-			(5	)
Net cash used in financing activities		(22,616	)		(7,935	)

Net increase in cash and cash equivalents		10,131			23,755
Cash and cash equivalents, beginning of period		67,828			41,017
Cash and cash equivalents, end of period	$	77,959		$	64,772

Supplemental disclosures of cash flow information:
Interest paid	$	6,419		$	7,311
Income taxes paid	$	-		$	-

Supplemental disclosures of non-cash information:
Loans transferred to other real estate	$	9,248		$	5,587
Loans transferred to held-for-sale	$	-		$	-

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements include Atlantic Coast Financial Corporation (the Company) and its wholly owned subsidiary, Atlantic Coast Bank (the Bank). The consolidated financials also include First Community Financial Services, Inc. (FCFS), an inactive wholly owned subsidiary of Atlantic Coast Bank. All significant inter-company balances and transactions have been eliminated in consolidation. The principal activity of the Company is the ownership of the Bank’s common stock, as such, the terms “Company” and “Bank” are used interchangeably throughout this Quarterly Report on Form 10-Q.

The accompanying condensed consolidated balance sheets as of December 31, 2012, which was derived from our audited financial statements, and the unaudited condensed consolidated financial statements as of June 30, 2013 and for the three and six months ended June 30, 2013 and 2012 have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statement presentation. In the opinion of management, all adjustments (all of which are normal and recurring in nature) considered necessary for (i) a fair presentation and (ii) to make such statements not misleading, have been included. Operating results for the three and six months ended June 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013. The 2012 Atlantic Coast Financial Corporation consolidated financial statements, as presented in the Company’s Annual Report on Form 10-K, should be read in conjunction with these statements.

Certain items in the prior period financial statements have been reclassified to conform to the current presentation. The reclassifications have no effect on net loss or stockholders’ equity as previously reported.

Going Concern

The unaudited condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The unaudited condensed consolidated financial statements do not include any adjustment that might be necessary if the Company is unable to continue as a going concern.

Use of Estimates

To prepare unaudited condensed consolidated financial statements in conformity with U.S. GAAP management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. Estimates associated with the allowance for loan losses, realization of deferred tax assets, and the fair values of securities and other financial instruments are particularly susceptible to material change in the near term.

Impact of Certain Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2013-02, Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income (ASU 2013-02). ASU 2013-02 requires new footnote disclosures of items reclassified from accumulated other comprehensive income (loss) to net income (loss). The new guidance is effective for interim and annual periods beginning after December 15, 2012. The Company adopted the guidance for the first quarter of 2013, there was no impact on the Company’s financial statements or results of operations but future filings may include additional disclosures related to reclassifications from accumulated other comprehensive income (loss) to net income (loss).

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 2. MATERIAL UNCERTAINTIES

The Company recorded an operating loss in the first six months of 2013 of $3.6 million, resulting in a retained deficit of $18.0 million as of June 30, 2013. Prior to 2013, the Company had recorded five consecutive years of operating losses aggregating $63.3 million. During the period from January 1, 2008 until June 30, 2013 the Bank has recorded provision for loan losses of $90.4 million, goodwill impairment of $2.8 million, other than temporary impairment of investment securities of $5.1 million and has a full valuation reserve for deferred tax assets totaling $30.0 million (see Note 11). The Company’s earnings capability is also impacted by the expense of its long term debt, which at June 30, 2013 had a weighted average rate of 4.56% with collective prepayment penalties to extinguish the debt of $22.8 million. The uncertainty about future provision for loan losses and other credit costs, and the impact on net interest income of the expense of the long term debt combined with continued decline in yields on interest-earning assets creates uncertainty about the Company’s ability to attain profitability.

During 2012 the Bank’s contingent sources of liquidity to meet loan demand or other liquidity needs became limited due to reductions in approved borrowing limits with the Federal Reserve Bank of Atlanta (the FRB) and the FHLB. In July 2012 the FRB notified the Bank that it was not eligible to participate in its Primary Borrowing program but may be eligible to borrow under its Secondary Borrowing program under limited circumstances. Due to declining credit ratings and reduced collateral values, the Bank’s borrowing capacity at the FHLB was $5.0 million as of June 30, 2013. The Bank had unpledged securities of $13.0 million as of June 30, 2013 acting as additional contingent liquidity in the event the Bank’s cash and cash equivalents, which totaled $77.9 million at the end of the second quarter of 2013, was not sufficient to meet liquidity demand. Under the Consent Order (the Order) the Bank is prohibited from renewing or increasing Broker Deposits without the prior approval of the OCC. The Bank’s holding company does not have meaningful liquid resources and therefore is not an immediate source of liquidity support for the Bank. In the event of a sudden decline in deposits, or a reduction in deposits over time, the Bank’s liquidity resources may not be sufficient to meet demands.

The Bank’s long-term debt, which is comprised of $92.8 million of structured notes in connection with a reverse repurchase agreement and $110.0 million of FHLB debt, are collateralized by investment securities and portfolio loans. Under the terms of the debt, the Bank must maintain collateral requirements as defined by the counterparties. Failure to maintain the required collateral would constitute a default under the debt agreements that would result in the counterparties having the option to call the debt including prepayment fees. In the event the debt were called and depending on the exact amount of these penalties at the time of repayment, the Bank may be deemed to be less than adequately capitalized which could result in additional restrictions and directives from its regulators.

The Board of Directors of the Bank entered into the Order with the OCC on August 10, 2012, that among other matters, required that the Bank achieve and maintain a total risk based capital ratio of 13.00% of risk weighted assets and a Tier 1 capital ratio of 9.00% of adjusted total assets. As of June 30, 2013 these ratios were 9.55% and 4.83%, respectively. Under applicable banking regulations for undercapitalized banks such a determination could result in additional restrictions and directives from the OCC and the FDIC that could include sale, liquidation, or federal conservatorship or receivership of the Bank. Any such action would have a material adverse effect on the Company’s business, results of operations and financial position.

In November 2011 the Company’s Board of Directors began a review of the strategic alternatives available to it to address its capital needs. Following the June 2013 rejection of the proposed merger of the Company with Bond Street Holdings, Inc. by stockholders (Note 3), the Company's Board of Directors has begun to evaluate other strategic alternatives to raise capital in the near term, including a possible recapitalization.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 3. MERGER AGREEMENT WITH BOND STREET HOLDINGS, INC.

On February 25, 2013, the Company and the Bank entered into an Agreement and Plan of Merger (the Merger Agreement) with Bond Street Holdings, Inc. (Bond Street) and its bank subsidiary, Florida Community Bank, N.A. (Florida Community Bank). Pursuant to the Merger Agreement, the Company was to be merged with and into Bond Street (the Merger) and the Bank was then to merge with and into Florida Community Bank.

On April 22, 2013, the Company and the Bank entered into Amendment Number 1 to the Merger Agreement (the Amended Merger Agreement) with Bond Street and Florida Community Bank. Under the terms of the Amended Merger Agreement, each share of the Company’s common stock issued and outstanding immediately prior to the completion of the merger would have been converted into the right to receive $5.00 in cash at closing.

On June 11, 2013, the proposed merger was rejected by the stockholders of the Company. On June 24, 2013, the Company provided notice to Bond Street that it was terminating the Merger Agreement pursuant to provisions of the Merger Agreement that permitted either the Company or Bond Street to terminate the Merger Agreement if stockholders of the Company did not approve the Merger Agreement by June 21, 2013.

Current Litigation Relating to the Merger

As described in greater detail in the Proxy Statement of the Company filed with the Securities and Exchange Commission on May 13, 2013, two putative class action lawsuits related to the proposed merger were originally filed against the Company, the Bank, Bond Street and Florida Community Bank and certain directors of the Company. The two prior lawsuits were voluntarily dismissed and a new combined federal court action was filed on May 20, 2013.

On June 5, 2013, Plaintiff Jason Laugherty, individually and on behalf of a putative class of similarly situated stockholders, the Company, the Bank, Bond Street, Florida Community Bank, and individual defendants Forrest W. Sweat, Jr., Charles E. Martin, Jr., Thomas F. Beeckler, G. Thomas Frankland, John J. Linfante, W. Eric Palmer, and H. Dennis Woods, entered into a Memorandum of Understanding (the MOU) regarding the settlement in principle of a putative class action lawsuit filed in the United States District Court for the District of Maryland (the Action). The Action was filed in response to the Merger Agreement and alleged claims against the Company, the Bank, Bond Street, Florida Community Bank and certain directors of the Company for breaches of fiduciary duties, aiding and abetting breaches of fiduciary duties, and violations of federal proxy disclosure laws relating to the proposed merger.

Under the terms of the MOU, the Company, the Bank, Bond Street and Florida Community Bank, the other named individual director defendants, and the Plaintiff reached an agreement in principle to settle the class action lawsuit and to release the defendants from all claims in the Action and the prior lawsuits relating to the proposed merger, subject to the approval of the United States District Court for the District of Maryland and the consummation of the proposed merger. Under the terms of the MOU, Plaintiff’s counsel also reserved the right to seek an award of attorney’s fees and expenses if the proposed merger was not approved by the Company’s stockholders.

On June 7, 2013, the parties to the MOU submitted a joint motion to stay the Action and/or to extend case deadlines pending consummation of the proposed merger and the filing of a motion for a preliminary approval of settlement. The court granted the motion and stayed the Action pending consummation of the merger. Although the vote on the proposed merger transaction was unsuccessful, the Action remains pending. The Company continues to believe the lawsuit is meritless and intends to vigorously defend against any remaining claims.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 4. FAIR VALUE

Asset and liability fair value measurements (in this note and Note 5) have been categorized based upon the fair value hierarchy described below:

Level 1 – Valuation is based upon quoted market prices for identical instruments in active markets.

Level 2 – Valuation is based upon quoted market prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates or assumptions that market participants would use in pricing the assets or liabilities. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Assets and liabilities measured at fair value on a recurring basis as of June 30, 2013 and December 31, 2012 are summarized below:

			Fair Value Hierarchy
	Total		Level 1		Level 2		Level 3
	(Dollars in Thousands)

June 30, 2013
Assets:
Securities available-for-sale:
U.S. Government-sponsored enterprises	$	4,619		-	$	4,619		-
State and municipal		988		-		988		-
Mortgage-backed securities – residential		125,874		-		125,874		-
Collateralized mortgage obligations – U.S. Government		29,375		-		29,375		-
Total	$	160,856		-	$	160,856		-

December 31, 2012
Assets:
Securities available-for-sale:
State and municipal	$	979		-	$	979		-
Mortgage-backed securities – residential		119,647		-		119,647		-
Collateralized mortgage obligations – U.S. Government		39,119		-		39,119		-
Total	$	159,745		-	$	159,745		-

The fair values of securities available-for-sale are determined by quoted market prices, if available (Level 1). For securities available-for-sale where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities available-for-sale where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is less liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 4. FAIR VALUE (continued)

Assets and liabilities measured at fair value on a non-recurring basis as of June 30, 2013 and December 31, 2012 are summarized below:

			Fair Value Hierarchy
	Total		Level 1		Level 2		Level 3
	(Dollars in Thousands)
June 30, 2013
Assets:
Other real estate owned	$	12,861		-		-	$	12,861
Impaired loans – collateral dependent (reported on the Condensed Consolidated Balance Sheets in portfolio loans, net)		2,381		-		-		2,381

December 31, 2012
Assets:
Other real estate owned	$	8,065		-		-	$	8,065
Impaired loans – collateral dependent (reported on the Condensed Consolidated Balance Sheets in portfolio loans, net)		9,784		-		-		9,784

Quantitative information about Level 3 fair value measurements as of June 30, 2013 and December 31, 2012 is summarized below:

	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average) (1)
	(Dollars in Thousands)

June 30, 2013
Assets:
Other real estate owned	$	12,861	Broker price opinions, appraisal of collateral (2) (3)	Appraisal adjustments (4) Liquidation expenses	0.0% to 36.2% (4.7%) 8.0% to 10.0% (9.6%)
Impaired loans – collateral dependent (reported on the Condensed Consolidated Balance Sheets in portfolio loans, net)		2,381	Appraisal of collateral (2)	Appraisal adjustments (4) Liquidation expenses	0.0% to 27.5% (0.5%) 10.0% (10.0%)

December 31, 2012
Assets:
Other real estate owned	$	8,065	Broker price opinions, appraisal of collateral (2) (3)	Appraisal adjustments (4) Liquidation expenses	0.0% to 44.0% (2.1%) 8.0% to 10.0% (8.8%)
Impaired loans – collateral dependent (reported on the Condensed Consolidated Balance Sheets in portfolio loans, net)		9,784	Appraisal of collateral (2)	Appraisal adjustments (4) Liquidation expenses	0.0% (0.0%) 8.0% to 10.0% (8.9%)

(1)

The range and weighted average of other appraisal adjustments and liquidation expenses are presented as a percent of the appraised value.

(2)

Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

(3)

Includes qualitative adjustments by management and estimated liquidation expenses.

(4)

Appraisals may be adjusted by management for qualitative factors such as economic conditions and liquidation expenses.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 4. FAIR VALUE (continued)

The fair values of other real estate owned (OREO) is determined using inputs which include current and prior appraisals and estimated costs to sell (Level 3). Assets acquired through or in lieu of loan foreclosure are initially recorded at fair value based on appraisals, as adjusted, less estimated selling costs at the date of foreclosure, establishing a new cost basis. At the initial time of transfer to OREO, an impairment loss is recognized through the allowance in cases where the carrying amount exceeds the new cost basis. Subsequent declines in fair value are recorded directly as an adjustment to current earnings through noninterest expense. Costs relating to improvement of property may be capitalized, whereas costs relating to the holding of property are expensed. Write-downs on OREO for the three months ended June 30, 2013 and 2012 were $112,000 and $116,000, respectively. Write-downs on OREO for the six months ended June 30, 2013 and 2012 were $139,000 and $202,000, respectively.

The fair values of impaired loans that are collateral dependent are based on a valuation model which incorporates the most current real estate appraisals available, as well as assumptions used to estimate the fair value of all non-real estate collateral as defined in the Bank’s internal loan policy (Level 3).

NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS

Carrying amount and estimated fair value of financial instruments, not previously presented, as of June 30, 2013 and December 31, 2012 were as follows:

					Fair Value Hierarchy
	Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
	(Dollars in Thousands)
June 30, 2013
Assets:
Cash and due from financial institutions	$	3,758	$	3,758	$	3,758	$	-		-
Short-term interest-earning deposits		74,201		74,201		74,201		-		-
Portfolio loans, net		386,285		399,914		-		397,533		2,381
Loans held-for-sale		2,217		2,513		-		2,513		-
Warehouse loans		60,653		60,653		-		60,653		-
Federal Home Loan Bank stock, at cost		5,879		5,879		-		-		5,879
Accrued interest receivable		1,971		1,971		-		1,971		-
Liabilities:
Deposits		502,144		502,658		-		502,658		-
Securities sold under agreements to repurchase		92,800		103,759		-		103,759		-
Federal Home Loan Bank advances		110,000		121,889		-		121,889		-
Accrued interest payable (reported on the Condensed Consolidated Balance Sheets in accrued expenses and other liabilities)		1,106		1,106		-		1,106		-

December 31, 2012
Assets:
Cash and due from financial institutions	$	7,490	$	7,490	$	7,490	$	-		-
Short-term interest-earning deposits		60,338		60,338		60,338		-		-
Portfolio loans, net		421,201		435,040		-		425,256		9,784
Loans held-for-sale		4,089		4,527		-		4,527		-
Warehouse loans		68,479		68,479		-		68,479		-
Federal Home Loan Bank stock, at cost		7,260		7,260		-		-		7,260
Accrued interest receivable		2,035		2,035		-		2,035		-
Liabilities:
Deposits		499,760		500,469		-		500,469		-
Securities sold under agreements to repurchase		92,800		107,034		-		107,034		-
Federal Home Loan Bank advances		135,000		150,707		-		150,707		-
Accrued interest payable (reported on the Condensed Consolidated Balance Sheets in accrued expenses and other liabilities)		1,120		1,120		-		1,120		-

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)

The methods and assumptions used to estimate fair value are described below.

Carrying amount is the estimated fair value for cash and cash equivalents, accrued interest, demand and savings deposits and variable rate loans or deposits that re-price frequently and fully. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life without considering the need for adjustments for market illiquidity or credit risk. Fair value of loans held-for-sale is based on quoted market prices, where available, or is determined based on discounted cash flows using current market rates applied to the estimated life and credit risk. Carrying amount is the estimated fair value for warehouse loans, due to the rapid repayment of the loans which generally have an average duration of less than 30 days. Fair value of the FHLB advances and securities sold under agreements to repurchase is based on current rates for similar financing. It was not practicable to determine the fair value of the FHLB stock due to restrictions placed on its transferability. The estimated fair value of other financial instruments and off-balance-sheet commitments approximate cost and are not considered significant to this presentation.

The Bank is a member of the FHLB of Atlanta and as such, is required to maintain a minimum investment in stock of the FHLB that varies with the level of advances outstanding with the FHLB. The stock is bought from and sold to the FHLB based upon its $100.00 par value. The stock does not have a readily determinable fair value and as such, is classified as restricted stock, carried at cost and evaluated for impairment. Accordingly, the stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) the significance of the decline in net assets of the FHLB as compared to the capital stock amount and the length of time this situation has persisted, (b) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) the impact of legislative and regulatory changes on the customer base of the FHLB and (d) the liquidity position of the FHLB. The Company did not consider the FHLB stock to be impaired as of June 30, 2013.

NOTE 6. SECURITIES AVAILABLE-FOR-SALE

The following table summarizes the amortized cost and fair value of the securities available-for-sale and the corresponding amounts of unrealized gains and losses therein as of June 30, 2013 and December 31, 2012:

	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
	(Dollars in Thousands)
June 30, 2013
U.S. Government-sponsored enterprises	$	5,000	$	-	$	(381	)	$	4,619
State and municipal		943		45		-			988
Mortgage-backed securities – residential		129,886		125		(4,137	)		125,874
Collateralized mortgage obligations – U.S. Government		29,868		27		(520	)		29,375
	$	165,697	$	197	$	(5,038	)	$	160,856

December 31, 2012
State and municipal	$	943	$	42	$	(6	)	$	979
Mortgage-backed securities – residential		118,970		847		(170	)		119,647
Collateralized mortgage obligations – U.S. Government		39,146		127		(154	)		39,119
	$	159,059	$	1,016	$	(330	)	$	159,745

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 6. SECURITIES AVAILABLE-FOR-SALE (continued)

The amortized cost and fair value of securities available-for-sale segregated by contractual maturity as of June 30, 2013, is shown below. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities available-for-sale not due at a single maturity date, include mortgage-backed securities and collateralized mortgage obligations, are shown separately.

	Amortized Cost		Fair Value
	(Dollars in Thousands)
Due in one year or less	$	-	$	-
Due from more than one to five years		-		-
Due from more than five to ten years		943		988
Due after ten years		-		-
U.S. Government-sponsored enterprises		5,000		4,619
Mortgage-backed securities – residential		129,886		125,874
Collateralized mortgage obligations – U.S. Government		29,868		29,375
	$	165,697	$	160,856

The following table summarizes the securities available-for-sale with unrealized losses as of June 30, 2013 and December 31, 2012, aggregated by investment category and length of time in a continuous unrealized loss position:

	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in Thousands)

June 30, 2013
U.S. Government-sponsored enterprises	$	4,619	$	(381	)	$	-	$	-		$	4,619	$	(381	)
State and municipal		-		-			-		-			-		-
Mortgage-backed securities – residential		122,438		(4,137	)		-		-			122,438		(4,137	)
Collateralized mortgage obligations – U.S. Government		22,410		(451	)		3,579		(69	)		25,989		(520	)
	$	149,467	$	(4,969	)	$	3,579	$	(69	)	$	153,046	$	(5,038	)

December 31, 2012
State and municipal	$	-	$	-		$	454	$	(6	)	$	454	$	(6	)
Mortgage-backed securities – residential		61,172		(170	)		-		-			61,172		(170	)
Collateralized mortgage obligations – U.S. Government		13,207		(78	)		5,054		(76	)		18,261		(154	)
	$	74,379	$	(248	)	$	5,508	$	(82	)	$	79,887	$	(330	)

The increase in unrealized losses during the first six months of 2013 is due to an increase in interest rates, which started in late May and continued through the end of June. The 10-year treasury rate as of June 30, 2013 and December 31, 2012 was 2.52% and 1.78%, respectively.

Other-Than-Temporary Impairment

Management evaluates securities available-for-sale for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 6. SECURITIES AVAILABLE-FOR-SALE (continued)

As of June 30, 2013 the Company’s security portfolio consisted of 42 securities available-for-sale, 33 of which were in an unrealized loss position. Nearly all unrealized losses were related to debt securities whose underlying collateral is residential mortgages. However, all of these debt securities were issued by government sponsored organizations as discussed below.

As of June 30, 2013, $159.9 million, or approximately 99.4% of the debt securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. The decline in fair value was attributable to changes in interest rates and not credit quality. The Company does not have the intent to sell these securities and it is not likely it will be required to sell the securities before their anticipated recovery. Therefore, the Company does not consider these debt securities to be other-than-temporarily impaired as of June 30, 2013. During the three and six months ended June 30, 2013 and 2012, the Company did not record OTTI related to non-agency collateralized mortgage-backed securities or collateralized mortgage obligations.

Proceeds from Securities Available-for-Sale

Proceeds from sales, payments, maturities and calls of securities available-for-sale were $8.9 million and $8.2 million for the three months ended June 30, 2013 and 2012, respectively. Proceeds from sales, payments, maturities and calls of securities available-for-sale were $18.0 million and $16.0 million for the six months ended June 30, 2013 and 2012, respectively. No gross gains and no gross losses were realized during the three and six months ended June 30, 2013 and 2012, respectively. Gains and losses on sales of securities are recorded on the settlement date, which is not materially different from the trade date, and determined using the specific identification method.

NOTE 7. PORTFOLIO LOANS

Following is a comparative composition of net portfolio loans as of June 30, 2013 and December 31, 2012:

	June 30, 2013			% of Total Loans			December 31, 2012			% of Total Loans
	(Dollars in Thousands)
Real estate loans:
One- to four-family	$	174,177			44.6	%	$	193,057			45.3	%
Commercial		49,145			12.6	%		58,193			13.7	%
Other (land and multi-family)		18,513			4.8	%		19,908			4.7	%
Total real estate loans		241,835			62.0	%		271,158			63.7	%

Real estate construction loans:
One- to four-family		-			0.0	%		-			0.0	%
Commercial		8,114			2.1	%		5,049			1.2	%
Acquisition and development		-			0.0	%		-			0.0	%
Total real estate construction loans		8,114			2.1	%		5,049			1.2	%

Other loans:
Home equity		57,950			14.8	%		63,867			15.0	%
Consumer		57,556			14.7	%		61,558			14.4	%
Commercial		25,097			6.4	%		24,308			5.7	%
Total other loans		140,603			35.9	%		149,733			35.1	%

Total portfolio loans		390,552			100.0	%		425,940			100.0	%
Allowance for portfolio loan losses		(10,029	)					(10,889	)
Net deferred portfolio loan costs		5,762						6,150
Portfolio loans, net	$	386,285					$	421,201

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents the contractual aging of the recorded investment in past due loans by class of portfolio loans as of June 30, 2013 and December 31, 2012:

	Current		30 – 59 Days Past Due		60 – 89 Days Past Due		> 90 Days Past Due		Total Past Due		Total
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	162,886	$	3,600	$	1,347	$	6,344	$	11,291	$	174,177
Commercial		46,665		99		-		2,381		2,480		49,145
Other (land and multi-family)		17,820		75		139		479		693		18,513
Total real estate loans		227,371		3,774		1,486		9,204		14,464		241,835

Real estate construction loans:
One- to four-family		-		-		-		-		-		-
Commercial		8,114		-		-		-		-		8,114
Acquisition and development		-		-		-		-		-		-
Total real estate construction loans		8,114		-		-		-		-		8,114

Other loans:
Home equity		56,026		349		225		1,351		1,925		57,950
Consumer		55,616		703		413		824		1,940		57,556
Commercial		24,342		-		-		755		755		25,097
Total other loans		135,983		1,052		638		2,930		4,620		140,603

Total portfolio loans	$	371,468	$	4,826	$	2,124	$	12,134	$	19,084	$	390,552

December 31, 2012
Real estate loans:
One- to four-family	$	179,242	$	3,598	$	1,658	$	8,559	$	13,815	$	193,057
Commercial		49,922		101		-		8,170		8,271		58,193
Other (land and multi-family)		19,289		24		-		595		619		19,908
Total real estate loans		248,453		3,723		1,658		17,324		22,705		271,158

Real estate construction loans:
One- to four-family		-		-		-		-		-		-
Commercial		4,310		-		-		739		739		5,049
Acquisition and development		-		-		-		-		-		-
Total real estate construction loans		4,310		-		-		739		739		5,049

Other loans:
Home equity		60,342		1,008		305		2,212		3,525		63,867
Consumer		59,451		987		418		702		2,107		61,558
Commercial		22,937		200		-		1,171		1,371		24,308
Total other loans		142,730		2,195		723		4,085		7,003		149,733

Total portfolio loans	$	395,493	$	5,918	$	2,381	$	22,148	$	30,447	$	425,940

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

Non-performing portfolio loans, including non-accrual portfolio loans, as of June 30, 2013 and December 31, 2012 were $12.4 million and $24.9 million, respectively. There were no portfolio loans over 90 days past-due and still accruing interest as of June 30, 2013 or December 31, 2012. Non-performing portfolio loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and larger individually evaluated loans classified as impaired loans.

The following table presents performing and non-performing portfolio loans by class of loans as of June 30, 2013 and December 31, 2012:

	Performing		Non-performing		Total
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	167,645	$	6,532	$	174,177
Commercial		46,764		2,381		49,145
Other (land and multi-family)		18,034		479		18,513
Total real estate loans		232,443		9,392		241,835

Real estate construction loans:
One- to four-family		-		-		-
Commercial		8,114		-		8,114
Acquisition and development		-		-		-
Total real estate construction loans		8,114		-		8,114

Other loans:
Home equity		56,599		1,351		57,950
Consumer		56,686		870		57,556
Commercial		24,342		755		25,097
Total other loans		137,627		2,976		140,603

Total portfolio loans	$	378,184	$	12,368	$	390,552

December 31, 2012
Real estate loans:
One- to four-family	$	182,502	$	10,555	$	193,057
Commercial		49,550		8,643		58,193
Other (land and multi-family)		19,313		595		19,908
Total real estate loans		251,365		19,793		271,158

Real estate construction loans:
One- to four-family		-		-		-
Commercial		4,310		739		5,049
Acquisition and development		-		-		-
Total real estate construction loans		4,310		739		5,049

Other loans:
Home equity		61,655		2,212		63,867
Consumer		60,589		969		61,558
Commercial		23,137		1,171		24,308
Total other loans		145,381		4,352		149,733

Total portfolio loans	$	401,056	$	24,884	$	425,940

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The Company utilizes an internal asset classification system for portfolio loans other than consumer and residential loans as a means of reporting problem and potential problem loans. Under the risk rating system, the Company classifies problem and potential problem loans as “Special Mention”, “Substandard”, and “Doubtful” which correspond to risk ratings five, six and seven, respectively. Substandard portfolio loans, or risk rated six, include those characterized by the distinct possibility the Company may sustain some loss if the deficiencies are not corrected. Portfolio loans classified as Doubtful, or risk rated seven, have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Portfolio loans that do not currently expose the Company to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that deserve management’s close attention are deemed to be Special Mention, or risk rated five. Risk ratings are updated any time the facts and circumstances warrant.

The Company evaluates consumer and residential loans based on whether the loans are performing or non-performing as well as other factors. One- to four-family residential loan balances are charged down by the expected loss amount at the time they become non-performing, which is generally 90 days past due. Consumer loans including automobile, manufactured housing, unsecured, and other secured loans are charged-off, net of expected recovery when the loan becomes significantly past due over a range of up to 180 days, depending on the type of loan.

The following table presents the risk category of those portfolio loans evaluated by internal asset classification as of June 30, 2013 and December 31, 2012:

	Pass		Special Mention		Substandard		Doubtful		Total
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
Commercial	$	42,207	$	2,261	$	4,677	$	-	$	49,145
Other (land and multi-family)		12,416		401		5,696		-		18,513
Total real estate loans		54,623		2,662		10,373		-		67,658

Real estate construction loans:
Commercial		8,114		-		-		-		8,114
Total real estate construction loans		8,114		-		-		-		8,114

Other loans:
Commercial		22,013		98		2,986		-		25,097
Total other loans		22,013		98		2,986		-		25,097

Total portfolio loans	$	84,750	$	2,760	$	13,359	$	-	$	100,869

December 31, 2012
Real estate loans:
Commercial	$	43,542	$	2,308	$	12,343	$	-	$	58,193
Other (land and multi-family)		13,004		413		6,491		-		19,908
Total real estate loans		56,546		2,721		18,834		-		78,101

Real estate construction loans:
Commercial		4,310		-		739		-		5,049
Total real estate construction loans		4,310		-		739		-		5,049

Other loans:
Commercial		22,342		104		1,862		-		24,308
Total other loans		22,342		104		1,862		-		24,308

Total portfolio loans	$	83,198	$	2,825	$	21,435	$	-	$	107,458

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

When establishing the allowance for portfolio loan losses, management categorizes loans into risk categories generally based on the nature of the collateral and the basis of repayment. These risk categories and the relevant risk characteristics are as follows:

Real Estate Loans

One- to four-family residential loans have historically had less risk than other loan types as they tend to be smaller balance loans without concentrations to a single borrower or group of borrowers. Repayment depends on the individual borrower’s capacity. Given the rapid deterioration in the market value of residential real estate over the last several years, there is now a greater risk of loss if actions such as foreclosure or short sale become necessary to collect the loan and private mortgage insurance was not purchased. In addition, depending on the state in which the collateral is located, the risk of loss may increase, due to the time required to complete the foreclosure process on a property.

Commercial real estate loans generally have greater credit risks compared to one- to four-family residential real estate loans, as they usually involve larger loan balances secured by non-homogeneous or specific use properties. Repayment of these loans typically relies on the successful operation of a business or the generation of lease income by the property and is therefore more sensitive to adverse conditions in the economy and real estate market.

Other real estate loans include loans secured by multi-family residential real estate and land. Generally these loans involve a greater degree of credit risk than residential real estate loans, but are normally smaller individual loan balances than commercial real estate loans; land loans due to the lack of cash flow and reliance on borrower’s capacity and multi-family due the reliance on the successful operation the project. Both loan types are also more sensitive to adverse economic conditions.

Real Estate Construction Loans

Real estate construction loans, including one- to four-family, commercial and acquisition and development loans, generally have greater credit risk than traditional one- to four-family residential real estate loans. The repayment of these loans can be dependent on the sale of the property to third parties or the successful completion of the improvements by the builder for the end user. In the event a loan is made on property that is not yet approved for the planned development, there is the risk that approvals will not be granted or will be delayed. Construction loans also run the risk that improvements will not be completed on time or accordance with specifications and projected costs. Included in construction loans are SBA construction loans, which generally have less credit risk than traditional construction loans due to a portion of the balance being guaranteed upon completion of the construction.

Other Loans

Home equity loans and home equity lines are similar to one- to four-family residential loans and generally carry less risk than other loan types as they tend to be smaller balance loans without concentrations to a single borrower or group or borrowers. However, similar to one- to four-family residential loans, risk of loss has increased over the last several years due to deterioration of the real estate market.

Consumer loans often are secured by depreciating collateral, including cars and mobile homes, or are unsecured and may carry more risk than real estate secured loans. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

Commercial loans are secured by business assets or may be unsecured and repayment is directly dependent on the successful operation of the borrower’s business and the borrower’s ability to convert the assets to operating revenue and possess greater risk than most other types of loans should the repayment capacity of the borrower not be adequate.

Activity in the allowance for portfolio loan losses for the three months ended June 30, 2013 and 2012 was as follows:

	Beginning Balance		Charge-Offs			Recoveries		Provisions			Ending Balance
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	4,126	$	(407	)	$	244	$	(241	)	$	3,722
Commercial		1,004		(734	)		-		1,051			1,321
Other (land and multi-family)		979		(247	)		21		(63	)		690
Total real estate loans		6,109		(1,388	)		265		747			5,733

Real estate construction loans:
One- to four-family		-		-			-		-			-
Commercial		273		-			-		(199	)		74
Acquisition and development		-		-			-		-			-
Total real estate construction loans		273		-			-		(199	)		74

Other loans:
Home equity		2,142		(199	)		177		(151	)		1,969
Consumer		1,272		(471	)		58		599			1,457
Commercial		670		(97	)		-		223			796
Total other loans		4,084		(767	)		235		671			4,222

Total portfolio loans	$	10,466	$	(2,155	)	$	500	$	1,219		$	10,029

June 30, 2012
Real estate loans:
One- to four-family	$	5,730	$	(3,184	)	$	215	$	2,013		$	4,773
Commercial		2,066		(1	)		-		(109	)		1,956
Other (land and multi-family)		810		(684	)		-		587			713
Total real estate loans		8,606		(3,869	)		215		2,490			7,442

Real estate construction loans:
One- to four-family		2		-			-		(2	)		-
Commercial		-		(202	)		-		210			8
Acquisition and development		-		-			-		-			-
Total real estate construction loans		2		(202	)		-		208			8

Other loans:
Home equity		3,132		(915	)		58		910			3,186
Consumer		1,049		(297	)		92		189			1,032
Commercial		727		-			-		(56	)		671
Total other loans		4,908		(1,212	)		150		1,043			4,889

Total portfolio loans	$	13,516	$	(5,283	)	$	365	$	3,741		$	12,339

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

Activity in the allowance for portfolio loan losses for the six months ended June 30, 2013 and 2012 was as follows:

	Beginning Balance		Charge-Offs			Recoveries		Provisions			Ending Balance
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	4,166	$	(1,372	)	$	614	$	314		$	3,722
Commercial		958		(855	)		-		1,218			1,321
Other (land and multi-family)		986		(349	)		36		17			690
Total real estate loans		6,110		(2,576	)		650		1,549			5,733

Real estate construction loans:
One- to four-family		-		-			-		-			-
Commercial		50		-			-		24			74
Acquisition and development		-		-			-		-			-
Total real estate construction loans		50		-			-		24			74

Other loans:
Home equity		2,636		(972	)		323		(18	)		1,969
Consumer		1,448		(738	)		121		626			1,457
Commercial		645		(131	)		10		272			796
Total other loans		4,729		(1,841	)		454		880			4,222

Total portfolio loans	$	10,889	$	(4,417	)	$	1,104	$	2,453		$	10,029

June 30, 2012
Real estate loans:
One- to four-family	$	6,030	$	(4,301	)	$	471	$	2,573		$	4,773
Commercial		3,143		(2,138	)		2		949			1,956
Other (land and multi-family)		1,538		(1,585	)		-		760			713
Total real estate loans		10,711		(8,024	)		473		4,282			7,442

Real estate construction loans:
One- to four-family		120		-			-		(120	)		-
Commercial		-		(202	)		-		210			8
Acquisition and development		-		-			-		-			-
Total real estate construction loans		120		(202	)		-		90			8

Other loans:
Home equity		3,125		(2,044	)		71		2,034			3,186
Consumer		885		(780	)		172		755			1,032
Commercial		685		(71	)		2		55			671
Total other loans		4,695		(2,895	)		245		2,844			4,889

Total portfolio loans	$	15,526	$	(11,121	)	$	718	$	7,216		$	12,339

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents ending balances for the allowance for portfolio loan losses and portfolio loans based on the impairment method as of June 30, 2013:

	Individually Evaluated for Impairment		Collectively Evaluated for Impairment		Total Ending Balance
	(Dollars in Thousands)

Allowance for portfolio loan losses:
Real estate loans:
One- to four-family	$	1,020	$	2,702	$	3,722
Commercial		138		1,183		1,321
Other (land and multi-family)		173		517		690
Total real estate loans		1,331		4,402		5,733

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		74		74
Acquisition and development		-		-		-
Total real estate construction loans		-		74		74

Other loans:
Home equity		395		1,574		1,969
Consumer		45		1,412		1,457
Commercial		425		371		796
Total other loans		865		3,357		4,222

Total ending allowance balance	$	2,196	$	7,833	$	10,029

Portfolio loans:
Real estate loans:
One- to four-family	$	6,010	$	168,167	$	174,177
Commercial		8,910		40,235		49,145
Other (land and multi-family)		7,551		10,962		18,513
Total real estate loans		22,471		219,364		241,835

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		8,114		8,114
Acquisition and development		-		-		-
Total real estate construction loans		-		8,114		8,114

Other loans:
Home equity		1,969		55,981		57,950
Consumer		330		57,226		57,556
Commercial		1,460		23,637		25,097
Total other loans		3,759		136,844		140,603

Total ending portfolio loans balance	$	26,230	$	364,322	$	390,552

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents ending balances for the allowance for portfolio loan losses and portfolio loans based on the impairment method as of December 31, 2012:

	Individually Evaluated for Impairment		Collectively Evaluated for Impairment		Total Ending Balance
	(Dollars in Thousands)

Allowance for portfolio loan losses:
Real estate loans:
One- to four-family	$	1,116	$	3,050	$	4,166
Commercial		165		793		958
Other (land and multi-family)		156		830		986
Total real estate loans		1,437		4,673		6,110

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		50		50
Acquisition and development		-		-		-
Total real estate construction loans		-		50		50

Other loans:
Home equity		384		2,252		2,636
Consumer		59		1,389		1,448
Commercial		308		337		645
Total other loans		751		3,978		4,729

Total ending allowance balance	$	2,188	$	8,701	$	10,889

Portfolio loans:
Real estate loans:
One- to four-family	$	7,966	$	185,091	$	193,057
Commercial		15,034		43,159		58,193
Other (land and multi-family)		8,507		11,401		19,908
Total real estate loans		31,507		239,651		271,158

Real estate construction loans:
One- to four-family		-		-		-
Commercial		739		4,310		5,049
Acquisition and development		-		-		-
Total real estate construction loans		739		4,310		5,049

Other loans:
Home equity		2,957		60,910		63,867
Consumer		467		61,091		61,558
Commercial		2,006		22,302		24,308
Total other loans		5,430		144,303		149,733

Total ending portfolio loans balance	$	37,676	$	388,264	$	425,940

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

Portfolio loans for which the concessions have been granted as a result of the borrower’s financial difficulties are considered a troubled debt restructuring (TDR). These concessions, which in general are applied to all categories of portfolio loans, may include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, or a combination of these or other actions intended to maximize collection.

For homogeneous loan categories, such as one- to four-family residential loans and home equity loans, the amount of impairment resulting from the modification of the loan terms is calculated in aggregate by category of portfolio loan. The resulting impairment is included in specific reserves. If an individual homogeneous loan defaults under terms of the TDR and becomes non-performing, the Bank follows its usual practice of charging the loan down to its estimated fair value and the charge-off is considered as a factor in determining the amount of the general component of the allowance for loan losses.

For larger non-homogeneous loans, each loan that is modified is evaluated individually for impairment based on either discounted cash flow or, for collateral dependent loans, the appraised value of the collateral less selling costs. If the loan is not collateral dependent, the amount of the impairment, if any, is recorded as a specific reserve in the allowance for loan loss reserve. If the loan is collateral dependent, the amount of the impairment is charged off. There was an allocated allowance for loan losses for loans individually evaluated for impairment of approximately $0.5 million at June 30, 2013 and December 31, 2012, respectively.

Portfolio loans modified as TDRs with market rates of interest are classified as impaired loans in the year of restructure and until the loan has performed for 12 months in accordance with the modified terms. The resulting impairment is included in specific reserves. TDRs classified as impaired loans as of June 30, 2013 and December 31, 2012 were as follows:

	June 30, 2013		December 31, 2012
	(Dollars in Thousands)

Real estate loans:
One- to four-family	$	6,010	$	7,966
Commercial		6,300		7,635
Other (land and multi-family)		6,847		2,053
Total real estate loans		19,157		17,654

Real estate construction loans:
One- to four-family		-		-
Commercial		-		-
Acquisition and development		-		-
Total real estate construction loans		-		-

Other loans:
Home equity		1,969		2,957
Consumer		330		467
Commercial		904		1,329
Total other loans		3,203		4,753

Total TDRs classified as impaired loans	$	22,360	$	22,407

There were no commitments to lend additional amounts on TDRs as of June 30, 2013 and December 31, 2012.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The Company is proactive in modifying residential, home equity and consumer loans in early stage delinquency because we believe modifying the loan prior to it becoming non-performing results in the least cost to the Bank. The Bank also modifies larger commercial and commercial real estate loans as TDRs rather than pursuing other means of collection when it believes the borrower is committed to the successful repayment of the loan and the business operations are likely to support the modified loan terms. The following table presents information on TDRs during the six months ended June 30, 2013:

	Number of Contracts		Pre-Modification Outstanding Recorded Investments		Post-Modification Outstanding Recorded Investments
	(Dollars in Thousands)

Troubled debt restructuring:
Real estate loans:
One- to four-family		4	$	613	$	613
Other (land and multi-family)		3		5,756		5,756
Total real estate loans		7		6,369		6,369

Other loans:
Home equity		5		143		143
Consumer		5		218		218
Commercial		3		298		298
Total other loans		13		659		659

Total troubled debt restructurings		20	$	7,028	$	7,028

There were no subsequent defaults on portfolio loans that were restructured as troubled debt restructurings during the six months ended June 30, 2013.

The following table presents information on TDRs and subsequent defaults during the six months ended June 30, 2012:

	Number of Contracts		Pre-Modification Outstanding Recorded Investments		Post-Modification Outstanding Recorded Investments
	(Dollars in Thousands)
Troubled debt restructuring:
Real estate loans:
One- to four-family		20	$	2,740	$	2,141
Commercial		4		587		577
Other (land and multi-family)		6		655		497
Total real estate loans		30		3,982		3,215

Other loans:
Home equity		11		1,280		1,090
Consumer		4		313		312
Commercial		1		46		41
Total other loans		16		1,639		1,443

Total troubled debt restructurings		46	$	5,621	$	4,658

	Number of Contracts		Recorded Investments
	(Dollars in Thousands)
Troubled debt restructuring that subsequently defaulted:
Real estate loans:
Other (land and multi-family)		2	$	315

Total troubled debt restructurings that subsequently defaulted		2	$	315

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents information about impaired portfolio loans as of June 30, 2013:

	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(Dollars in Thousands)

With no related allowance recorded:
Real estate loans:
One- to four-family	$	-	$	-	$	-
Commercial		5,990		6,082		-
Other (land and multi-family)		7,150		7,388		-
Total real estate loans		13,140		13,470		-

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		-		-
Acquisition and development		-		-		-
Total real estate construction loans		-		-		-

Other loans:
Home equity		-		-		-
Consumer		-		-		-
Commercial		621		621		-
Total other loans		621		621		-

Total with no related allowance recorded	$	13,761	$	14,091	$	-

With an allowance recorded:
Real estate loans:
One- to four-family	$	6,010	$	6,010	$	1,020
Commercial		2,920		2,920		138
Other (land and multi-family)		401		401		173
Total real estate loans		9,331		9,331		1,331

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		-		-
Acquisition and development		-		-		-
Total real estate construction loans		-		-		-

Other loans:
Home equity		1,969		2,069		395
Consumer		330		330		45
Commercial		839		839		425
Total other loans		3,138		3,238		865

Total with an allowance recorded	$	12,469	$	12,569	$	2,196

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents information about impaired portfolio loans as of December 31, 2012:

	Recorded Investment		Unpaid Principal Balance		Related Allowance
	(Dollars in Thousands)

With no related allowance recorded:
Real estate loans:
One- to four-family	$	-	$	-	$	-
Commercial		12,073		12,758		-
Other (land and multi-family)		6,490		6,493		-
Total real estate loans		18,563		19,251		-

Real estate construction loans:
One- to four-family		-		-		-
Commercial		739		4,988		-
Acquisition and development		-		-		-
Total real estate construction loans		739		4,988		-

Other loans:
Home equity		-		-		-
Consumer		-		-		-
Commercial		1,117		2,814		-
Total other loans		1,117		2,814		-

Total with no related allowance recorded	$	20,419	$	27,053	$	-

With an allowance recorded:
Real estate loans:
One- to four-family	$	7,966	$	8,071	$	1,116
Commercial		2,961		2,961		165
Other (land and multi-family)		2,017		2,195		156
Total real estate loans		12,944		13,227		1,437

Real estate construction loans:
One- to four-family		-		-		-
Commercial		-		-		-
Acquisition and development		-		-		-
Total real estate construction loans		-		-		-

Other loans:
Home equity		2,957		3,160		384
Consumer		467		467		59
Commercial		889		889		308
Total other loans		4,313		4,516		751

Total with an allowance recorded	$	17,257	$	17,743	$	2,188

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents interest income on impaired portfolio loans by class of portfolio loans for the three months ended June 30, 2013 and 2012:

	Average Balance		Interest Income Recognized		Cash Basis Interest Income Recognized
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	6,507	$	48	$	-
Commercial		11,425		80		-
Other (land and multi-family)		7,839		93		-
Total real estate loans		25,771		221		-

Real estate construction loans:
One- to four-family		-		-		-
Commercial		370		-		-
Acquisition and development		-		-		-
Total real estate construction loans		370		-		-

Other loans:
Home equity		2,184		15		-
Consumer		348		7		-
Commercial		1,540		11		-
Total other loans		4,072		33		-

Total portfolio loans	$	30,213	$	254	$	-

June 30, 2012
Real estate loans:
One- to four-family	$	10,880	$	155	$	-
Commercial		15,350		210		-
Other (land and multi-family)		5,203		29		-
Total real estate loans		31,433		394		-

Real estate construction loans:
One- to four-family		-		-		-
Commercial		2,236		-		-
Acquisition and development		-		-		-
Total real estate construction loans		2,236		-		-

Other loans:
Home equity		2,673		37		-
Consumer		475		11		-
Commercial		3,812		16		-
Total other loans		6,960		64		-

Total portfolio loans	$	40,629	$	458	$	-

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The following table presents interest income on impaired portfolio loans by class of portfolio loans for the six months ended June 30, 2013 and 2012:

	Average Balance		Interest Income Recognized		Cash Basis Interest Income Recognized
	(Dollars in Thousands)

June 30, 2013
Real estate loans:
One- to four-family	$	6,988	$	141	$	-
Commercial		11,973		173		-
Other (land and multi-family)		8,029		165		-
Total real estate loans		26,990		479		-

Real estate construction loans:
One- to four-family		-		-		-
Commercial		370		-		-
Acquisition and development		-		-		-
Total real estate construction loans		370		-		-

Other loans:
Home equity		2,463		43		-
Consumer		399		12		-
Commercial		1,733		22		-
Total other loans		4,595		77		-

Total portfolio loans	$	31,955	$	556	$	-

June 30, 2012
Real estate loans:
One- to four-family	$	10,709	$	233	$	-
Commercial		17,529		271		-
Other (land and multi-family)		5,179		60		-
Total real estate loans		33,417		564		-

Real estate construction loans:
One- to four-family		228		-		-
Commercial		2,236		-		-
Acquisition and development		-		-		-
Total real estate construction loans		2,464		-		-

Other loans:
Home equity		2,398		65		-
Consumer		420		17		-
Commercial		3,917		23		-
Total other loans		6,735		105		-

Total portfolio loans	$	42,616	$	669	$	-

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 7. PORTFOLIO LOANS (continued)

The Company has originated portfolio loans with directors and executive officers and their associates. These loans totaled approximately $1.5 million and $1.6 million as of June 30, 2013 and December 31, 2012, respectively. The activity on these loans during the six months ended June 30, 2013 and the year ended December 31, 2012 was as follows:

	June 30, 2013			December 31, 2012
	(Dollars in Thousands)

Beginning balance	$	1,563		$	1,587
New portfolio loans and advances on existing loans		42			2
Effect of changes in related parties		-			71
Repayments		(63	)		(97	)
Ending balance	$	1,542		$	1,563

NOTE 8. OTHER LOANS

Other loans was comprised of loans secured by one- to four-family residential homes originated internally and held-for-sale (mortgage loans held-for-sale), small business loans originated internally and held-for-sale (SBA loans held-for-sale), and loans secured by one- to four-family residential homes originated under purchase and assumption agreements by third-party originators (warehouse loans). The Company originates mortgage loans held-for-sale with the intent to sell the loans and the servicing rights to investors. The Company originates SBA loans held-for-sale with the intent to sell the guaranteed portion of the loans to investors, while maintaining the servicing rights. The Company originates warehouse loans and permits the third-party originator to sell the loans and servicing rights to investors in order to repay the warehouse balance outstanding. Due to the generally short duration of time the Company holds these loans, the collateral arrangements related to the loans, and other factors, management has determined that no allowance for loan losses is necessary.

The Company did not internally originate any mortgage loans held-for-sale during the three or six months ended June 30, 2013. The Company internally originated approximately $12.8 million and $23.9 million of mortgage loans held-for-sale during the three and six months ended June 30, 2012, respectively. The gain recorded on sale of mortgage loans held-for-sale during the three and six months ended June 30, 2012 was $0.2 million and $0.6 million, respectively.

During the three months ended June 30, 2013 and 2012, the Company internally originated approximately $2.5 million and $1.7 million, respectively, of SBA loans held-for-sale. During the six months ended June 30, 2013 and 2012 the Company internally originated approximately $4.9 million and $4.3 million, respectively, of SBA loans held-for-sale. The gain recorded on sales of SBA loans held-for-sale was $0.3 million and $0.1 million during the three months ended June 30, 2013 and 2012, respectively, and $0.6 million and $0.3 million during the six months ended June 30, 2013 and 2012, respectively. Additionally, the Company recognized gains on the servicing of these loans of $18,000 and $89,000 during the three months ended June 30, 2013 and 2012, respectively, and $79,000 and $216,000 during the six months ended June 30, 2013 and 2012, respectively.

During the three months ended June 30, 2013 and 2012, the Company originated approximately $292.7 million and $203.4 million, respectively, of warehouse loans from third parties. During the six months ended June 30, 2013 and 2012 the Company originated approximately $569.8 million and $378.8 million, respectively, of warehouse loans from third parties. The weighted average number of days outstanding of warehouse loans was 17 days and 23 days for the three months ended June 30, 2013 and 2012, respectively, and 20 days and 25 days for the six months ended June 30, 2013 and 2012, respectively.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 9. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The Company has securities sold under agreements to repurchase with a carrying amount of $92.8 million as of June 30, 2013 and December 31, 2012. Under the terms of the agreements the collateral is subject to a haircut determined by the counterparty and must be pledged in amounts equal to the debt plus the fair market value of the debt that is in excess of the principal amount of the debt. As a result, the Company had $120.0 million and $116.9 million in securities posted as collateral for these instruments as of June 30, 2013 and December 31, 2012, respectively. The Company will be required to post additional collateral if the gap between the market value of the liability and the contractual amount of the liability increases. In the event the Bank pre-pays the agreements prior to maturity, it must do so at its fair value, which as of June 30, 2013 exceeded the book value of the individual agreements by $10.9 million.

Information concerning securities sold under agreements to repurchase as of and for the six months ending June 30, 2013, and as of and for the year ended December 31, 2012 is summarized as follows:

	June 30, 2013			December 31, 2012
	(Dollars in Thousands)

Average daily balance	$	92,800		$	92,800
Weighted average coupon interest rate during the period		5.10	%		5.10	%
Maximum month-end balance during the period	$	92,800		$	92,800
Weighted average coupon interest rate at end of period		5.10	%		5.10	%
Weighted average maturity (months)		36			42

The securities sold under agreements to repurchase as of June 30, 2013 mature as follows:

	Amount Maturing
	(Dollars in Thousands)

2013	$	-
2014		26,500
2015		10,000
2016		5,000
2017		25,000
Thereafter		26,300
Total	$	92,800

Beginning in January 2009, the lender has the option to terminate individual advances in whole the following quarter; there is no termination penalty if terminated by the lender. There have been no early terminations.

Under the terms of the agreement with the counterparty on $77.8 million of the $92.8 million the Bank is required to pledge additional collateral if its capital ratios decrease below the Prompt Corrective Action (PCA) defined levels of well-capitalized or adequately capitalized. Due to the decline in capital ratios below the PCA defined levels at December 31, 2012, the Company was required to increase pledged collateral by $4.0 million. Failure to maintain required collateral levels is in violation of the default provision under the terms of the agreement and could result in a termination penalty. At June 30, 2013, the fair value of $77.8 million of the debt exceeded the carrying value by approximately $8.7 million, which approximates the termination penalty.

NOTE 10. FEDERAL HOME LOAN BANK ADVANCES

FHLB borrowings at June 30, 2013 and December 31, 2012 were $110.0 million and $135.0 million, respectively. During the six months ended June 30, 2013, the Company prepaid advances scheduled for maturity in the third and fourth quarter of 2013 totaling $25.0 million, resulting in a prepayment penalty of $0.5 million. The FHLB advances had a weighted-average maturity of 45 months and a weighted-average rate of 4.11% at June 30, 2013.

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 10. FEDERAL HOME LOAN BANK ADVANCES (continued)

The Bank’s borrowing capacity with the FHLB is $5.0 million at June 30, 2013. The minimal borrowing capacity is due to the declining balance of outstanding loans used as collateral as a result of normal loan payments and payoffs. In addition, due to the Bank’s financial condition the FHLB has increased the amount of discount applied to determine the collateral value of the loans. The Bank intends to supplement its loan collateral with investment securities as needed to secure the FHLB borrowings, or pre-pay advances to reduce the amount of collateral required to secure the debt. Unpledged securities available for collateral amounted to $13.0 million as of June 30, 2013. In the event the Bank pre-pays additional advances prior to maturity, it must do so at its fair value. Additionally, effective August 31, 2012, the FHLB required that the Bank collateralize the excess of the fair value of the FHLB advances over the book value with cash and securities. As of June 30, 2013, fair value exceeded the book value of the individual advances by $11.9 million.

NOTE 11. INCOME TAXES

The Company considers at each reporting period all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed to reduce its deferred tax asset to an amount that is more likely than not to be realized. A determination of the need for a valuation allowance for the deferred tax assets is dependent upon management’s evaluation of both positive and negative evidence. Positive evidence includes the probability of achieving forecasted future taxable income, applicable tax strategies and assessments of the current and future economic and business conditions. Negative evidence includes the Company’s cumulative losses and expiring tax credit carryforwards.

As of June 30, 2013, the Company evaluated the expected realization of its federal and state deferred tax assets which, prior to a valuation allowance, totaled $30.0 million and was primarily comprised of future tax benefits associated with the allowance for loan losses and net operating loss carryforward. Based on this evaluation it was concluded that a valuation allowance continues to be required for the federal deferred tax asset. However, under the rules of Internal Revenue Code § 382 (IRC § 382), a change in the ownership of the Company occurred during the first quarter of 2013. The Company became aware of the change in ownership during the second quarter of 2013 based on applicable filings made by stockholders with the Securities and Exchange Commission. In accordance with IRC § 382, the gross amount of net operating loss carryovers the Company can use is limited to $325,000 per year. The effects of the limitation on the existing deferred tax asset are currently being analyzed. The realization of the deferred tax asset is dependent upon generating taxable income. The Company also continues to maintain a valuation allowance for the state deferred tax asset. If the valuation allowance is reduced or eliminated, future tax benefits will be recognized as a reduction to income tax expense which will have a positive non-cash impact on our net income and stockholders’ equity.

The Company recorded income tax expense of $150,000 for the six months ended June 30, 2012 related to an IRS examination of the 2008 tax return which resulted in the disallowance of certain bad debt expense deductions. Income tax expense (benefit) for the six months ending June 30, 2013 and 2012 was as follows:

	Six months ending June 30,
	2013			2012
	(Dollars in Thousands)

Loss before income tax expense	$	(3,593	)	$	(4,555	)
Effective tax rate		39.6	%		36.5	%
Income tax benefit		(1,424	)		(1,663	)
Increase in valuation allowance – federal		1,286			1,625
Increase in valuation allowance – state		138			188
Income tax expense	$	-		$	150

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 12. LOSS PER COMMON SHARE

The basic weighted average common shares and common stock equivalents are computed using the treasury stock method. The basic weighted average common shares outstanding for the period is adjusted for average unallocated employee stock ownership plan shares, average director’s deferred compensation shares, and average unearned restricted stock awards. Stock options and stock awards for shares of common stock were not considered in computing diluted weighted average common shares outstanding for the three and six months ended June 30, 2013 and 2012, respectively. Due to reported losses in each period there was no dilutive effect.

The following table summarizes the basic and diluted loss per common share computation for the three and six months ended June 30, 2013 and 2012:

	Three months ending June 30,						Six months ending June 30,
	2013			2012			2013			2012
	(Dollars in Thousands, Except Share Information)

Basic:
Net Loss	$	(1,554	)	$	(2,996	)	$	(3,593	)	$	(4,705	)
Weighted average common shares outstanding		2,628,969			2,628,969			2,628,969			2,628,969
Less: average unallocated employee stock ownership plan shares		(86,227	)		(91,017	)		(86,227	)		(91,017	)
Less: average director’s deferred compensation shares		(37,712	)		(39,478	)		(37,926	)		(40,842	)
Less: average unvested restricted stock awards		(813	)		(1,242	)		(817	)		(1,317	)
Weighted average common shares outstanding, as adjusted		2,504,217			2,497,232			2,503,999			2,495,793
Basic loss per common share	$	(0.62	)	$	(1.20	)	$	(1.43	)	$	(1.89	)

Diluted:
Net Loss	$	(1,554	)	$	(2,996	)	$	(3,593	)	$	(4,705	)
Weighted average common shares outstanding, as adjusted (from above)		2,504,217			2,497,232			2,503,999			2,495,793
Add: dilutive effects of assumed exercise of stock options		-			-			-			-
Add: dilutive effects of full vesting of stock awards		-			-			-			-
Weighted average dilutive shares outstanding		2,504,217			2,497,232			2,503,999			2,495,793
Diluted loss per common share	$	(0.62	)	$	(1.20	)	$	(1.43	)	$	(1.89	)

NOTE 13. REGULATORY SUPERVISION

On August 10, 2012 the Board of Directors of the Bank agreed to the Order with its primary regulator, the OCC. The Order does not affect Atlantic Coast Bank’s ability to continue to conduct its banking business with customers in a normal fashion. Banking products and services, hours of operation, internet banking, ATM usage, and FDIC deposit insurance coverage are unaffected. The Order provided that:

the Order replaces and therefore terminates the Supervisory Agreement entered into between the Bank and the Office of Thrift Supervision on December 10, 2010;

within 10 days of the date of the Order, the Board had to establish a compliance committee that will be responsible for monitoring and coordinating the Bank’s adherence to the provisions of the Order;

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 13. REGULATORY SUPERVISION (continued)

•

within 90 days of the date of the Order, the Board had to develop and submit to the OCC for receipt of supervisory non-objection of at least a two-year strategic plan to achieve objectives for the Bank’s risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital and liquidity adequacy and updating such plan each year by January 31 beginning on January 31, 2014;

•

until such time as the OCC provides written supervisory non-objection of the Bank’s strategic plan, the Bank will not significantly deviate from products, services, asset composition and size, funding sources, structures, operations, policies, procedures and markets of the Bank that existed prior to the Order without receipt of prior non-objection from the OCC;

•

by December 31, 2012, the Bank needed to achieve and maintain a total risk based capital ratio of 13.00% of risk weighted assets and Tier 1 capital ratio of 9.00% of adjusted total assets;

•

within 60 days of the date of the Order, the Board needed to develop and implement an effective internal capital planning process to assess the Bank’s capital adequacy in relation to its overall risks and to ensure maintenance of appropriate capital levels, which should be no less than total risk based capital ratio of 13.00% of risk weighted assets and Tier 1 capital ratio of 9.00% of adjusted total assets;

•

the Bank may not accept, renew or roll over any brokered deposit unless it has applied for and been granted a waiver of this prohibition by the Federal Deposit Insurance Corporation (the FDIC);

•

within 90 days of the date of the Order, the Board had to forward to the OCC for receipt of written supervisory non-objection a written capital plan for the Bank covering at least a two year period that achieves and maintains total risk based capital ratio of 13.00% of risk weighted assets and Tier 1 capital ratio of 9.00% of adjusted total assets in addition to certain other requirements;

•

the Bank may declare or pay a dividend or make a capital distribution only when it is in compliance with its approved capital plan and would remain in compliance with its approved capital plan after payment of such dividends or capital distribution and receives prior written approval of the OCC;

•

following receipt of written no supervisory objection of its capital plan, the Board will monitor the Bank’s performance against the capital plan and shall review and update the plan annually no later than January 31 of each year, beginning with January 31, 2014;

•

if the Bank fails to achieve and maintain the required capital ratios by December 31, 2012, fails to submit a capital plan within 90 days of the date of the Order or fails to implement a written capital plan for which the OCC has provided a written determination of no supervisory objection, then, at the sole discretion of the OCC, the Bank may be deemed undercapitalized for purposes of the Order;

•

within 30 days of the date of the Order, the Board had to revise and maintain a comprehensive liquidity risk management program which assesses on an ongoing basis, the Bank’s current and projected funding needs, and that ensures that sufficient funds or access to funds exist to meet those needs;

•

within 60 days of the date of the Order, the Board had to revise its problem asset reduction plan (PARP) the design of which will be to eliminate the basis of criticism of those assets criticized as “doubtful”, “substandard” or “special mention” during the OCC’s most recent report of examination as well as any subsequent examination or review by the OCC and any other internal or external loan reviews;

•

within 60 days of the date of the Order, the Board had to revise its written concentration management program for identifying, monitoring, and controlling risks associated with asset and liability concentrations, including off-balance sheet concentrations;

ATLANTIC COAST FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

June 30, 2013

(unaudited)

NOTE 13. REGULATORY SUPERVISION (continued)

•

the Bank’s concentration management program will include a contingency plan to reduce or mitigate concentrations deemed imprudent for the Bank’s earnings, capital, or in the event of adverse market conditions, including strategies to reduce the current concentrations to Board established limits and a restriction on purchasing bank owned life insurance (BOLI) until such time as the BOLI exposure has been reduced below regulatory guidelines of 25.00% of total capital; and

•

the Board will immediately take all necessary steps to ensure that the Bank management corrects each violation of law, rule or regulation cited in the OCC’s most recent report of examination and within 60 days of the date of the Order, the Board shall adopt, implement, and thereafter ensure Bank adherence to specific procedures to prevent future violations and the Bank’s adherence to general procedures addressing compliance management of internal controls and employee education regarding laws, rules and regulations.

The Bank believes it has accomplished all requirements under the Order to date, excluding achieving a total risk based capital ratio of 13.00% of risk weighted assets and Tier 1 capital ratio of 9.00% of adjusted total assets. In the event the Bank achieves the minimum capital ratios, the OCC may continue to enforce the Order, or portions thereof, for some period of time to monitor the Company’s continued compliance with the Order. Atlantic Coast Bank’s actual and required capital levels and ratios were as follows:

	Actual					Required for Capital Adequacy Purposes					Required Capital Levels Under the Consent Order
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in Millions)
June 30, 2013
Total capital (to risk weighted assets)	$	41.7		9.55	%	$	34.9		8.00	%	$	56.7		13.00	%
Tier 1 (core) capital (to risk weighted assets)		36.2		8.29	%		17.5		4.00	%		n/a		n/a
Tier 1 (core) capital (to adjusted total assets)		36.2		4.83	%		29.9		4.00	%		67.4		9.00	%

December 31, 2012
Total capital (to risk weighted assets)	$	45.6		9.78	%	$	37.3		8.00	%	$	60.6		13.00	%
Tier 1 (core) capital (to risk weighted assets)		39.7		8.52	%		18.6		4.00	%		n/a		n/a
Tier 1 (core) capital (to adjusted total assets)		39.7		5.13	%		30.9		4.00	%		69.6		9.00	%

The Bank’s capital classification as of June 30, 2013, was adequately capitalized.

The Company remains subject to the Supervisory Agreement with the Federal Reserve Bank of Atlanta which was entered into on December 10, 2010 and provides, among other things, that: (1) the Company must comply with regulatory prior notification requirements with respect to changes in directors and senior executive officers; (2) the Company cannot declare or pay dividends or make any other capital distributions without prior written Federal Reserve approval; (3) the Company will not be permitted to enter into, renew, extend or revise any contractual arrangement relating to compensation or benefits for any senior executive officers or directors, unless it provides 30 days prior written notice of the proposed transaction to the Federal Reserve Board; (4) the Company may not make any golden parachute payment or prohibited indemnification payment without FRB prior written approval; (5) the Company may not incur, issue, renew or rollover any debt or debt securities, increase any current lines of credit, guarantee the debt of any entity, or otherwise incur any additional debt without the prior written non-objection of the Federal Reserve Board.

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

The following discussion should be read in conjunction with Item 1. Financial Statements and the notes thereto included in this report and the Company’s Annual Report on Form 10-K for the period ended December 31, 2012, as filed with the Securities and Exchange Commission on April 1, 2013. The discussion below contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements in this filing that are not strictly historical are forward-looking and are based upon current expectations that may differ materially from actual results. These forward-looking statements, identified by words such as "expects," "anticipates," "believes," "estimates," "targets," "intends," "plans," "goal" and other similar expressions or future or conditional verbs such as "will," "may," "might," "should," "would" and "could," involve risks and uncertainties that could cause actual results to differ materially from those anticipated by the statements made herein. These risks and uncertainties involve general economic trends and changes in interest rates, increased competition, changes in consumer demand for financial services, the possibility of unforeseen events affecting the industry generally, the uncertainties associated with newly developed or acquired operations, market disruptions and other effects of terrorist activities.

Atlantic Coast Financial Corporation wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and advise readers that various factors could affect Atlantic Coast Financial Corporation’s financial performance and could cause Atlantic Coast Financial Corporation’s actual results for future periods to differ materially from those anticipated or projected. Atlantic Coast Financial Corporation undertakes no obligation, and specifically disclaims any obligation, to publicly release revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unforeseen events, except as required to be reported under the rules and regulations of the Securities and Exchange Commission.

General Description of Business

The principal business of Atlantic Coast Financial Corporation (the Company) and Atlantic Coast Bank (the Bank) consists of attracting retail deposits from the general public and investing those funds primarily in loans secured by one- to four-family residences originated under purchase and assumption agreements by third party originators (warehouse loans), and, to a lesser extent, first mortgages on owner occupied, one- to four-family residences, home equity loans and automobile and other consumer loans originated for retention in our loan portfolio. In addition we have been increasing our focus on small business lending through our Small Business Administration (SBA) lending programs, as well as commercial business and owner occupied commercial real estate loans to small businesses. Loans are obtained principally through retail staff and, brokers. The Company sells the guaranteed portion of loans originated through SBA lending, rather than hold the loans in portfolio. We also originate multi-family residential loans and commercial construction and residential construction loans, but no longer emphasize the origination of such loans unless they are connected with SBA lending. We also invest in investment securities, primarily those issued by U.S. government-sponsored agencies or entities, including Fannie Mae, Freddie Mac and Ginnie Mae.

Revenues are derived principally from interest on loans and other interest-earning assets, such as investment securities. To a lesser extent, revenue is generated from service charges, gains on the sale of loans and other income.

The Company offers a variety of deposit accounts having a wide range of interest rates and terms, which generally include savings accounts, money market accounts, demand deposit accounts and time deposit accounts with terms ranging from 90 days to five years. In accordance with the Consent Order (the Order) entered into with the Office of the Comptroller of the Currency (the OCC) on August 10, 2012, interest rates paid on deposit are limited and subject to national rates published weekly by the Federal Deposit Insurance Corporation. Deposits are primarily solicited in the Bank’s market area of the Jacksonville metropolitan area and southeastern Georgia when necessary to fund loan demand, or other liquidity needs.

Recent Events

Merger Agreement with Bond Street Holdings, Inc.

Deferred Tax Asset

Under the rules of Internal Revenue Code § 382 (IRC § 382), a change in the ownership of the Company occurred during the first quarter of 2013. The Company became aware of the change in ownership during the second quarter of 2013 based on applicable filings made by stockholders with the Securities and Exchange Commission. In accordance with IRC § 382, the gross amount of net operating loss carryovers the Company can use is limited to $325,000 per year. The effects of the limitation on the existing deferred tax asset are currently being analyzed. The deferred tax asset is discussed in detail in Note 14 of the Notes to the Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on April 1, 2013.

Critical Accounting Policies

Certain accounting policies are important to the presentation of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances, including, but without limitation, changes in interest rates, performance of the economy, financial condition of borrowers and laws and regulations. Management believes that its critical accounting policies include determining the allowance for loan losses, determining fair value of securities available-for-sale, other real estate owned and accounting for deferred income taxes. These accounting policies are discussed in detail in Note 1 of the Notes to the Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on April 1, 2013.

Allowance for Loan Losses

An allowance for loan losses (allowance) is maintained to reflect probable incurred losses in the loan portfolio. The allowance is based on ongoing assessments of the estimated losses incurred in the loan portfolio and is established as these losses are recognized through a provision for loan losses charged to earnings. Generally, loan losses are charged against the allowance when management believes the uncollectibity of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Due to the decline in real estate values in our markets since 2008 and the weak United States economy in general, we believe it is likely that collateral for non-performing one- to four-family residential and home equity loans, will not be sufficient to fully repay such loans. Therefore the Company charges one- to four-family residential and home equity loans down by the expected loss amount at the time they become non-performing, which is generally 90 days past due. This process accelerates the recognition of charge-offs on one- to four-family residential and home equity loans but has no impact on the impairment evaluation process.

The reasonableness of the allowance is reviewed and established by management, within the context of applicable accounting and regulatory guidelines, based upon its evaluation of then-existing economic and business conditions affecting the Bank’s key lending areas. Senior credit officers monitor the conditions discussed above continuously and reviews are conducted monthly with the Bank’s senior management and Board of Directors.

Management’s methodology for assessing the reasonableness of the allowance consists of several key elements, which include a general loss component for unimpaired loans by type of loan and specific allowances for identified impaired loans.

The general loss component is calculated by applying loss factors, adjusted for other qualitative factors to outstanding unimpaired loan balances. Loss factors are based on the Bank’s recent loss experience. Qualitative factors consider current market conditions that may impact real estate values within the Bank’s primary lending areas, and on other significant factors that, in management’s judgment, may affect the ability to collect loans in the portfolio as of the evaluation date. Other significant qualitative factors that exist as of the balance sheet date that are considered in determining the adequacy of the allowance include the following: (1) Current delinquency levels and trends; (2) Non-performing asset levels and trends and related charge-off history; (3) Economic trends – local and national; (4) Changes in loan policy; (5) Expertise of management and staff of the Bank; (6) Volumes and terms of loans; and (7) Concentrations of credit.

The impact of the general loss component on the allowance began increasing during 2008 and has remained at an elevated level through the end of the second quarter of 2013. The increase reflected the deterioration of market conditions since 2008, and the increase in the recent loan loss experience that has resulted from management’s proactive approach to charging off losses on impaired one- to four-family and home equity loans in the period the impairment is identified.

Management also evaluates the allowance for loan losses based on a review of certain large balance individual loans. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows management expects to receive on impaired loans that may be susceptible to significant change and risks. For all specifically reviewed loans where it is probable that the Bank will be unable to collect all amounts due according to the terms of the loan agreement, impairment is determined by computing a fair value based on either discounted cash flows using the loan’s initial interest rate or the fair value of the collateral if the loan is collateral dependent. No specific allowance is recorded unless fair value is less than carrying value. Large groups of smaller balance homogeneous loans, such as individual consumer and residential loans are collectively evaluated for impairment and are excluded from the specific impairment evaluation; for these loans, the allowance for loan losses is calculated in accordance with the general allowance for loan losses policy described above. Accordingly, individual consumer and residential loans are not separately identified for impairment disclosures, unless the loan has been modified as a troubled debt restructuring as discussed below.

Loans for which the terms have been modified as a result of the borrower’s financial difficulties are classified as troubled debt restructurings (TDR). TDRs are measured for impairment based upon the present value of estimated future cash flows using the loan’s interest rate at inception of the loan or the appraised value of the collateral if the loan is collateral dependent. Impairment of homogeneous loans, such as one- to four-family residential loans, that have been modified as TDRs is calculated in the aggregate based on the present value of estimated future cash flows. Loans modified as TDRs with market rates of interest are classified as impaired loans in the year of restructure and until the loan has performed for 12 months in accordance with the modified terms.

Fair Value of Securities Available-for-Sale

Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in other comprehensive income (loss), net of tax. The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

Management evaluates securities for other-than-temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at the determination date.

When OTTI is determined to have occurred, the amount of the OTTI recognized in earnings depends on whether we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI recognized in earnings is equal to the entire difference between its amortized cost basis and its fair value at the balance sheet date. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized as a charge to earnings. The amount of the OTTI related to other factors is recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. The Company recorded no OTTI for the six months ended June 30, 2013 and 2012.

Other Real Estate Owned

Assets acquired through or in lieu of loan foreclosure are initially recorded at fair value based on an independent appraisal, less estimated selling costs, at the date of foreclosure, establishing a new cost basis. If fair value declines subsequent to foreclosure, the asset value is written down through expense. Costs relating to improvement of property are capitalized, whereas costs relating to the holding of property are expensed.

Deferred Income Taxes

After converting to a federally chartered savings association, the Bank became a taxable organization. Income tax expense, or benefit, is the total of the current year income tax due, or refundable, and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary difference between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates and operating loss carryforwards. The Company’s principal deferred tax assets result from the allowance for loan losses and operating loss carry forwards. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Internal Revenue Code and applicable regulations are subject to interpretation with respect to the determination of the tax basis of assets and liabilities for credit unions that convert charters and become a taxable organization. Since the Bank’s transition to a federally chartered savings bank, the Company has recorded income tax expense based upon management’s interpretation of the applicable tax regulations. Positions taken by the Company in preparing our federal and state tax returns are subject to the review of taxing authorities, and the review by taxing authorities of the positions taken by management could result in a material adjustment to the financial statements.

All available evidence, both positive and negative, is considered when determining whether or not a valuation allowance is necessary to reduce the carrying amount to a balance that is considered more likely than not to be realized. The determination of the realizability of deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of such evidence. Positive evidence considered includes the probability of achieving forecasted taxable income and the ability to implement tax planning strategies to accelerate taxable income recognition. Negative evidence includes the Company’s cumulative losses. Following the initial establishment of a valuation allowance, if the Company is unable to generate sufficient pre-tax income in future periods or otherwise fails to meet forecasted operating results, an additional valuation allowance may be required. Any valuation allowance is required to be recorded during the period identified. As of June 30, 2013, the Company had a valuation allowance of $30.0 million for the net deferred tax asset.

The future realization of the Company’s net operating loss carryovers is limited to approximately $325,000 per year, and the effects of the limitation on the existing deferred tax asset are currently being analyzed. See Recent Events: Deferred Tax Asset for additional information.

Comparison of Financial Condition at June 30, 2013 and December 31, 2012

General

Total assets decreased $30.4 million, or 3.9%, to $742.2 million at June 30, 2013 as compared to $772.6 million at December 31, 2012. The decrease in assets was primarily due to a decrease in net portfolio loans of $34.9 million, and lower held-for-sale and warehouse loans which decreased $9.7 million, partially offset by an increase in cash and cash equivalents of $10.1 million. The Company continued to manage its balance sheet consistent with its capital preservation strategy as well as to strengthen the Company’s balance sheet liquidity. Total deposits increased $2.3 million, or 0.5%, to $502.1 million at June 30, 2013 from $499.8 million at December 31, 2012. Time deposits grew by a total of $7.5 million and noninterest-bearing demand accounts increased $1.9 million, while savings and money market accounts decreased by $6.9 million and interest-bearing demand accounts decreased $0.2 million during the six months ended June 30, 2013. Total borrowings decreased by $25.0 million to $202.8 million at June 30, 2013 from $227.8 million at December 31, 2012 due to the repayment of $25.0 million of Federal Home Loan Bank (FHLB) advances. Stockholders’ equity decreased by $9.1 million to $31.2 million at June 30, 2013 from $40.3 million at December 31, 2012 due to the net loss of $3.6 million and a decrease in other comprehensive income (loss) of $5.5 million, related to a negative change in the fair value of securities available-for-sale because of an increase in interest rates during the six months ended June 30, 2013.

Following is a summarized comparative balance sheet as of June 30, 2013 and December 31, 2012:

	June 30,		December 31,		Increase / (Decrease)
	2013		2012		Amount			%
	(Dollars in Thousands)
Assets:
Cash and cash equivalents	$	77,959	$	67,828	$	10,131			14.9	%
Securities available-for-sale		160,856		159,745		1,111			0.7	%
Portfolio loans		396,314		432,090		(35,776	)		-8.3	%
Allowance for loan losses		10,029		10,889		(860	)		-7.9	%
Portfolio loans, net		386,285		421,201		(34,916	)		-8.3	%
Other loans (held-for-sale and warehouse)		62,870		72,568		(9,698	)		-13.4	%
Other Assets		54,224		51,277		2,947			5.7	%
Total assets	$	742,194	$	772,619	$	(30,425	)		-3.9	%

Liabilities and stockholders’ equity:
Deposits:
Noninterest-bearing demand	$	43,889	$	41,904	$	1,985			4.7	%
Interest-bearing demand		73,240		73,490		(250	)		-0.3	%
Savings and money market		174,777		181,708		(6,931	)		-3.8	%
Time		210,238		202,658		7,580			3.7	%
Total deposits		502,144		499,760		2,384			0.5	%
Securities sold under agreements to repurchase		92,800		92,800		-			-
Federal Home Loan Bank advances		110,000		135,000		(25,000	)		-18.5	%
Accrued expenses and other liabilities		6,085		4,799		1,286			26.8	%
Total liabilities		711,029		732,359		(21,330	)		-2.9	%
Total stockholders’ equity		31,165		40,260		(9,095	)		-22.6	%
Total liabilities and stockholders’ equity	$	742,194	$	772,619	$	(30,425	)		-3.9	%

Cash and Cash Equivalents

Cash and cash equivalents increased $10.1 million to $77.9 million at June 30, 2013 from $67.8 million at December 31, 2012. The Bank’s cash and cash equivalent balances are maintained at elevated amounts in response to reduced contingent sources of liquidity from the FHLB and the FRB and to ensure sufficient immediately available liquidity.

Securities Available-for-Sale

Securities available-for-sale was comprised primarily of debt securities of U.S. Government-sponsored enterprises, and mortgage-backed securities. The investment portfolio increased $1.1 million to $160.8 million at June 30, 2013, from $159.7 million at December 31, 2012. As of June 30, 2013, approximately $120.0 million of securities available-for-sale were pledged as collateral for the securities sold under agreements to repurchase and $24.9 million were pledged to the FHLB as collateral for advances and estimated prepayment fees. At June 30, 2013, $159.9 million, or 99.4%, of the debt securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. In the near term, the Company intends to moderately increase its investment in securities available-for-sale in order to meet increasing collateral requirements for its debt.

Portfolio Loans

Below is a comparative composition of net portfolio loans as of June 30, 2013 and December 31, 2012, excluding loans held-for-sale and warehouse loans:

	June 30, 2013			% of Total Portfolio Loans			December 31, 2012			% of Total Portfolio Loans
	(Dollars in Thousands)
Real estate loans:
One- to four-family	$	174,177			44.6	%	$	193,057			45.3	%
Commercial		49,145			12.6	%		58,193			13.7	%
Other (land and multi-family)		18,513			4.7	%		19,908			4.7	%
Total real estate loans		241,835			61.9	%		271,158			63.7	%
Real estate construction loans:
One- to four-family		-			0.0	%		-			0.0	%
Commercial		8,114			2.1	%		5,049			1.2	%
Acquisition and development		-			0.0	%		-			0.0	%
Total real estate construction loans		8,114			2.1	%		5,049			1.2	%
Other loans:
Home equity		57,950			14.9	%		63,867			15.0	%
Consumer		57,556			14.7	%		61,558			14.4	%
Commercial		25,097			6.4	%		24,308			5.7	%
Total other loans		140,603			36.0	%		149,733			35.1	%

Total loans		390,552			100.0	%		425,940			100.0	%
Allowance for loan losses		(10,029	)					(10,889	)
Net deferred loan costs		5,762						6,150
Loans, net	$	386,285					$	421,201

Total gross portfolio loans declined $35.4 million, or 3.3%, to $390.5 million at June 30, 2013 as compared to $425.9 million at December 31, 2012 primarily due to principal amortization and increased prepayments of one- to four-family residential and home equity loans during the six months ended June 30, 2013 consistent with the low interest rate environment for one- to four-family mortgages. Total portfolio loans also declined due to gross loan charge-offs of $2.3 million and transfers to other real estate owned (OREO) of non-performing loans of $9.2 million during the first six months of 2013.

Small business loan originations, including SBA portfolio loans and small business loans originated internally and held-for-sale (SBA loans held-for-sale), were $6.1 million during the six months ended June 30, 2013. The Company sells the guaranteed portion of SBA loans upon completion of loan funding and approval by the SBA. The unguaranteed portion of SBA loans at June 30, 2013 and December 31, 2012 was $4.3 million and $3.3 million, respectively. The Company plans to continue to expand this business line going forward.

Until there is greater certainty about the economic recovery in our market area and the Bank increases its capital levels, management believes portfolio loan balances will likely continue to decline. Principal amortization and loan payoffs are expected to exceed growth in the SBA portfolio and other small business loan production. However, due to the favorable interest rate environment, production of warehouse loans will continue to be a strategic focus but there is no certainty that the balance of such loans will increase.

The composition of the Bank’s portfolio loans is heavily weighted toward one- to four-family residential mortgage loans. As of June 30, 2013, first mortgages (including residential construction loans), second mortgages and home equity loans totaled $232.1 million, or 59.4% of total gross loans. Approximately $34.1 million, or 58.8% of loans recorded as home equity loans are in a first lien position. Accordingly, $208.2 million, or 89.7% of loans collateralized by one- to four-family residential loans were in a first lien position as of June 30, 2013.

The composition of the Bank’s loan portfolio by state as of June 30, 2013 was as follows:

	Florida		Georgia		Other States		Total
	(Dollars in Thousands)
One- to four-family first mortgages	$	114,674	$	35,847	$	23,656	$	174,177
One- to four-family second mortgages		27,867		28,552		1,531		57,950
One- to four-family construction loans		-		-		-		-
	$	142,541	$	64,399	$	25,187	$	232,127

Allowance for Loan Losses

The allowance for loan losses was $10.0 million, or 2.5% of total loans at June 30, 2013 compared to $10.9 million, or 2.5% of total loans at December 31, 2012. The activity in the allowance for loan losses for the six months ended June 30, 2013 and 2012 was as follows:

	2013			2012
	(Dollars in Thousands)

Balance at beginning of period	$	10,889		$	15,526

Charge-offs:
Real estate loans:
One- to four-family		(1,372	)		(4,301	)
Commercial		(855	)		(2,138	)
Other (land and multi-family)		(349	)		(1,585	)
Real estate construction loans:
One- to four-family		-			-
Commercial		-			(202	)
Acquisition and development		-			-
Other loans:
Home equity		(972	)		(2,044	)
Consumer		(738	)		(780	)
Commercial		(131	)		(71	)
Total charge-offs		(4,417	)		(11,121	)

Recoveries:
Real estate loans:
One- to four-family		614			471
Commercial		-			2
Other (land and multi-family)		36			-
Real estate construction loans:
One- to four-family		-			-
Commercial		-			-
Acquisition and development		-			-
Other loans:
Home equity		323			71
Consumer		121			172
Commercial		10			2
Total recoveries		1,104			718

Net charge-offs		(3,313	)		(10,403	)
Provision for loan losses		2,453			7,216
Balance at end of period	$	10,029		$	12,339

Net charge-offs during the first six months of 2013 decreased compared to the same period in 2012 primarily due to $4.2 million less in charge-offs related to one-to-four family residential loans and home equity loans, $1.3 million less in charge-offs for collateral-dependent commercial real estate property, $0.6 million less in charge-offs related to residential land loans, and $0.9 million less in charge-offs related to collateral-dependent commercial land loans.

It is the Company’s policy to charge-off one- to four-family first mortgages and home equity loans to the estimated fair value of the collateral at the time the loan becomes non-performing. During the six months ended June 30, 2013, charge-offs included partial charge-offs of $1.4 million of one- to four-family first mortgages and home equity loans identified as non-performing, a decrease of $0.5 million as compared to $1.9 million for the six months ended June 30, 2012, principally attributable to decreased losses on first mortgages and home equity loans.

Below is a comparative composition of non-performing assets as of June 30, 2013 and December 31, 2012:

	June 30, 2013			December 31, 2012
	(Dollars in Thousands)

Non-performing assets:
Real estate loans:
One- to four-family	$	6,531		$	10,555
Commercial		2,381			8,643
Other (land and multi-family)		480			595
Real estate construction loans:
One- to four-family		-			-
Commercial		-			739
Acquisition and development		-			-
Other loans:
Home equity		1,351			2,212
Consumer		870			969
Commercial		755			1,171
Total non-performing loans		12,368			24,884
Other real estate owned		12,861			8,065
Total non-performing assets	$	25,229		$	32,949

Non-performing loans to total loans		3.1	%		5.8	%
Non-performing assets to total assets		3.4	%		4.3	%

Non-performing loans were $12.4 million or 3.1% of total loans at June 30, 2013 as compared to $24.9 million, or 5.8% of total loans at December 31, 2012. The decrease in non-performing loans was primarily due to the transfer of $9.2 million in non-performing loans to OREO and the return to performing status of a $1.0 million residential mortgage loan. Additionally, the decrease is due to fewer performing loans becoming non-performing loans.

During 2012 and continuing into 2013 the market for disposing of non-performing assets has become more active. These types of transactions may result in additional losses over the amounts provided for in the allowance for loan losses, however, the Company continues to attempt to reduce non-performing assets through the least costly means possible. The allowance for loan losses is determined by the information available at the time such determination is made and reflects management’s best estimate of loss.

As of June 30, 2013, total non-performing one- to four-family residential and home equity loans of $7.9 million was comprised of $11.7 million in contractual balances that had been written-down to the estimated fair value of their collateral, less estimated selling costs, at the date that the loan was classified as non-performing. Further declines in the fair value of the collateral, or a decision to sell such loans as distressed assets, could result in additional losses. As of June 30, 2013 and December 31, 2012 all non-performing loans were classified as non-accrual, and there were no loans 90 days past due and accruing interest as of June 30, 2013 and December 31, 2012.

OREO increased $4.8 million to $12.9 million at June 30, 2013 from $8.1 million at December 31, 2012 as transfers from non-performing loans into OREO of $9.2 million exceeded foreclosed asset sales of $4.6 million during the first six months of 2013. Historically, the Company does not incur additional material losses after non-performing loans are moved to OREO, or as a result of the sale of OREO. The Company recorded a net gain on the sale of foreclosed assets of $0.2 million and $0.1 million for the six months ended June 30, 2013 and 2012, respectively.

At June 30, 2013 the five largest non-performing loans were as follows. The largest relationship was a $1.8 million loan secured by commercial property. The property went into receivership during the first quarter of 2013. The Bank’s second largest relationship was a $0.7 million loan secured by a multi-family development adjacent to Disney World in central Florida. The project was halted during construction and is in the process of foreclosure. The third largest relationship was a $0.6 million working capital line of credit secured by business assets. The borrower and one of its owners filed Chapter 7 bankruptcy during the first quarter of 2013. The Bank’s fourth and fifth largest relationships were two $0.4 million loans secured by a one- to four-family residence.

Impaired Loans

The following table shows impaired loans segregated by performing and non-performing status and the associated specific reserve as of June 30, 2013 and December 31, 2012:

	June 30, 2013				December 31, 2012
	Balance		Specific Reserve		Balance		Specific Reserve
	(Dollars in Thousands)

Performing	$	504	$	-	$	6,465	$	-
Non-performing		4,100		417		11,196		286
Troubled debt restructuring by category:
Performing troubled debt restructuring – commercial		12,715		165		7,632		214
Performing troubled debt restructuring – residential		8,912		1,613		12,383		1,688
Total impaired loans	$	26,231	$	2,195	$	37,676	$	2,188

No portfolio loans were added to performing impaired loans during the first six months of 2013. The decline in non-performing impaired loans was primarily due to the transfer of $9.2 million in loans to OREO during the six months ended June 30, 2013.

Impaired loans include large non-homogeneous loans where it is probable that the Bank will not receive all principal and interest when contractually due. Impaired loans also include TDRs where the borrower has performed for less than 12 months under the terms of the modification and/or the TDR loan is at less than market rate at the time of restructure. When a TDR loan with a market rate of interest has performed for over 12 months under terms of the modification it is classified as a performing loan.

TDR loans totaled $22.3 million as of June 30, 2013 as compared to $22.4 million at December 31, 2012. Approximately $14.6 million of restructured loans have demonstrated 12 months of performance under restructured terms and are reported as performing.

Other Loans

Other loans was comprised of loans secured by one- to four-family residential homes originated internally (mortgage loans held-for-sale), small business loans originated internally (SBA loans held-for-sale), and loans secured by one- to four-family residences originated under purchase and assumption agreements by third party originators (warehouse loans).

The following table shows other loans, segregated by held-for-sale and warehouse, as of June 30, 2013 and December 31, 2012:

	June 30, 2013		December 31, 2012
	(Dollars in Thousands)
Other loans:
Held-for-sale	$	2,217	$	4,089
Warehouse		60,653		68,479
Total other loans	$	62,870	$	72,568

Other loans decreased $9.7 million, or 13.4% to $62.9 million at June 30, 2013 as compared to $72.6 million at December 31, 2012 primarily due to a decrease in the weighted average number of days outstanding of warehouse loans. The decrease in days outstanding was partially offset by an increase in production by our warehouse lending operations.

During 2012, the Company phased out its internally generated one- to four-family residential mortgage business in favor of a referral program whereby the Bank earns a fee for closed loans. As a result, the Company did not internally originate or sell any mortgage loans held-for-sale during the six months ended June 30, 2013 as compared to originations of $23.9 million and sales of $21.9 million during the six months ended June 30, 2012. The gain recorded on sale of mortgage loans held-for-sale during the six months ended June 30, 2012 was $0.6 million.

During the six months ended June 30, 2013 the Company internally originated $4.9 million and sold $7.4 million of SBA loans held-for-sale compared to originations of $4.3 million and sales of $4.3 million during the same six month period in 2012. The gain recorded on sales of SBA loans held-for-sale during the six months ended June 30, 2013 and 2012 was $0.6 million and $0.3 million, respectively.

Loans originated and sold under the Company’s warehouse lending program were $569.8 million and $577.6 million, respectively for the six months ended June 30, 2013 as compared to originations and sales of $378.8 million and $385.7 million, respectively for the six months ended June 30, 2012. Loan sales under the warehouse lending program, which are done at par, earned interest on outstanding balances for both the six months ended June 30, 2013 and 2012 of $1.0 million. For the six months ended June 30, 2013 the weighted average number of days outstanding of warehouse loans was 20 days.

Deferred Income Taxes

As of both June 30, 2013 and 2012 the Company concluded that, while improved operating results are expected as the economy begins to improve and the Bank’s non-performing assets decline, a more likely than not conclusion of realization of the Company’s deferred tax asset could not be supported due to the variability of the credit related costs and the impact of its high debt costs on profitability. Consequently the Company has recorded a valuation allowance of $30.0 million for nearly the entire amount of the net federal and state deferred tax assets as of June 30, 2013. Until such time as the Company determines it is more likely than not that it is able to generate taxable income, no tax benefits will be recorded in future periods to reduce net losses before taxes. However, at such time in the future that the Company records taxable income or determines that realization of the deferred tax asset is more likely than not, some or all of the valuation allowance may be available as a tax benefit.

The future realization of the Company’s net operating loss carryovers is limited to $325,000 per year, and the effects of the limitation on the existing deferred tax asset are currently being analyzed. See Recent Events: Deferred Tax Asset for additional information.

Deposits

Total deposits were $502.1 million at June 30, 2013, an increase of $2.3 million from $499.8 million at December 31, 2012. Non-maturing deposits decreased by $5.2 million during the first six months of 2013, while time deposits increased by $7.5 million during the same time period. Non-maturing deposits decreased to $291.9 million at June 30, 2013 primarily due to a $6.9 million decrease in savings and money market deposits, offset by an increase in noninterest-bearing demand deposits as the Bank focused sales and marketing efforts on increasing demand deposit customers. Time deposits increased to $210.2 million as of June 30, 2013 due to an increase of $25.0 million related to a retail certificates of deposit promotion, partially offset by a decrease of $7.2 million in our standard certificates of deposit, a decrease of $4.0 million in deposits originally acquired through a national internet deposit program and broker deposit declines of $5.0 million.

As a part of its capital preservation strategy, the Bank strategically lowered rates on time deposits beginning in the second half of 2009 in order to reduce those deposits consistent with loan balance decreases. Management believes near term deposit growth will be moderate with an emphasis on transaction deposit accounts to match asset growth expectations. The Bank uses a combination of strategic retail certificates of deposit promotions and national internet deposit programs to meet liquidity needs that exceed demand deposit growth. Dramatic changes in the short-term interest rate environment could affect the availability of deposits in our local market and therefore cause the Bank to change its strategy to promote time deposit growth in order to meet liquidity needs. Under Atlantic Coast Bank’s Consent Order with the OCC dated August 10, 2012, the Bank may not renew or increase brokered deposits without prior written non-objection from the OCC. At June 30, 2013 the Bank did not have any brokered deposits. The prohibition not to renew or increase brokered deposits also prevents the Bank from offering deposit rates higher than 75 basis points over the FDIC published national average rate for comparable deposit types.

Securities Sold Under Agreements to Repurchase

The Company has securities sold under agreements to repurchase with a carrying amount of $92.8 million as of June 30, 2013 and December 31, 2012. Collateral for the structured notes are subject to a reduction of 8.0% after applying values set by the counterparties. Under the terms of the agreements the counterparties require that the Company provide additional collateral for the borrowings as protection for their market risk when the fair value of the borrowings exceeds the contractual amounts. As a result, the Company had $120.0 million and $116.9 million in securities posted as collateral for these instruments as of June 30, 2013 and December 31, 2012, respectively. The Company will be required to post additional collateral if the gap between the market value of the liability and the contractual amount of the liability increases. In the event the Bank pre-pays the agreements prior to maturity, it must do so at its fair value, which as of June 30, 2013 exceeded the book value of the individual agreements by $10.9 million.

Information concerning securities sold under agreements to repurchase as of and for the six months ended June 30, 2013, and as of and for the year ended December 31, 2012 is summarized as follows:

	June 30, 2013			December 31, 2012
	(Dollars in Thousands)

Average daily balance	$	92,800		$	92,800
Weighted average coupon interest rate during the period		5.10	%		5.10	%
Maximum month-end balance during the period	$	92,800		$	92,800
Weighted average coupon interest rate at end of period		5.10	%		5.10	%
Weighted average maturity (months)		39			42

Under the terms of the agreement with the counterparty on $77.8 million of the $92.8 million the Bank is required to pledge additional collateral if its capital ratios decrease below the PCA defined levels of well-capitalized or adequately capitalized. Due to the decline in capital ratios below the PCA defined category of well-capitalized at December 31, 2012, the Company was required to increase pledged collateral by $4.0 million in the first quarter of 2013. Failure to maintain required collateral levels is a violation of the default provision under the terms of the agreement and could result in a termination penalty. At June 30, 2013, the fair value of $77.8 million of the debt exceeded the carrying value by $8.7 million, which approximates the termination penalty.

Federal Home Loan Bank Advances

Federal Home Loan Bank (FHLB) borrowings at June 30, 2013 and December 31, 2012 were $110.0 million and $135.0 million, respectively. The FHLB advances had a weighted-average maturity of 45 months and a weighted-average rate of 4.11% at June 30, 2013. The FHLB advances had a weighted-average maturity of 43 months and a weighted-average rate of 3.88% at December 31, 2012.

The Bank’s remaining borrowing capacity with the FHLB is $5.0 million at June 30, 2013. The minimal borrowing capacity was due to the declining balance of outstanding loans used as collateral as a result of normal loan payments and payoffs. The Bank intends to supplement its loan collateral with investment securities as needed to secure the FHLB borrowings or pre-pay advances to reduce the amount of collateral required to secure the debt. Due to the Bank’s financial condition the FHLB discounts the value of the collateral pledged for advances at rates higher than those used for banks with stronger credit, accordingly, the amount of required collateral is elevated compared to better performing peers. During the first quarter of 2013, the Company prepaid advances scheduled for maturity in the third and fourth quarters of 2013 totaling $25.0 million, resulting in a prepayment penalty of $0.5 million. This prepayment reduced interest expense by $0.2 million for the current quarter and reduced the amount of collateral required to secure the debt. Unpledged securities available for collateral amounted to $13.0 million as of June 30, 2013. In the event the Bank pre-pays additional advances prior to maturity, it must do so at its fair value. Additionally, effective August 31, 2012, the FHLB required that the Bank collateralize the excess of the fair value of the FHLB advances over the book value with cash and securities. As of June 30, 2013, fair value exceeded the book value of the individual advances by $11.9 million. To the extent it is required to purchase additional securities to collateralize the FHLB debt, the Company’s profitability may decrease as liquidity may not be available for higher interest-earning asset growth.

Stockholders’ Equity

Stockholders’ equity decreased by $9.1 million to $31.2 million at June 30, 2013 from $40.3 million at December 31, 2012 due to the net loss of $3.6 million and a decrease in other comprehensive income (loss) of $5.5 million for the six months ended June 30, 2013. The decrease in other comprehensive income (loss) was due to a negative change in the fair value of securities available-for-sale because of an increase in interest rates during the first six months of 2013.

Beginning in 2009 and continuing into 2013, the Company implemented strategies to preserve capital including the suspension of cash dividends and its stock repurchase program. Resumption of these programs is not expected to occur in the near term. The Company’s equity to assets ratio decreased to 4.2% at June 30, 2013, from 5.2% at December 31, 2012. As of June 30, 2013, the Bank’s Tier 1 capital to adjusted assets ratio was 4.83%, Total risk based capital to risk- weighted assets ratio was 9.55% and Tier 1 capital to risk-weighted assets ratio was 8.29%. These ratios as of December 31, 2012 were 5.13%, 9.78%, and 8.52%, respectively. The Bank is currently deemed as adequately capitalized for regulatory supervision purposes.

In November 2011 the Company’s Board of Directors began a review of the strategic alternatives available to it to address its capital needs. Following the June 2013 rejection of the proposed merger of the Company with Bond Street Holdings, Inc. by stockholders, the Company's Board of Directors has begun to evaluate other strategic alternatives to raise capital in the near term, including a possible recapitalization

Comparison of Results of Operations for the Three Months Ended June 30, 2013 and 2012.

General

Net loss for the three months ended June 30, 2013 was $1.6 million, as compared to a net loss of $3.0 million for the three months ended June 30, 2012. The net loss for the second quarter of 2013 decreased compared with the same period in 2012 due to a reduction in the provision for loan losses of $2.5 million, partially offset by a decrease in net interest income of $0.9 million and an increase in noninterest expense of $0.2 million. Net interest income decreased in the second quarter of 2013 due to a reduction in portfolio loans outstanding and the impact of lower interest rates on funds reinvested in investment securities, partially offset by an increase in held-for-sale and warehouse loans outstanding, and decreased interest expense for deposits and FHLB borrowings. Noninterest expense increased during the second quarter of 2013 compared to the same period in 2012 primarily due to additional professional and outside services expense and data processing costs, both associated with the proposed merger which was rejected by stockholders, and higher FDIC insurance expense, partially offset by decreased compensation costs and decreased cost of foreclosed assets.

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table sets forth certain information for the three months ended June 30, 2013 and 2012. The average yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented.

	Three Months Ended June 30,
	2013								2012
	Average Balance		Interest			Average Yield / Cost			Average Balance		Interest			Average Yield / Cost
	(Dollars in Thousands)								(Dollars in Thousands)
Interest-earning assets:
Loans (1)	$	459,291	$	6,712			5.85	%	$	533,021	$	7,730			5.80	%
Securities available-for-sale (2)		161,578		590			1.46	%		142,620		828			2.32	%
Other interest-earning assets (3)		89,386		84			0.37	%		65,226		65			0.40	%
Total interest-earning assets		710,255		7,386			4.16	%		740,867		8,623			4.64	%
Noninterest-earning assets		37,601								35,768
Total assets	$	747,856							$	776,635

Interest-bearing liabilities:
Interest-bearing demand accounts	$	74,194	$	57			0.31	%	$	76,509	$	84			0.44	%
Savings deposits		71,381		63			0.35	%		78,982		86			0.44	%
Money market accounts		103,355		120			0.47	%		121,899		144			0.47	%
Time deposits		209,365		627			1.20	%		181,072		684			1.51	%
Securities sold under agreements to repurchase		92,800		1,196			5.15	%		92,800		1,195			5.15	%
Federal Home Loan Bank advances		110,000		1,144			4.16	%		135,000		1,326			3.93	%
Total interest-bearing liabilities		661,095		3,207			1.96	%		686,262		3,519			2.04	%
Noninterest-bearing liabilities		49,887								44,332
Total liabilities		710,982								730,594
Total stockholders’ equity		36,874								46,041
Total liabilities and stockholders’ equity	$	747,856							$	776,635

Net interest income			$	4,179							$	5,104
Net interest spread							2.20	%							2.60	%
Net interest-earning assets	$	49,160							$	54,605
Net interest margin (4)							2.35	%							2.76	%
Average interest-earning assets to average interest-bearing liabilities				107.44	%							107.96	%

(1)

Calculated net of deferred loan fees. Nonaccrual loans included as loans carrying a zero yield, includes portfolio loans and other loans.

(2)

Calculated based on carrying value. Not full tax equivalents, as the numbers would not change materially from those presented in the table.

(3)

Includes Federal Home Loan Bank stock at cost and term deposits with other financial institutions.

(4)

Net interest income divided by average interest-earning assets.

Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume multiplied by the old rate; and (2) changes in rate, which are changes in rate multiplied by the old volume; and (3) changes not solely attributable to rate or volume have been allocated proportionately to the change due to volume and the change due to rate.

	Increase / (Decrease)
	Due to Volume			Due to Rate			Total Increase / (Decrease)
	(Dollars in Thousands)

Interest-earning assets:
Loans	$	(1,077	)	$	59		$	(1,018	)
Securities available-for-sale		99			(337	)		(238	)
Other interest-earning assets		23			(4	)		19
Total interest-earning assets		(955	)		(282	)		(1,237	)

Interest-bearing liabilities:
Interest-bearing demand accounts		(2	)		(25	)		(27	)
Savings deposits		(8	)		(15	)		(23	)
Money market accounts		(22	)		(2	)		(24	)
Time deposits		97			(154	)		(57	)
Securities sold under agreements to repurchase		-			1			1
Federal Home Loan Bank advances		(256	)		74			(182	)
Total interest-bearing liabilities		(191	)		(121	)		(312	)

Net interest income	$	(764	)	$	(161	)	$	(925	)

Interest Income

Total interest income decreased $1.2 million to $7.4 million for the three months ended June 30, 2013 from $8.6 million for the three months ended June 30, 2012 primarily due to the decrease in interest income on loans and securities available-for-sale. Interest income on loans decreased to $6.7 million for the three months ended June 30, 2013 from $7.7 million in the second quarter of 2012. This decrease was due to a decline in the average balance of loans, which decreased $73.7 million to $459.3 million for the three months ended June 30, 2013 from $533.0 million in the prior year quarter, partially offset by an increase in average yield on loans of 5 basis points to 5.85% for the three months ended June 30, 2013. The average balance of loans declined due to the reduction in portfolio loans outstanding, partially offset by the increase in warehouse loans outstanding. Warehouse loan originations continue to increase while the weighted average number of days warehouse loans are outstanding continues to decrease, this results in reduced interest income and increased fee income. Interest income earned on securities decreased $0.2 million to $0.6 million for the three months ended June 30, 2013 from $0.8 million for the second quarter of 2012. This decrease was due to lower yields on reinvested securities and increased amortization of purchase premiums due to higher prepayments. The impact of the decline in average yield by 86 basis points to 1.46% for the current quarter was partially offset by an increase in the average balance of securities of $19.0 million to $161.6 million for the three months ended June 30, 2013. Due to the decline in average yield as a result of the low interest rate environment, the decrease in the average balance of interest-earning assets, and the change in the mix of interest-earning assets related to our capital preservation strategy into higher balances maintained in lower yielding cash and cash equivalents in order to meet liquidity targets, the Company expects interest income to be lower during 2013 as compared to 2012.

Interest Expense

Interest expense declined by $0.3 million to $3.2 million for the three months ended June 30, 2013 from $3.5 million in the second quarter of 2012 due to the decrease in interest expense on deposits and FHLB advances. The decrease in interest expense on deposits for the three months ended June 30, 2013, as compared to the second quarter of 2012, was primarily due to lower average rates paid on interest-bearing deposits. The average cost of deposits decreased 11 basis points to 0.69% for the three months ended June 30, 2013 as compared to 0.80% in the second quarter of 2012 due to the low interest rate environment. During the first quarter of 2013, the Company prepaid advances scheduled for maturity in the third and fourth quarter of 2013 totaling $25.0 million. This prepayment reduced interest expense by $0.2 million for the current quarter. The Bank’s overall cost of funds, including noninterest-bearing deposits, was 1.82% for the three months ended June 30, 2013 down from 1.94% for the three months ended June 30, 2012, primarily due to lower cost of deposits. The Bank’s cost of funds is elevated relative to the current interest rate environment due to the structured rates associated with the securities sold under agreements to repurchase and FHLB advances which are at interest rates significantly above market rates.

Net Interest Income

Net interest income decreased $0.9 million to $4.2 million for the three months ended June 30, 2013 from $5.1 million for the three months ended June 30, 2012, due to the decrease in interest income resulting from a reduction in average outstanding balances of interest-earning assets and lower average yields earned on those assets partially offset by decreased interest expense on deposits. Our net interest rate spread, which is the difference between the interest rate earned on interest-earning assets and the interest rate paid on interest-bearing liabilities, decreased 40 basis points to 2.20% for the three months ended June 30, 2013 as compared to 2.60% in the second quarter of 2012. Our net interest margin, which is net interest income expressed as a percentage of our average interest-earning assets, decreased 41 basis points to 2.35% for the three months ended June 30, 2013 as compared to 2.76% in the second quarter of 2012. The decline in both the net interest rate spread and the net interest margin primarily reflected the impact of the Bank’s high fixed-interest rate debt, which has a weighted average rate of 4.56%, combined with declining balances of interest-earning assets and the change in mix due to higher levels of lower yielding cash equivalent balances to meet liquidity needs.

Provision for Loan Losses

The detail of the net charge-offs and provision for portfolio loan losses for the three months ended June 30, 2013 and 2012 is as follows:

	2013						2012
	Net Charge-offs			Provision			Net Charge-offs			Provision
	(Dollars in Thousands)
Real estate loans:
One- to four-family	$	(163	)	$	(241	)	$	(2,969	)	$	2,013
Commercial		(734	)		1,051			(1	)		(109	)
Other (land and multi-family)		(226	)		(63	)		(684	)		587
Total real estate loans		(1,123	)		747			(3,654	)		2,490

Real estate construction loans:
One- to four-family		-			-			-			(2	)
Commercial		-			(199	)		(202	)		210
Acquisition and development		-			-			-			-
Total real estate construction loans		-			(199	)		(202	)		208

Other loans:
Home equity		(22	)		(151	)		(857	)		910
Consumer		(413	)		599			(205	)		189
Commercial		(97	)		223			-			(56	)
Total other loans		(532	)		671			(1,062	)		1,043

Total	$	(1,655	)	$	1,219		$	(4,918	)	$	3,741

Provision for loan losses of $1.2 million and $3.7 million were made during the three months ended June 30, 2013 and 2012, respectively. The decline in the provision for loan losses during the three months ended June 30, 2013 compared with the year-earlier quarter reflected reduced non-performing loans and a decline in early-stage delinquencies of one- to four-family residential and home equity loans. The decline in the provision for loan losses also reflected provisioning for certain residential loans disposed of in the second quarter of 2012 and two commercial loans that were disposed of in July 2012, which did not recur in 2013. Net charge-offs for the three months ended June 30, 2013 were $1.8 million as compared to $4.9 million in the second quarter of 2012. The decrease in net charge-offs in the second quarter of 2013 compared with the second quarter of 2012 primarily reflected $3.5 million less in charge-offs in the second quarter of 2013 related to one-to-four family residential loans and home equity loans, and $0.6 million less in charge-offs related to residential land loans in the second quarter of 2013, partially offset by a $0.7 million charge-off in the second quarter of 2013 for a collateral-dependent commercial real estate property.

Noninterest Income

The components of noninterest income for the three months ended June 30, 2013 and 2012 were as follows:

					Increase / (Decrease)
	2013		2012		Amount			Percentage
	(Dollars in Thousands)

Service charges and fees	$	750	$	786	$	(36	)		-4.6	%
Gain on sale of loans held-for-sale		299		381		(82	)		-21.5	%
Bank owned life insurance earnings		98		116		(18	)		-15.5	%
Interchange fees		404		408		(4	)		-1.0	%
Other		182		108		74			68.5	%
	$	1,733	$	1,799	$	(66	)		-3.7	%

Noninterest income for the three months ended June 30, 2013 decreased $0.1 million to $1.7 million as compared to $1.8 million in the second quarter of 2012. The decrease in noninterest income was primarily due to reductions in gains on sales of loans held-for-sale.

For the three months ended June 30, 2013, gains on sales of loans held-for-sale was entirely related to SBA loans held-for-sale, and included $0.1 million in net gains recognized for the servicing of SBA loans. For the three months ended June 30, 2012, gains on sales of mortgage loans held-for-sale was $0.2 million and gains on sales of SBA loans held-for-sale was $0.1 million. The Company expects gains on sales of SBA loans to represent the majority of gains on loan sales in the future as the Company emphasizes small business lending and has phased out the business activity of internally originated mortgage loans held-for-sale.

Noninterest Expense

The components of noninterest expense for the three months ended June 30, 2013 and 2012 were as follows:

						Increase / (Decrease)
	2013			2012		Amount			Percentage
	(Dollars in Thousands)
Compensation and benefits	$	2,127		$	2,434	$	(307	)		-12.6	%
Occupancy and equipment		482			517		(35	)		-6.8	%
FDIC insurance premiums		442			272		170			62.5	%
Foreclosed assets, net		(171	)		79		(250	)		-316.5	%
Data processing		446			340		106			31.2	%
Outside professional services		1,070			694		376			54.2	%
Collection expense and repossessed asset losses		676			635		41			6.5	%
Other		1,175			1,037		138			13.3	%
	$	6,247		$	6,008	$	239			4.0	%

Noninterest expense increased $0.2 million to $6.2 million for the three months ended June 30, 2013 from $6.0 million for the three months ended June 30, 2012. Noninterest expense for the second quarter of 2013 compared with the second quarter of 2012 primarily reflected additional professional and outside services expense and data processing costs, both associated with the proposed merger which was rejected by stockholders, and higher FDIC insurance expense due to our regulatory status, partially offset by decreased compensation costs and increased gains on the sale of foreclosed assets. The costs associated with the proposed merger amounted to $1.1 million during the second quarter of 2013.

Income Tax

The Company recorded no income tax expense for the three months ended June 30, 2013 and $0.5 million in income tax expense for the three months ended June 30, 2012. The recognition of future tax benefits or the reversal of the valuation reserve is dependent upon the Company’s ability to generate future taxable income.

Comparison of Results of Operations for the Six Months Ended June 30, 2013 and 2012.

General

Net loss for the six months ended June 30, 2013 was $3.6 million, as compared to a net loss of $4.7 million for the six months ended June 30, 2012. The net loss for the first six months of 2013 decreased compared with the same period in 2012 due to a reduction in the provision for loan losses of $4.8 million, partially offset by a decrease in net interest income of $1.6 million and an increase in noninterest expense of $1.7 million. Net interest income decreased in the first six months of 2013 due to a reduction in portfolio loans, held-for-sale loans and warehouse loans outstanding and the impact of lower interest rates on funds reinvested in investment securities, partially offset by a decreased interest expense for deposits and FHLB borrowings. Noninterest expense increased during the first six months of 2013 compared to the same period in 2012 primarily due to additional professional and outside services expense and data processing costs, both associated with the proposed merger which was rejected by stockholders, the FHLB prepayment penalty, increased collection and credit expense, and higher FDIC insurance expense, partially offset by decreased compensation costs and decreased cost of foreclosed assets.

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table sets forth certain information for the six months ended June 30, 2013 and 2012. The average yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented.

	Six Months Ended June 30,
	2013								2012
	Average Balance		Interest			Average Yield / Cost			Average Balance		Interest			Average Yield / Cost
	(Dollars in Thousands)								(Dollars in Thousands)
Interest-earning assets:
Loans (1)	$	470,964	$	13,673			5.81	%	$	547,088	$	15,603			5.70	%
Securities available-for-sale (2)		158,401		1,087			1.37	%		137,204		1,653			2.41	%
Other interest-earning assets (3)		83,721		161			0.38	%		62,422		117			0.38	%
Total interest-earning assets		713,086		14,921			4.18	%		746,714		17,373			4.66	%
Noninterest-earning assets		37,229								34,179
Total assets	$	750,315							$	780,893

Interest-bearing liabilities:
Interest-bearing demand accounts	$	74,047	$	116			0.31	%	$	76,416	$	222			0.58	%
Savings deposits		71,738		126			0.35	%		77,267		192			0.50	%
Money market accounts		104,591		242			0.46	%		124,286		320			0.51	%
Time deposits		209,701		1,265			1.21	%		184,681		1,509			1.63	%
Securities sold under agreements to repurchase		92,800		2,378			5.13	%		92,800		2,392			5.15	%
Federal Home Loan Bank advances		110,138		2,278			4.14	%		135,000		2,651			3.93	%
Total interest-bearing liabilities		663,015		6,405			1.94	%		690,450		7,286			2.12	%
Noninterest-bearing liabilities		49,404								43,901
Total liabilities		712,419								734,351
Total stockholders’ equity		35,654								46,542
Total liabilities and stockholders’ equity	$	748,073							$	780,893

Net interest income			$	8,516							$	10,087
Net interest spread							2.24	%							2.54	%
Net interest-earning assets	$	50,071							$	56,264
Net interest margin (4)							2.39	%							2.70	%
Average interest-earning assets to average interest-bearing liabilities				107.55	%							108.15	%

(1)

Calculated net of deferred loan fees. Nonaccrual loans included as loans carrying a zero yield, includes portfolio loans and other loans.

(2)

Calculated based on carrying value. Not full tax equivalents, as the numbers would not change materially from those presented in the table.

(3)

Includes Federal Home Loan Bank stock at cost and term deposits with other financial institutions.

(4)

Net interest income divided by average interest-earning assets.

Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume multiplied by the old rate; and (2) changes in rate, which are changes in rate multiplied by the old volume; and (3) changes not solely attributable to rate or volume have been allocated proportionately to the change due to volume and the change due to rate.

	Increase / (Decrease)
	Due to Volume			Due to Rate			Total Increase / (Decrease)
	(Dollars in Thousands)

Interest-earning assets:
Loans	$	(2,206	)	$	276		$	(1,930	)
Securities available-for-sale		226			(792	)		(566	)
Other interest-earning assets		41			3			44
Total interest-earning assets		(1,939	)		(513	)		(2,452	)

Interest-bearing liabilities:
Interest-bearing demand accounts		(7	)		(99	)		(106	)
Savings deposits		(13	)		(53	)		(66	)
Money market accounts		(48	)		(30	)		(78	)
Time deposits		186			(430	)		(244	)
Securities sold under agreements to repurchase		-			(14	)		(14	)
Federal Home Loan Bank advances		(508	)		135			(373	)
Total interest-bearing liabilities		(390	)		(491	)		(881	)

Net interest income	$	(1,549	)	$	(22	)	$	(1,571	)

Interest Income

Total interest income decreased $2.5 million to $14.9 million for the six months ended June 30, 2013 from $17.4 million for the six months ended June 30, 2012 primarily due to the decrease in interest income on loans and securities available-for-sale. Interest income on loans decreased to $13.7 million for the six months ended June 30, 2013 from $15.6 million in the first six months of 2012. This decrease was due to a decline in the average balance of loans, which decreased $76.1 million to $471.0 million for the six months ended June 30, 2013 from $547.1 million in the prior year period, partially offset by an increase in average yield on loans of 11 basis points to 5.81% for the six months ended June 30, 2013 due to the change in mix of loans and decreasing non-performing assets. The average balance of loans declined due to the reduction in portfolio loans outstanding. Interest income earned on securities decreased $0.6 million to $1.1 million for the six months ended June 30, 2013 from $1.7 million in the first six months of 2012. This decrease was due to lower yields on reinvested securities and increased amortization of purchase premiums due to higher prepayments. The impact of the decline in average yield by 104 basis points to 1.37% for the six months ended June 30, 2013 was partially offset by an increase in the average balance of securities of $21.2 million to $158.4 million for the six months ended June 30, 2013. Due to the decline in average yield as a result of the low interest rate environment, the decrease in the average balance of interest-earning assets, and the change in the mix of interest-earning assets related to our capital preservation strategy into higher balances maintained in lower yielding cash and cash equivalents in order to meet liquidity targets, the Company expects interest income to be lower during 2013 as compared to 2012.

Interest Expense

Interest expense declined by $0.9 million to $6.4 million for the six months ended June 30, 2013 from $7.3 million for the first six months of 2012 due to the decrease in interest expense on deposits and FHLB advances. The decrease in interest expense on deposits for the six months ended June 30, 2013, as compared to the first six months of 2012, was primarily due to lower average rates paid on interest-bearing deposits. The average cost of deposits decreased 21 basis points to 0.69% for the six months ended June 30, 2013 as compared to 0.90% in the first six months of 2012 due to the low interest rate environment. During the first quarter of 2013, the Company prepaid advances scheduled for maturity in the third and fourth quarter of 2013 totaling $25.0 million. This prepayment reduced interest expense by $0.4 million for the first six months of 2013. The Bank’s overall cost of funds, including noninterest-bearing deposits, was 1.81% for the six months ended June 30, 2013 down from 2.00% for the six months ended June 30, 2012, primarily due to lower cost of deposits. The Bank’s cost of funds is elevated relative to the current interest rate environment due to the structured rates associated with the securities sold under agreements to repurchase and FHLB advances which are at interest rates significantly above market rates.

Net Interest Income

Net interest income decreased $1.6 million to $8.5 million for the six months ended June 30, 2013 from $10.1 million for the six months ended June 30, 2012, due to the decrease in interest income resulting from a reduction in average outstanding balances of interest-earning assets and lower average yields earned on those assets partially offset by decreased interest expense on deposits and FHLB advances. Our net interest rate spread, which is the difference between the interest rate earned on interest-earning assets and the interest rate paid on interest-bearing liabilities, decreased 30 basis points to 2.24% for the six months ended June 30, 2013 as compared to 2.54% in the first six months of 2012. Our net interest margin, which is net interest income expressed as a percentage of our average interest-earning assets, decreased 31 basis points to 2.39% for the six months ended June 30, 2013 as compared to 2.70% in the first six months of 2012. The decline in both the net interest rate spread and the net interest margin primarily reflected the impact of the Bank’s high fixed-interest rate debt, which has a weighted average rate of 4.56%, combined with declining balances of interest-earning assets and the change in mix due to higher levels of lower yielding cash equivalent balances to meet liquidity needs.

Provision for Loan Losses

The detail of the net charge-offs and provision for portfolio loan losses for the six months ended June 30, 2013 and 2012 is as follows:

	2013						2012
	Net Charge-offs			Provision			Net Charge-offs			Provision
	(Dollars in Thousands)
Real estate loans:
One- to four-family	$	(758	)	$	314		$	(3,830	)	$	2,573
Commercial		(855	)		1,218			(2,136	)		949
Other (land and multi-family)		(313	)		17			(1,585	)		760
Total real estate loans		(1,926	)		1,549			(7,551	)		4,282

Real estate construction loans:
One- to four-family		-			-			-			(120	)
Commercial		-			24			(202	)		210
Acquisition and development		-			-			-			-
Total real estate construction loans		-			24			(202	)		90

Other loans:
Home equity		(649	)		(18	)		(1,973	)		2,034
Consumer		(617	)		626			(608	)		755
Commercial		(121	)		272			(69	)		55
Total other loans		(1,387	)		880			(2,650	)		2,844

Total	$	(3,313	)	$	2,453		$	(10,403	)	$	7,216

Provision for loan losses of $2.4 million and $7.2 million were made during the six months ended June 30, 2013 and 2012, respectively. The decline in the provision for loan losses during the six months ended June 30, 2013 compared with the year-earlier period reflected reduced non-performing loans and a decline in early-stage delinquencies of one- to four-family residential and home equity loans. The decline in the provision for loan losses also reflected provisioning for certain residential loans disposed of in the first six months of 2012 and two commercial loans that were disposed of in July 2012, which did not recur in 2013. Net charge-offs for the six months ended June 30, 2013 were $3.5 million as compared to $10.4 million in the first six months of 2012. The decrease in net charge-offs in the first six months of 2013 compared with the first six months of 2012 primarily reflected $4.2 million less in charge-offs in 2013 related to one-to-four family residential loans and home equity loans, $1.3 million less in charge-offs in 2013 for collateral-dependent commercial real estate property, $0.6 million less in charge-offs related to residential land loans in 2013, and $0.9 million less in charge-offs in the first six months of 2013 related to collateral-dependent commercial land loans.

Noninterest Income

The components of noninterest income for the six months ended June 30, 2013 and 2012 were as follows:

					Increase / (Decrease)
	2013		2012		Amount			Percentage
	(Dollars in Thousands)

Service charges and fees	$	1,497	$	1,570	$	(73	)		-4.6	%
Gain on sale of loans held-for-sale		633		1,118		(485	)		-43.4	%
Bank owned life insurance earnings		197		232		(35	)		-15.1	%
Interchange fees		799		812		(13	)		-1.6	%
Other		322		222		100			45.0	%
	$	3,448	$	3,954	$	(506	)		-12.8	%

Noninterest income for the six months ended June 30, 2013 decreased $0.5 million to $3.4 million as compared to $3.9 million in the first six months of 2012. The decrease in noninterest income was primarily due to reductions in gains on sales of loans held-for-sale.

For the six months ended June 30, 2013, gains on sales of loans held-for-sale was entirely related to SBA loans held-for-sale, and included $0.2 million in net gains recognized for the servicing of SBA loans. For the six months ended June 30, 2012, gains on sales of mortgage loans held-for-sale was $0.6 million and gains on sales of SBA loans held-for-sale was $0.3 million. The Company expects gains on sales of SBA loans to represent the majority of gains on loan sales in the future as the Company emphasizes small business lending and has phased out the business activity of internally originated mortgage loans held-for-sale.

Noninterest Expense

The components of noninterest expense for the six months ended June 30, 2013 and 2012 were as follows:

							Increase / (Decrease)
	2013			2012			Amount			Percentage
	(Dollars in Thousands)
Compensation and benefits	$	4,403		$	4,624		$	(221	)		-4.8	%
Occupancy and equipment		965			1,033			(68	)		-6.6	%
FDIC insurance premiums		882			547			335			61.2	%
Foreclosed assets, net		(189	)		(74	)		(115	)		-155.4	%
Data processing		776			670			106			15.8	%
Outside professional services		1,958			1,468			490			33.4	%
Collection expense and repossessed asset losses		1,588			1,121			467			41.7	%
Other		2,721			1,991			730			36.7	%
	$	13,104		$	11,380		$	1,724			15.1	%

Noninterest expense increased $1.7 million to $13.1 million for the six months ended June 30, 2013 from $11.4 million for the six months ended June 30, 2012. Noninterest expense for the first six months of 2013 compared with the first six months of 2012 primarily reflected additional professional and outside services expense and data processing costs, both associated with the proposed merger which was rejected by stockholders, the FHLB prepayment penalty, increased collection and credit expense and higher FDIC insurance expense due to our regulatory status, partially offset by decreased compensation costs. The costs associated with the proposed merger amounted to $1.3 million during the first six months of 2013.

Management expects noninterest expense associated with collection and foreclosure activities will continue at elevated levels primarily as a result of on-going credit issues and the extended time involved in the foreclosure process in Florida. Additionally, management expects noninterest expense will be higher for the full year 2013 due to merger related expenses, however, merger related expenses are not expected in the third or fourth quarters due to the rejection of the proposed merger.

Income Tax

The Company recorded no income tax expense for the six months ended June 30, 2013 and $0.5 million in income tax expense for the six months ended June 30, 2012. The recognition of future tax benefits or the reversal of the valuation reserve is dependent upon the Company’s ability to generate future taxable income.

Liquidity

Management maintains a liquidity position it believes will adequately provide funding for loan demand and deposit run-off that may occur in the normal course of business. Atlantic Coast Financial Corporation relies on a number of different sources in order to meet its potential liquidity demands. The primary sources of funds are increases in deposit accounts, cash flows from loan payments and securities sales and borrowings. The scheduled amortization of loans and securities as well as proceeds from borrowings, are predictable sources of funds. In addition warehouse loans, repay rapidly with an average duration of approximately 20 days, with repayments generally funding advances. Other funding sources, however, such as inflows from new deposits, mortgage and investment securities prepayments and mortgage loan sales are greatly influenced by market interest rates, economic conditions and competition.

While primary sources of funds continue to be adequate to meet demands, the Bank has limited contingent liquidity sources available to meet potential funding requirements. As a result, management has increased the amount of cash and cash equivalents held during the first six months of 2013 to an average of $81.1 million from an average of $64.3 million during the year ended December 31, 2012. As of June 30, 2013 and December 31, 2012, the Company had additional borrowing capacity of $5.0 million and $5.2 million, respectively, with the FHLB of Atlanta. During 2012, the Company’s borrowing capacity was reduced following an FHLB of Atlanta credit and collateral review. Also, during 2012, the Bank was notified by the FRB that it is no longer eligible to borrow under the Primary Credit program and that it no longer has daylight overdraft capacity available, although the Bank has not participated in these programs in the past. Unpledged marketable investment securities were approximately $13.0 million and $21.6 million as of June 30, 2013 and December 31, 2012, respectively. The Company also utilizes a non-brokered Direct Deposit certificate of deposit listing service to meet funding needs at interest rates equal to or less than local market rates. During the first six months of 2013, the Bank decreased deposits from this service by $4.0 million, but expects it will continue to utilize the program, as necessary, to supplement retail deposit production.

Threats to the Bank’s liquidity position include rapid declines in deposit balances due to market volatility caused by major changes in interest rates or negative public perception about the Bank, or the financial services industry in general. In addition the amount of investment securities that would otherwise be available to meet liquidity needs is limited due to the collateral requirements of our long term debt. Specifically, the Bank’s securities sold under agreements to repurchase which total $92.8 million at June 30, 2013 have collateral requirements in excess of the debt. Under the terms of the agreement with the counterparty on $77.8 million of the $92.8 million of long-term debt, the Bank is required to pledge additional collateral if its capital ratios decrease below the PCA defined levels of well-capitalized or adequately capitalized. Due to the decline in capital ratios below well-capitalized at December 31, 2012, the Company was required to increase pledged collateral by $4.0 million. Additionally, the collateral requirements of the FHLB debt are supplemented with investment securities collateral and the Bank is required to collateralize the prepayment penalty amount using investment securities.

During the first six months of 2013, cash and cash equivalents increased $10.1 million from $67.8 million as of December 31, 2012 to $77.9 million as of June 30, 2013 as part of the Bank’s strategy to strengthen its overall liquidity position. Cash from operating activities of $3.1 million and cash from investing activities of $29.6 million was more than cash used in financing activities of $22.6 million. Primary sources of cash were from repayment of warehouse loans of $577.6 million, net decreases in portfolio loans of $23.4 million, proceeds from maturities and payments of securities available-for-sale of $18.0 million and proceeds from the sale of loans held-for-sale of $7.4 million. Primary uses of cash included funding of warehouse loans of $569.8 million, purchases of securities available-for-sale of $25.6 million, and repayment of FHLB advances of $25.0 million.

During the first six months of 2012, cash and cash equivalents increased $23.8 million from $41.0 million as of December 31, 2011, to $64.8 million as of June 30, 2012. Cash from investing activities of $32.2 million was more than cash used in operating activities of $0.5 million and cash used in financing activities of $7.9 million. Primary sources of cash were from sales of warehouse loans of $385.7 million, net decreases in portfolio loans of $37.7 million, proceeds from the sale of loans held-for-sale of $26.2 million, and proceeds from maturities and payments of securities available-for-sale of $16.0 million. Primary uses of cash included funding of warehouse loans $378.8 million, originating loans held-for-sale of $28.2 million, purchases of securities available-for-sale of $33.8 million, and net decreases in deposits of $7.9 million.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Bank is subject to interest rate risk to the extent that its interest-bearing liabilities, primarily deposits, re-price more rapidly or at different rates than its interest-earning assets. In order to address the potential for adverse effects of material prolonged increases or decreases in interest rates on our results of operations, management has adopted an asset and liability management policy. The Board of Directors sets the asset and liability policy for the Company, which is implemented by the Asset/Liability Committee (ALCO).

The purpose of the ALCO is to communicate, coordinate and control asset/liability management consistent with our business plan and board approved policies. The ALCO establishes and monitors the volume and mix of assets and funding sources taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The objectives are to manage assets and funding sources to produce results that are consistent with liquidity, capital adequacy, growth, risk, and profitability goals.

The ALCO generally meets at least quarterly, but more frequently if needed, to review, among other things, economic conditions and interest rate outlook, current and projected liquidity needs and capital position, anticipated changes in the volume and mix of assets and liabilities and interest rate exposure limits versus current projections pursuant to income simulations. The ALCO recommends appropriate strategy changes based on this review. The ALCO also is responsible for reviewing and reporting the effects of the policy implementations and strategies to the Board of Directors at least quarterly.

A key element of our asset/liability plan is to protect net earnings by managing the maturity or re-pricing mismatch between our interest-earning assets and rate-sensitive liabilities. Historically, the Company has sought to reduce exposure to its earnings through the use of adjustable rate loans and through the sale of certain fixed rate loans in the secondary market, and by extending funding maturities through the use of the FHLB advances.

In part, the Bank measures its exposure to interest rate risk using an analytical model referred to as Net Portfolio Value (NPV) that estimates the value of the net cash flows of interest-earning assets and its interest-bearing liabilities under different interest rate scenarios.

The Bank also measures interest rate risk by estimating the impact of interest rate changes on its net interest income which is defined as the difference between the interest income we earn on our interest-earning assets, such as loans and securities, and the interest we pay on our interest-bearing liabilities, such as deposits and borrowings. In our model, we estimate what our net interest income would be for a rolling forward twelve-month period using historical data for assumptions such as loan prepayment rates and deposit decay rates, the current term structure for interest rates, and current deposit and loan offering rates. We then calculate what the net interest income would be for the same period in the event of an instantaneous 100, 200 and 300 basis point increase or a 100 basis point decrease in market interest rates.

Given the current relatively low level of market interest rates, the Bank does not consider interest rate decreases of greater than 100 basis points in either of the two models used to measure interest rate risk.

As shown below the Company’s greatest risk is due to a decline in interest rates, which would decrease the net present value of cash flows and net interest income. In an upward rate environment the Company’s net interest income would improve, despite the decrease in net present value of cash flows. This is due to several factors including, but not limited to, the decreasing asset base, the average life of assets being extended in comparison to the average life of liabilities, as a decrease in the prepayment speed of one- to four-family residential and home equity loans would likely occur, and the high level of fixed rate debt at interest rates well above market. The Company’s exposure to interest risk will continue to be at an elevated level as long as interest rates remain low, which magnifies the impact of the cost of the Company’s long term debt and increased investment in lower rate investment securities along with an overall decline in interest-earning assets.

The change in the net present value of cash flows, as compared to December 31, 2012, is attributable to the increase in long-term treasury rates, which results in reduced estimated prepayment speeds of one- to four-family residential and home equity loans. The 10-year treasury rate as of June 30, 2013 and December 31, 2012 was 2.52% and 1.78%, respectively.

									Net Present Value as a Percentage of Present Value of Assets (PVA) (3)						Net Interest Income
			Estimated Increase / (Decrease) in Net Present Value														Increase / (Decrease) in Estimated Net Interest Income
Change in Interest Rates – Basis Points (1)	Estimated Net Present Value (2)		Amount			Percent			Net Present Value Ratio (4)			Increase / (Decrease) – Basis Points			Estimated Net Interest Income		Amount			Percent
(Dollars in Thousands)

As of June 30, 2013:
+300	$	25,059	$	(6,282	)		-20.0	%		3.55	%		(58	)	$	18,203	$	882			5.1	%
+200		30,211		(1,130	)		-3.6	%		4.17	%		4			17,910		589			3.4	%
+100		30,519		(822	)		-2.6	%		4.11	%		(2	)		17,615		294			1.7	%
0		31,341		-			-			4.13	%		-			17,321		-			-
-100		26,982		(4,359	)		-13.9	%		3.50	%		(63	)		17,051		(270	)		-1.6	%

As of December 31, 2012:
+300	$	31,035	$	2,850			10.1	%		4.16	%		62		$	19,897	$	1,860			10.3	%
+200		34,583		6,398			22.7	%		4.53	%		99			18,903		866			4.8	%
+100		32,097		3,912			13.9	%		4.11	%		57			18,470		433			2.4	%
0		28,185		-			-			3.54	%		-			18,037		-			-
-100		18,409		(9,776	)		-34.7	%		2.29	%		(125	)		17,602		(435	)		-2.4	%

(1)

Assumes an instantaneous uniform change in interest rates at all maturities.

(2)

Net Present Value is the discounted present value of expected cash flows from assets, liabilities and off-balance sheet contracts. Discount rates are unique to each class of asset and liability and are principally estimated as spreads over wholesale rates.

(3)

PVA represents the discounted present value of incoming cash flows on interest-earning assets.

(4)

Net Present Value Ratio represents Net Present Value divided by PVA.

Certain shortcomings are inherent in the methodologies used in determining interest rate risk through changes in net portfolio value and net interest income. Modeling changes require making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the net portfolio value and net interest income information presented assume that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assume that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or re-pricing of specific assets and liabilities. Accordingly, although interest rate-risk calculations provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and will differ from actual results.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. As of the end of the period covered by this Quarterly Report on Form 10-Q, the Registrant’s principal executive officer and principal financial officer have concluded that the Registrant’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities and Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

(b) Changes in internal controls. There were no changes in the Registrant’s internal control over financial reporting (as defined in Rule 13a-15(f)) that occurred during the quarter ended June 30, 2013, that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time, the Company is involved as plaintiff or defendant in various legal actions arising in the normal course of business. Management does not anticipate incurring any material liability as a result of litigation at June 30, 2013, other than the litigation described below.

Current Litigation Relating to the Merger

ITEM 1A. RISK FACTORS

In addition to the risk factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, investors should consider the risk factor below before investing in our common stock.

We rely on our management team for the successful implementation of our business strategy.

Since June 11, 2013, when the proposed merger between the Company and Bond Street Holdings, Inc. was rejected by the stockholders of the Company, both the Chief Executive Officer and the Chairman of the Board of Directors’ have resigned from their positions. The Company appointed an Interim President and Chief Executive Officer until such time that a permanent replacement can be appointed. Additionally, three members of the Board of Directors announced their decisions not to stand for re-election and are expected to be replaced by three director nominees at the Company’s annual meeting on August 16, 2013.

Additional turnover of key management and directors, or the loss of other senior managers would have a disproportionate impact on the Company and may have a material adverse effect on our ability to implement our business plan and comply with the terms of the Consent Order the Board of Directors of the Bank agreed to with the Office of the Comptroller of the Currency on August 10, 2012. As we are a relatively small bank with a relatively small management team, certain members of our senior management team have more responsibility than his or her counterpart typically would have at a larger institution with more employees, and we have fewer management-level personnel who are in a position to assume the responsibilities of our executive management team.

Changes in the Company’s strategic direction as a result of the changes in executive management and the Board of Directors, if any, are currently unknown.

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

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

31.

Certification of Chief Executive Officer and Chief Financial Officer of Atlantic Coast Financial Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.

Certification of Chief Executive Officer and Chief Financial Officer of Atlantic Coast Financial Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS

XBRL Instance Document *

101.SCH

XBRL Taxonomy Extension Schema Document *

101.CAL

XBRL Taxonomy Calculation Linkbase Document *

101 DEF

XBRL Taxonomy Extension Definition Linkbase Document *

101 LAB

XBRL Taxonomy Label Linkbase Document *

101.PRE

XBRL Taxonomy Presentation Linkbase Document *

______________________________

We have attached these documents formatted in XBRL (Extensible Business Reporting Language) as Exhibit 101 to this report. We advise users of this data that pursuant to Rule 406T of Regulation S-T, this interactive data file is deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

SIGNATURES

Pursuant to the requirements of the Section 13 or 15(d) 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.

	ATLANTIC COAST FINANCIAL CORPORATION

Date: August 13, 2013	By:	/s/ Thomas B. Wagers, Sr.

		Thomas B. Wagers, Sr.
		Interim President, Chief Executive Officer and
		Chief Financial Officer
		(Principal Executive, Financial and Accounting Officer)