SOUTHCOAST FINANCIAL CORP

One of the Company’s collateralized debt obligations with an amortized cost of approximately $1,831,000 and fair value of approximately $1,033,000 is receiving contractual interest payments, while the other with an amortized cost of approximately $1,741,000 and fair value of approximately $1,200,000 received an interest payment in March 2016 after an extended period of deferred interest payments. Due to the over-collateralized credit position and uninterrupted payment stream of the first security, no other-than-temporary impairment was recognized on this security. During the period of deferred interest payments on the second security, payment-in-kind interest was added to the par value of the security in lieu of cash interest payments. The Company did not accrue interest during the deferral period, and will continue to postpone accrual of interest until a sustained pattern of payments has been reestablished and the credit profile of the security has improved substantially. Presently, interest income on this security is recognized as payments are received. The Company recognized interest income on this security totaling approximately $42,000 for the three months ended March 31, 2016.

Changes that affect net interest income include changes in the average rate earned on interest earning assets, changes in the average rate paid on interest bearing liabilities, and changes in the volumes of interest earning assets and interest bearing liabilities. The decrease in the Company’s net interest income for the three months ended March 31, 2016 compared to the same period of 2015 was primarily due to decreased interest income between the two periods. The decrease in interest income was primarily related to recoveries of interest income on nonaccrual loans which paid off during the three months ended March 31, 2015. These recoveries provided an additional $241,000 of interest income when compared to recoveries of interest income on nonaccrual loans paid off during the three months ended March 31, 2016. Also contributing to the decrease in interest income was a change in the Company’s loan portfolio mix, as lower yielding residential mortgage loans comprised approximately 57.3% of average loans during the three months ended March 31, 2016, compared to approximately 54.2% of average loans during the three months ended March 31, 2015. Mortgage loan yields were 4.18% and 4.19% for the three months ended March 31, 2016 and March 31, 2015, respectively. Loan fees for the three months ended March 31, 2016 and March 31, 2015 were $91,000 and $151,000, respectively. The decrease of $60,000 in loan fees for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 also contributed to the decrease in loan yields between the two periods.

As shown above, for the three months ended March 31, 2016 the average yield on earning assets was 4.41 percent, while the average cost of interest bearing liabilities was 0.93 percent. For the three months ended March 31, 2015 the average yield on earning assets was 4.72 percent and the average cost of interest-bearing liabilities was 0.94 percent. The decrease in the overall asset yield is due to lower loan yields. The slight decrease in the cost of average interest bearing liabilities was due to decreases in average rates paid on other borrowings and savings and transaction accounts, partially offset by higher rates paid on time deposits and subordinated debt. The net interest margin was 3.62 percent and 3.89 percent for the three months ended March 31, 2016 and 2015, respectively. The decrease in the net interest margin was attributable to a decrease of $100,000 in net interest income, which was comprised of a decrease in interest income of $95,000 and an increase in interest expense of $5,000. The decrease in interest income was due to a $131,000 decrease in interest income on loans, partially offset by a $36,000 increase in interest income on investments and federal funds sold. The increase in interest expense was attributable to increases of $15,000 and $9,000 for other borrowings and subordinated debt, respectively, partially offset by decreases of $17,000 and $2,000 for time deposits and savings and transaction accounts, respectively.

Noninterest expenses for the three months ended March 31, 2016 were $3,158,000, compared to $3,140,000 for the three months ended March 31, 2015, an increase of $18,000. The largest contributing factor to this increase was a $98,000 increase in other expenses. This increase was primarily attributable to a $95,000 credit to the Allowance for Unfunded Commitments which was taken during the three months ended March 31, 2015. During the three months ended March 31, 2016, there was no provision or credit to the Allowance for Unfunded Commitments. Partially offsetting the increase in other expenses was a decrease of $64,000 in salaries and employee benefits. This decrease occurred due to a slight reduction in the number of employees between the two periods.

The Company’s income tax expense for the three months ended March 31, 2016 totaled $672,000, comprised of $585,000 for Federal income taxes and $87,000 for South Carolina income taxes. The Company’s income tax expense for the three months ended March 31, 2015 totaled $1,078,000, comprised of $978,000 for Federal income taxes and $100,000 for South Carolina income taxes. The effective tax rates for these periods were 35.7% and 35.3% for the three months ended March 31, 2016 and March 31, 2015, respectively.

For three months ended March 31, 2016 the Company credited its loan loss provision for $500,000. For the three months ended March 31, 2015 the Company credited its loan loss provision for $900,000. Net recoveries for the three months ended March 31, 2016 and March 31, 2015 totaled approximately $127,000 and $173,000, respectively. The need for future loan loss provisions will be influenced by loan defaults, loan delinquency levels, loan chargeoffs beyond what has already been provided for on individual loans, the level of loans with credit grades of 6 through 9, and the need for additional specific reserves on loans individually evaluated for impairment, among other factors. In reviewing the adequacy of the allowance for loan losses at each quarter end, management takes into consideration the historical loan losses we experienced, current levels of past due loans by loan type, the historical severity of loan losses by loan type, loan to value exceptions in our loan portfolio, potential repayment risk for floating and adjustable rate loans due to the potential for rising interest rates, risks posed by unseasoned loans during periods of growth in the loan portfolio, and collateral values of impaired loans deemed to be collateral dependent. As referenced in Note 6 to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this Form 10-Q, the Company’s general reserves portion of its allowance for loan losses decreased by $373,000 during the three months ended March 31, 2016, from $4,753,000 at December 31, 2015 to $4,380,000 at March 31, 2016. The main factor leading to the loan loss provision credit of $500,000 for the three months ended March 31, 2016 was a $496,000 reduction in required general reserves for Commercial Real Estate loans. General reserves for Commercial Real Estate loans totaled $930,000 at March 31, 2016, compared to $1,426,000 at December 31, 2015, a reduction of approximately 35%. This reduction was primarily attributable to a reduction in delinquencies, as delinquent commercial real estate loans at March 31, 2016 totaled $1,887,000, compared to$3,199,000 at December 31, 2015, a reduction of $1,312,000, or approximately 41%. The Company’s net recoveries of $127,000 for the three months ended Mach 31, 2016 were also a contributing factor to the loan loss provision credit of $500,000. Partially offsetting these reductions in required general reserves was a $95,000 increase in general reserves for 1-4 family residential loans, which was due primarily to a $1.8 million increase in delinquencies.