form10-q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
______________________

FORM 10-Q
______________________

(Mark One)

T
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014
or

£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________

Commission file number 001-31567
 
 
CENTRAL PACIFIC FINANCIAL CORP.
(Exact name of registrant as specified in its charter)

Hawaii
99-0212597
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)

220 South King Street, Honolulu, Hawaii 96813
(Address of principal executive offices) (Zip Code)

(808) 544-0500
(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  T   No  £
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  T   No  £

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

Large accelerated filer £
Accelerated filer T
Non-accelerated filer £
Smaller reporting company £

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  £   No  T
 
The number of shares outstanding of registrant’s common stock, no par value, on October 30, 2014 was 35,903,230 shares.
 


 
 

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES

Table of Contents
 
Part I.
Financial Information
   
Item I.
Financial Statements (Unaudited)
   
 
Consolidated Balance Sheets
September 30, 2014 and December 31, 2013
   
 
Consolidated Statements of Income
Three and nine months ended September 30, 2014 and 2013
   
 
Consolidated Statements of Comprehensive Income
Three and nine months ended September 30, 2014 and 2013
   
 
Consolidated Statements of Changes in Equity
Nine months ended September 30, 2014 and 2013
   
 
Consolidated Statements of Cash Flows
Nine months ended September 30, 2014 and 2013
   
 
Notes to Consolidated Financial Statements
   
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
   
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
   
Item 4.
Controls and Procedures
   
Part II.
Other Information
   
Item 1A.
Risk Factors
   
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
   
Item 6.
Exhibits
   
Signatures
 
Exhibit Index
 
 
 
 
2

 
PART I.   FINANCIAL INFORMATION

Forward-Looking Statements

This document may contain forward-looking statements concerning projections of revenues, income/loss, earnings/loss per share, capital expenditures, dividends, capital structure, or other financial items, concerning plans and objectives of management for future operations, concerning future economic performance, or concerning any of the assumptions underlying or relating to any of the foregoing. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts, and may include the words “believes,” “plans,” “intends,” “expects,” “anticipates,” “forecasts,” “hopes,” “should,” “estimates” or words of similar meaning. While we believe that our forward-looking statements and the assumptions underlying them are reasonably based, such statements and assumptions are by their nature subject to risks and uncertainties, and thus could later prove to be inaccurate or incorrect. Accordingly, actual results could materially differ from projections for a variety of reasons, to include, but not be limited to: an increase in inventory or adverse conditions in the Hawaii and California real estate markets and deterioration in the construction industry; adverse changes in the financial performance and/or condition of our borrowers and, as a result, increased loan delinquency rates, deterioration in asset quality, and losses in our loan portfolio; the impact of local, national, and international economies and events (including natural disasters such as wildfires, tsunamis, storms and earthquakes) on the Company’s business and operations and on tourism, the military, and other major industries operating within the Hawaii market and any other markets in which the Company does business; deterioration or malaise in domestic economic conditions, including any further destabilization in the financial industry and deterioration of the real estate market, as well as the impact of declining levels of consumer and business confidence in the state of the economy in general and in financial institutions in particular; changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act, changes in capital standards, other regulatory reform, including but not limited to regulations promulgated by the Consumer Financial Protection Bureau, government-sponsored enterprise reform, and any related rules and regulations on our business operations and competitiveness; the costs and effects of legal and regulatory developments, including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews; ability to successfully implement our initiatives to lower our efficiency ratio; the effects of and changes in trade, monetary and fiscal policies and laws, including the interest rate policies of the Board of Governors of the Federal Reserve System; inflation, interest rate, securities market and monetary fluctuations; negative trends in our market capitalization and adverse changes in the price of the Company’s common stock; political instability; acts of war or terrorism; changes in consumer spending, borrowings and savings habits; failure to maintain effective internal control over financial reporting or disclosure controls and procedures; technological changes; changes in the competitive environment among financial holding companies and other financial service providers; the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters; our ability to attract and retain skilled employees; changes in our organization, compensation and benefit plans; and our success at managing the risks involved in the foregoing items. For further information on factors that could cause actual results to materially differ from projections, please see the Company’s publicly available Securities and Exchange Commission filings, including the Company’s Form 10-K for the last fiscal year and, in particular, the discussion of “Risk Factors” set forth therein. The Company does not update any of its forward-looking statements except as required by law.
 
 
3

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
           
 
September 30,
   
December 31,
 
 
2014
   
2013
 
 
(Dollars in thousands)
 
Assets
         
Cash and due from banks
$ 76,047     $ 45,092  
Interest-bearing deposits in other banks
  14,074       4,256  
Investment securities:
             
   Available for sale, at fair value
  1,184,564       1,407,999  
   Held to maturity, at amortized cost (fair value of $235,929
             
      at September 30, 2014 and $238,705 at December 31, 2013)
  242,141       252,047  
      Total investment securities
  1,426,705       1,660,046  
               
Loans held for sale
  5,352       12,370  
               
Loans and leases
  2,874,755       2,630,601  
Allowance for loan and lease losses
  (82,838 )     (83,820 )
      Net loans and leases
  2,791,917       2,546,781  
               
Premises and equipment, net
  49,092       49,039  
Accrued interest receivable
  12,722       14,072  
Investment in unconsolidated subsidiaries
  7,548       9,127  
Other real estate
  3,596       5,163  
Other intangible assets
  30,498       32,783  
Bank-owned life insurance
  151,524       149,604  
Federal Home Loan Bank stock
  44,457       46,193  
Other assets
  136,737       166,672  
      Total assets
$ 4,750,269     $ 4,741,198  
               
Liabilities and Equity
             
Deposits:
             
   Noninterest-bearing demand
$ 996,033     $ 891,017  
   Interest-bearing demand
  802,336       728,619  
   Savings and money market
  1,229,576       1,207,016  
   Time
  1,020,151       1,109,521  
      Total deposits
  4,048,096       3,936,173  
               
Short-term borrowings
  -       8,015  
Long-term debt
  92,785       92,799  
Other liabilities
  40,346       44,037  
      Total liabilities
  4,181,227       4,081,024  
               
Equity:
             
   Preferred stock, no par value, authorized 1,100,000 shares, issued and outstanding
             
      none at September 30, 2014 and December 31, 2013, respectively
  -       -  
   Common stock, no par value, authorized 185,000,000 shares, issued and outstanding 35,903,230
             
      and 42,107,633 shares at September 30, 2014 and December 31, 2013, respectively
  655,219       784,547  
   Surplus
  77,598       75,498  
   Accumulated deficit
  (166,740 )     (184,087 )
   Accumulated other comprehensive income (loss)
  2,965       (15,845 )
      Total shareholders' equity
  569,042       660,113  
   Non-controlling interest
  -       61  
      Total equity
  569,042       660,174  
      Total liabilities and equity
$ 4,750,269     $ 4,741,198  
               
See accompanying notes to consolidated financial statements.
 
4

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
                       
 
Three Months Ended
   
Nine Months Ended
 
 
September 30,
   
September 30,
 
 
2014
   
2013
   
2014
   
2013
 
 
(Amounts in thousands, except per share data)
 
Interest income:
                     
  Interest and fees on loans and leases
$ 28,364     $ 26,414     $ 83,287     $ 77,362  
  Interest and dividends on investment securities:
                             
    Taxable interest
  7,744       8,114       25,716       22,518  
    Tax-exempt interest
  1,002       992       2,996       3,059  
    Dividends
  8       5       10       16  
  Interest on deposits in other banks
  9       21       24       178  
  Dividends on Federal Home Loan Bank stock
  12       12       35       12  
    Total interest income
  37,139       35,558       112,068       103,145  
                               
Interest expense:
                             
  Interest on deposits:
                             
    Demand
  96       91       277       259  
    Savings and money market
  225       227       672       663  
    Time
  629       671       1,880       2,150  
  Interest on short-term borrowings
  10       3       82       3  
  Interest on long-term debt
  647       795       1,923       2,457  
    Total interest expense
  1,607       1,787       4,834       5,532  
                               
    Net interest income
  35,532       33,771       107,234       97,613  
Provision (credit) for loan and lease losses
  (1,722 )     (3,189 )     (1,043 )     (9,977 )
    Net interest income after provision for loan and lease losses
  37,254       36,960       108,277       107,590  
                               
Other operating income:
                             
  Service charges on deposit accounts
  2,070       1,776       6,052       4,950  
  Loan servicing fees
  1,446       1,509       4,338       4,578  
  Other service charges and fees
  2,886       3,422       8,912       9,326  
  Income from fiduciary activities
  797       724       2,687       2,107  
  Equity in earnings of unconsolidated subsidiaries
  11       513       422       733  
  Fees on foreign exchange
  118       149       351       348  
  Investment securities gains
  -       -       240       -  
  Income from bank-owned life insurance
  810       611       2,246       1,492  
  Loan placement fees
  35       81       356       408  
  Net gain on sales of residential loans
  1,685       1,476       4,151       8,492  
  Net gain on sales of foreclosed assets
  218       276       962       8,528  
  Other
  1,387       1,393       2,894       1,810  
    Total other operating income
  11,463       11,930       33,611       42,772  
                               
Other operating expense:
                             
  Salaries and employee benefits
  16,552       19,167       50,536       55,944  
  Net occupancy
  4,051       3,802       11,375       10,651  
  Equipment
  953       952       2,694       2,788  
  Amortization of other intangible assets
  1,328       1,637       3,886       5,994  
  Communication expense
  925       907       2,693       2,727  
  Legal and professional services
  1,786       2,155       5,826       6,410  
  Computer software expense
  1,659       1,056       4,592       3,182  
  Advertising expense
  673       601       2,037       2,141  
  Foreclosed asset expense
  1,355       (12 )     1,443       993  
  Other
  5,964       6,247       14,982       13,435  
    Total other operating expense
  35,246       36,512       100,064       104,265  
                               
     Income before income taxes
  13,471       12,378       41,824       46,097  
Income tax expense (benefit)
  5,241       2,174       14,636       (115,683 )
     Net income
$ 8,230     $ 10,204     $ 27,188     $ 161,780  
                               
Per common share data:
                             
   Basic earnings per share
$ 0.23     $ 0.24     $ 0.72     $ 3.86  
   Diluted earnings per share
  0.23       0.24       0.71       3.83  
   Cash dividends declared
  0.10       0.08       0.26       0.08  
Shares used in computation:
                             
  Basic shares
  35,863       42,028       37,943       41,934  
  Diluted shares
  36,353       42,421       38,440       42,263  
                               
See accompanying notes to consolidated financial statements.
 
5

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
                       
 
Three Months Ended
   
Nine Months Ended
 
 
September 30,
   
September 30,
 
 
2014
   
2013
   
2014
   
2013
 
 
(Dollars in thousands)
 
                       
Net income
$ 8,230     $ 10,204     $ 27,188     $ 161,780  
Other comprehensive income (loss), net of tax
                             
   Net change in unrealized gain (loss) on investment securities
  (1,665 )     2,667       18,221       (25,256 )
   Net change in unrealized loss on derivatives
  -       -       -       10,993  
   Defined benefit plans
  212       375       589       1,375  
Other comprehensive income (loss), net of tax
  (1,453 )     3,042       18,810       (12,888 )
Comprehensive income
$ 6,777     $ 13,246     $ 45,998     $ 148,892  
                               
See accompanying notes to consolidated financial statements.
 
 
 
6

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Unaudited)
                                               
                               
Accumulated
             
 
Common
                           
Other
   
Non-
       
 
Shares
   
Preferred
   
Common
         
Accumulated
   
Comprehensive
   
Controlling
       
 
Outstanding
   
Stock
   
Stock
   
Surplus
   
Deficit
   
Income (Loss)
   
Interests
   
Total
 
 
(Dollars in thousands, except per share data)
 
                                               
Balance at December 31, 2013
42,107,633     $ -     $ 784,547     $ 75,498     $ (184,087 )   $ (15,845 )   $ 61     $ 660,174  
Net income
-       -       -       -       27,188       -       -       27,188  
Other comprehensive income
-       -       -       -       -       18,810       -       18,810  
Cash dividends paid ($0.26 per share)
-       -       -       -       (9,841 )     -       -       (9,841 )
1,118 net shares of common stock sold
                                                           
  by directors' deferred compensation plan
-       -       (11 )     -       -       -       -       (11 )
6,369,266 shares of common stock
                                                           
  repurchased and other related costs
(6,369,266 )     -       (129,391 )     -       -       -       -       (129,391 )
Share-based compensation
164,863       -       74       2,100       -       -       -       2,174  
Non-controlling interests
-       -       -       -       -       -       (61 )     (61 )
Balance at September 30, 2014
35,903,230     $ -     $ 655,219     $ 77,598     $ (166,740 )   $ 2,965     $ -     $ 569,042  
                                                             
Balance at December 31, 2012
42,088,976     $ -     $ 784,512     $ 70,567     $ (349,427 )   $ (830 )   $ 9,957     $ 514,779  
Net income
-       -       -       -       161,780       -       -       161,780  
Other comprehensive loss
-       -       -       -       -       (12,888 )     -       (12,888 )
Cash dividends paid ($0.08 per share)
-       -       -       -       (3,367 )     -       -       (3,367 )
1,782 net shares of common stock purchased
                                                           
  by directors' deferred compensation plan
-       -       (39 )     -       -       -       -       (39 )
Share-based compensation
2,204       -       -       3,168       -       -       -       3,168  
Non-controlling interests
-       -       -       -       -       -       (9,897 )     (9,897 )
Balance at September 30, 2013
42,091,180     $ -     $ 784,473     $ 73,735     $ (191,014 )   $ (13,718 )   $ 60     $ 653,536  
                                                             
See accompanying notes to consolidated financial statements.
 
 
 
 
7

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
             
   
Nine Months Ended
 
   
September 30,
 
   
2014
   
2013
 
   
(Dollars in thousands)
 
Cash flows from operating activities:
           
Net income
  $ 27,188     $ 161,780  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision (credit) for loan and lease losses
    (1,043 )     (9,977 )
Depreciation and amortization
    4,372       4,528  
Write down of other real estate, net of gain on sale
    529       (7,989 )
Amortization of other intangible assets
    3,886       5,994  
Net amortization of investment securities
    6,111       10,766  
Share-based compensation
    2,100       3,168  
Net gain on investment securities
    (240 )     -  
Net gain on sales of residential loans
    (4,151 )     (8,492 )
Proceeds from sales of loans held for sale
    279,641       545,199  
Originations of loans held for sale
    (268,472 )     (510,861 )
Equity in earnings of unconsolidated subsidiaries
    (422 )     (733 )
Increase in cash surrender value of bank-owned life insurance
    (2,402 )     (1,492 )
Deferred income taxes
    14,701       (115,683 )
Premium paid on repurchases of preferred stock of subsidiaries
    -       1,895  
Net change in other assets and liabilities
    702       (8,425 )
Net cash provided by operating activities
    62,500       69,678  
                 
Cash flows from investing activities:
               
Proceeds from maturities of and calls on investment securities available for sale
    104,784       387,409  
Proceeds from sales of investment securities available for sale
    162,470       -  
Purchases of investment securities available for sale
    (18,993 )     (501,502 )
Proceeds from maturities of and calls on investment securities held to maturity
    12,046       9,980  
Purchases of investment securities held to maturity
    (2,443 )     (4,595 )
Net loan originations
    (183,197 )     (258,612 )
Purchase of loan portfolio
    (62,648 )     (37,104 )
Proceeds from sales of loans originated for investment
    -       10,679  
Proceeds from sale of other real estate
    2,790       16,375  
Proceeds from bank-owned life insurance
    481       -  
Purchases of premises and equipment
    (4,425 )     (3,920 )
Distributions from unconsolidated subsidiaries
    470       553  
Contributions to unconsolidated subsidiaries
    466       (9,050 )
Proceeds from redemption of FHLB stock
    1,736       1,302  
Net cash provided by (used in) investing activities
    13,537       (388,485 )
                 
Cash flows from financing activities:
               
Net increase in deposits
    111,923       225,492  
Repayments of long-term debt
    (14 )     (13 )
Net increase (decrease) in short-term borrowings
    (8,015 )     28,000  
Cash dividends paid on common stock
    (9,841 )     (3,367 )
Repurchases of common stock and other related costs
    (129,391 )     -  
Repurchases of preferred stock of subsidiaries
    -       (11,781 )
Net proceeds from issuance of common stock and stock option exercises
    74       -  
Net cash provided by (used in) financing activities
    (35,264 )     238,331  
                 
Net increase (decrease) in cash and cash equivalents
    40,773       (80,476 )
Cash and cash equivalents at beginning of period
    49,348       177,375  
Cash and cash equivalents at end of period
  $ 90,121     $ 96,899  
                 
Supplemental disclosure of cash flow information:
               
Cash paid during the period for:
               
Interest
  $ 4,796     $ 17,436  
Income taxes
    -       5  
Cash received during the period for:
               
Income taxes
    79       -  
Supplemental disclosure of noncash investing and financing activities:
               
Net change in common stock held by directors' deferred compensation plan
  $ 11     $ 39  
Net reclassification of loans to other real estate
    1,752       3,461  
Net transfer of investment securities available for sale to held to maturity
    -       101,669  
                 
See accompanying notes to consolidated financial statements.
 
8

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.   BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of Central Pacific Financial Corp. and Subsidiaries (herein referred to as the “Company,” “we,” “us” or “our”) have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These interim condensed consolidated financial statements and notes should be read in conjunction with the Company’s consolidated financial statements and notes thereto filed on Form 10-K for the fiscal year ended December 31, 2013. In the opinion of management, all adjustments necessary for a fair presentation have been made and include all normal recurring adjustments. Interim results of operations are not necessarily indicative of results to be expected for the year.

Certain prior period amounts in the consolidated financial statements and the notes thereto have been reclassified to conform to the current period presentation. Such reclassifications had no effect on net income or shareholders’ equity for any periods presented.

2.   REGULATORY MATTERS

On October 9, 2012, the bank entered into a Memorandum of Understanding (the “Compliance MOU”) with the Federal Deposit Insurance Corporation (the “FDIC”) to improve the bank’s compliance management system (“CMS”). Under the Compliance MOU, we are required to, among other things, (i) improve the Board of Directors’ oversight of the bank’s CMS; (ii) ensure the establishment and implementation of the bank’s CMS is commensurate with the complexity of the bank’s operations; (iii) perform a full review of all compliance policy and procedures, then revise and adopt policy and procedures to ensure compliance with all consumer protection regulations; (iv) enhance the bank’s training program relating to consumer protection and fair lending regulations; (v) develop and implement an effective internal monitoring program to ensure compliance with all applicable laws and regulations; (vi) strengthen the compliance audit function to ensure that the compliance audits are appropriately and comprehensively scoped; (vii) develop and implement internal controls for the bank’s third-party payment processing activity; (viii) strengthen the Board of Directors and senior management’s oversight of third-party relationships and (ix) enhance the bank’s overdraft payment program. The bank believes it has fully complied with all of the requirements of the Compliance MOU. In addition, the bank received an “Outstanding” rating in the FDIC’s 2012 Community Reinvestment performance evaluation that measures how financial institutions support their communities in the areas of lending, investment and service.

We cannot assure you whether or when the Company and the bank will be in full compliance with the Compliance MOU or whether or when the Compliance MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators which restrict our activities or may impose higher capital ratios or other requirements on our business. The requirements and restrictions of the Compliance MOU are judicially enforceable and the Company or the bank's failure to comply with such requirements and restrictions may subject the Company and the bank to additional regulatory restrictions including: the imposition of additional regulatory requirements or orders; limitations on our activities; the imposition of civil monetary penalties; and further directives which affect our business, including, in the most severe circumstances, termination of the bank’s deposit insurance or appointment of a conservator or receiver for the bank.

3.   RECENT ACCOUNTING PRONOUNCEMENTS

In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists." The provisions of ASU 2013-11 provide guidance for financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar loss or a tax credit carryforward exists. The Company has reflected the adoption of this guidance prospectively on January 1, 2014, the effective date of ASU 2013-11. The adoption of this guidance did not have a material impact on our consolidated financial statements.

 
9

 
4.   INVESTMENT SECURITIES

A summary of available for sale and held to maturity investment securities are as follows:
 
       
Gross
   
Gross
   
Estimated
 
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
Cost
   
Gains
   
Losses
   
Value
 
(Dollars in thousands)
At September 30, 2014:
                   
Held to Maturity:
                   
   Mortgage-backed securities - U.S. Government sponsored entities
$ 242,141     $ 63     $ (6,275 )   $ 235,929
                             
Available for Sale:
                           
   Debt securities:
                           
      States and political subdivisions
$ 191,553     $ 1,844     $ (3,238 )   $ 190,159
      Corporate securities
  84,331       1,427       (206 )     85,552
   Mortgage-backed securities:
                           
      U.S. Government sponsored entities
  737,504       8,780       (5,745 )     740,539
      Non-agency collateralized mortgage obligations
  165,518       3,320       (1,377 )     167,461
   Other
  743       110       -       853
   Total
$ 1,179,649     $ 15,481     $ (10,566 )   $ 1,184,564
                             
At December 31, 2013:
                           
Held to Maturity:
                           
   Mortgage-backed securities - U.S. Government sponsored entities
$ 252,047     $ -     $ (13,342 )   $ 238,705
                             
Available for Sale:
                           
   Debt securities:
                           
      States and political subdivisions
$ 191,158     $ 305     $ (12,106 )   $ 179,357
      Corporate securities
  157,337       1,878       (1,120 )     158,095
   Mortgage-backed securities:
                           
      U.S. Government sponsored entities
  936,144       7,085       (15,603 )     927,626
      Non-agency collateralized mortgage obligations
  147,902       81       (5,937 )     142,046
   Other
  755       120       -       875
   Total
$ 1,433,296     $ 9,469     $ (34,766 )   $ 1,407,999
 
The amortized cost and estimated fair value of investment securities at September 30, 2014 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
September 30, 2014
 
Amortized Cost
   
Estimated Fair Value
 
(Dollars in thousands)
Held to Maturity
       
  Mortage-backed securities
$ 242,141     $ 235,929
             
Available for Sale
           
  Due in one year or less
$ 3,471     $ 3,471
  Due after one year through five years
  53,494       54,842
  Due after five years through ten years
  99,948       99,847
  Due after ten years
  118,971       117,551
  Mortage-backed securities
  903,022       908,000
  Other
  743       853
    Total
$ 1,179,649     $ 1,184,564
 
10

 
We sold certain available for sale investment securities during the second quarter of 2014 for gross proceeds of $162.5 million. Gross realized gains and losses on the sales of the available for sale investment securities were $0.9 million and $0.7 million, respectively. The specific identification method was used as the bases for determining the cost of all securities sold. We did not sell any available for sale securities during the first and third quarters of 2014 and the first nine months of 2013.

Investment securities of $894.1 million and $914.1 million at September 30, 2014 and December 31, 2013, respectively, were pledged to secure public funds on deposit and other long-term and short-term borrowings. None of these securities were pledged to a secured party that has the right to sell or repledge the collateral as of the same periods.

Provided below is a summary of the 218 and 321 investment securities which were in an unrealized loss position at September 30, 2014 and December 31, 2013, respectively.
   
Less than 12 months
   
12 months or longer
   
Total
 
    Fair    
Unrealized
    Fair    
Unrealized
    Fair    
Unrealized
 
Description of Securities
 
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
   
(Dollars in thousands)
 
At September 30, 2014:
                                   
Debt securities:
                                   
   States and political subdivisions
  $ 16,780     $ (192 )   $ 85,566     $ (3,046 )   $ 102,346     $ (3,238 )
   Corporate securities
    12,732       (75 )     8,354       (131 )     21,086       (206 )
Mortgage-backed securities:
                                               
   U.S. Government sponsored entities
    100,487       (577 )     461,952       (11,443 )     562,439       (12,020 )
   Non-agency collateralized mortgage obligations
    14,800       (52 )     47,194       (1,325 )     61,994       (1,377 )
   Total temporarily impaired securities
  $ 144,799     $ (896 )   $ 603,066     $ (15,945 )   $ 747,865     $ (16,841 )
                                                 
At December 31, 2013:
                                               
Debt securities:
                                               
   States and political subdivisions
  $ 137,176     $ (8,985 )   $ 32,747     $ (3,121 )   $ 169,923     $ (12,106 )
   Corporate securities
    75,368       (1,120 )     -       -       75,368       (1,120 )
Mortgage-backed securities:
                                               
   U.S. Government sponsored entities
    909,585       (28,386 )     4,848       (559 )     914,433       (28,945 )
   Non-agency collateralized mortgage obligations
    129,991       (5,937 )     -       -       129,991       (5,937 )
   Total temporarily impaired securities
  $ 1,252,120     $ (44,428 )   $ 37,595     $ (3,680 )   $ 1,289,715     $ (48,108 )
 
Other-Than-Temporary Impairment (“OTTI”)

Unrealized losses for all investment securities are reviewed to determine whether the losses are deemed “other-than-temporary.” Investment securities are evaluated for OTTI on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value below amortized cost is other-than-temporary. In conducting this assessment, we evaluate a number of factors including, but not limited to:

·  
The length of time and the extent to which fair value has been less than the amortized cost basis;
·  
Adverse conditions specifically related to the security, an industry, or a geographic area;
·  
The historical and implied volatility of the fair value of the security;
·  
The payment structure of the debt security and the likelihood of the issuer being able to make payments;
·  
Failure of the issuer to make scheduled interest or principal payments;
·  
Any rating changes by a rating agency; and
·  
Recoveries or additional decline in fair value subsequent to the balance sheet date.

The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value are not necessarily favorable, or that there is a general lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized for anticipated credit losses.

The declines in market value were primarily attributable to changes in interest rates. Because we have no intent to sell securities in an unrealized loss position and it is not more likely than not that we will be required to sell such securities before recovery of its amortized cost basis, we do not consider these investments to be other-than-temporarily impaired.

 
11

 
5.   LOANS AND LEASES

Loans and leases, excluding loans held for sale, consisted of the following:
 
   
September 30,
   
December 31,
 
   
2014
   
2013
 
   
(Dollars in thousands)
 
             
Commercial, financial and agricultural
  $ 441,697     $ 398,365  
Real estate:
               
  Construction
    109,617       75,927  
  Mortgage - residential
    1,249,717       1,135,155  
  Mortgage - commercial
    697,448       703,800  
Consumer
    371,693       311,670  
Leases
    3,691       6,241  
      2,873,863       2,631,158  
Net deferred costs (income)
    892       (557 )
  Total loans and leases
  $ 2,874,755     $ 2,630,601  
 
During the nine months ended September 30, 2014, we foreclosed on four loans with a carrying value of $1.8 million. We did not transfer any portfolio loans to the held-for-sale category and no portfolio loans were sold during the nine months ended September 30, 2014. In May 2014, we purchased participation interests in auto loans totaling $11.2 million, which included a $0.3 million premium over the $10.9 million outstanding balance. At the time of purchase, the auto loans had a weighted average remaining term of 71 months. During the nine months ended September 30, 2014, we also purchased participation interests in student loans totaling $51.5 million, which represented the outstanding balance at the time of purchase. At the time of purchase, the student loans had a weighted average remaining term of 123 months.

During the nine months ended September 30, 2013, we foreclosed on nine loans with a carrying value of $3.5 million. We did not transfer any portfolio loans to the held-for-sale category and no portfolio loans were sold during the nine months ended September 30, 2013. In June 2013, we purchased an auto loan portfolio for $21.6 million, which included a $0.8 million premium over the $20.8 million outstanding balance. At the time of purchase, the auto loan portfolio had a weighted average remaining term of 76 months. During the nine months ended September 30, 2013, we also purchased participation interests in student loans totaling $15.5 million, which represented the outstanding balance at the time of purchase. At the time of purchases, the student loans had a weighted average remaining term of 122 months.

 
12

 
Impaired Loans

The following table presents by class, the balance in the allowance for loan and lease losses and the recorded investment in loans and leases based on the Company’s impairment measurement method as of September 30, 2014 and December 31, 2013:
 
 
Commercial,
   
Real Estate
                   
 
Financial & Agricultural
   
Construction
   
Mortgage - Residential
   
Mortgage - Commercial
   
Consumer
   
Leases
   
Total
 
 
(Dollars in thousands)
 
September 30, 2014
                                       
Allowance for loan and lease losses:
                                       
   Ending balance attributable to loans:
                                       
      Individually evaluated for impairment
$ 2,778     $ -     $ -     $ -     $ -     $ -     $ 2,778  
      Collectively evaluated for impairment
  9,086       14,897       19,269       24,527       8,269       12       76,060  
    11,864       14,897       19,269       24,527       8,269       12       78,838  
      Unallocated
                                                  4,000  
         Total ending balance
$ 11,864     $ 14,897     $ 19,269     $ 24,527     $ 8,269     $ 12     $ 82,838  
                                                       
Loans and leases:
                                                     
   Individually evaluated for impairment
$ 15,998     $ 5,017     $ 30,671     $ 23,727     $ -     $ -     $ 75,413  
   Collectively evaluated for impairment
  425,699       104,600       1,219,046       673,721       371,693       3,691       2,798,450  
    441,697       109,617       1,249,717       697,448       371,693       3,691       2,873,863  
   Net deferred costs (income)
  634       (377 )     2,091       (874 )     (582 )     -       892  
         Total ending balance
$ 442,331     $ 109,240     $ 1,251,808     $ 696,574     $ 371,111     $ 3,691     $ 2,874,755  
                                                       
December 31, 2013
                                                     
Allowance for loan and lease losses:
                                                     
   Ending balance attributable to loans:
                                                     
      Individually evaluated for impairment
$ 349     $ -     $ -     $ -     $ -     $ -     $ 349  
      Collectively evaluated for impairment
  12,847       2,774       25,272       29,947       6,576       55       77,471  
    13,196       2,774       25,272       29,947       6,576       55       77,820  
      Unallocated
                                                  6,000  
         Total ending balance
$ 13,196     $ 2,774     $ 25,272     $ 29,947     $ 6,576     $ 55     $ 83,820  
                                                       
Loans and leases:
                                                     
   Individually evaluated for impairment
$ 3,939     $ 8,065     $ 36,779     $ 16,271     $ -     $ -     $ 65,054  
   Collectively evaluated for impairment
  394,426       67,862       1,098,376       687,529       311,670       6,241       2,566,104  
    398,365       75,927       1,135,155       703,800       311,670       6,241       2,631,158  
   Net deferred costs (income)
  351       (311 )     1,418       (1,033 )     (982 )     -       (557 )
         Total ending balance
$ 398,716     $ 75,616     $ 1,136,573     $ 702,767     $ 310,688     $ 6,241     $ 2,630,601  
 
 
13

 
The following table presents by class, impaired loans as of September 30, 2014 and December 31, 2013:
 
 
Unpaid Principal Balance
   
Recorded
Investment
   
Allowance
Allocated
 
(Dollars in thousands)
September 30, 2014
             
Impaired loans with no related allowance recorded:
             
Commercial, financial & agricultural
$ 3,113     $ 3,113     $ -
Real estate:
                   
   Construction
  11,404       5,017       -
   Mortgage - residential
  33,909       30,671       -
   Mortgage - commercial
  30,850       23,727       -
      Total impaired loans with no related allowance recorded
  79,276       62,528       -
Impaired loans with an allowance recorded:
                   
Commercial, financial & agricultural
  14,353       12,885       2,778
      Total impaired loans with an allowance recorded
  14,353       12,885       2,778
Total
$ 93,629     $ 75,413     $ 2,778
                     
December 31, 2013
                   
Impaired loans with no related allowance recorded:
                   
Commercial, financial & agricultural
$ 1,069     $ 1,040     $ -
Real estate:
                   
   Construction
  14,451       8,065       -
   Mortgage - residential
  41,117       36,779       -
   Mortgage - commercial
  22,353       16,271       -
      Total impaired loans with no related allowance recorded
  78,990       62,155       -
Impaired loans with an allowance recorded:
                   
Commercial, financial & agricultural
  4,367       2,899       349
      Total impaired loans with an allowance recorded
  4,367       2,899       349
Total
$ 83,357     $ 65,054     $ 349
 
The following table presents by class, the average recorded investment and interest income recognized on impaired loans for the three and nine months ended September 30, 2014 and 2013:
 
 
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
2014
   
2013
   
2014
   
2013
 
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
 
(Dollars in thousands)
Commercial, financial
                                           
   & agricultural
$ 16,377     $ 6     $ 4,104     $ 6     $ 14,031     $ 17     $ 4,189     $ 18
Real estate:
                                                           
   Construction
  5,088       43       20,812       942       5,712       119       28,149       1,409
   Mortgage - residential
  31,460       85       36,151       15       33,762       522       38,840       343
   Mortgage - commercial
  19,195       137       19,513       350       17,147       252       22,355       532
Leases
  -        -       -       -       -       -       43       -
Total
$ 72,120     $ 271     $ 80,580     $ 1,313     $ 70,652     $ 910     $ 93,576     $ 2,302
 
 
14

 
Aging Analysis of Accruing and Non-Accruing Loans and Leases

For all loan types, the Company determines delinquency status by considering the number of days full payments required by the contractual terms of the loan are past due. The following table presents by class, the aging of the recorded investment in past due loans and leases as of September 30, 2014 and December 31, 2013:
 
 
Accruing Loans 30 - 59 Days Past Due
   
Accruing Loans 60 - 89 Days Past Due
   
Accruing Loans
Greater Than 90
Days Past Due
   
Nonaccrual
Loans
   
Total
Past Due and Nonaccrual
   
Loans and
Leases Not
Past Due
   
Total
 
(Dollars in thousands)
September 30, 2014
                                     
Commercial, financial &                                                    
   agricultural
$ 633     $ 151     $ -     $ 15,625     $ 16,409     $ 425,922     $ 442,331
Real estate:
                                                   
   Construction
  -       -       -       324       324       108,916       109,240
   Mortgage - residential
  199       1,168       -       12,691       14,058       1,237,750       1,251,808
   Mortgage - commercial
  -       273       -       13,056       13,329       683,245       696,574
Consumer
  1,115       494       62       -       1,671       369,440       371,111
Leases
  -       -       -       -       -       3,691       3,691
   Total
$ 1,947     $ 2,086     $ 62     $ 41,696     $ 45,791     $ 2,828,964     $ 2,874,755
                                                     
December 31, 2013
                                                   
Commercial, financial &                                                    
   agricultural
$ 50     $ -     $ -     $ 3,533     $ 3,583     $ 395,133     $ 398,716
Real estate:
                                                   
   Construction
  -       120       -       4,015       4,135       71,481       75,616
   Mortgage - residential
  3,898       1,885       -       20,271       26,054       1,110,519       1,136,573
   Mortgage - commercial
  544       -       -       13,769       14,313       688,454       702,767
Consumer
  577       92       -       -       669       310,019       310,688
Leases
  -       -       15       -       15       6,226       6,241
   Total
$ 5,069     $ 2,097     $ 15     $ 41,588     $ 48,769     $ 2,581,832     $ 2,630,601
 
Modifications

Troubled debt restructurings (“TDRs”) included in nonperforming assets at September 30, 2014 consisted of 39 Hawaii residential mortgage loans with a combined principal balance of $7.6 million, a Hawaii commercial loan with a principal balance of $0.4 million, and a Hawaii construction and development loan with a principal balance of $0.2 million. Concessions made to the original contractual terms of these loans consisted primarily of the deferral of interest and/or principal payments due to deterioration in the borrowers’ financial condition. The principal balances on these TDRs had matured and/or were in default at the time of restructure and we have no commitments to lend additional funds to any of these borrowers. There were $29.9 million of TDRs still accruing interest at September 30, 2014, none of which were more than 90 days delinquent. At December 31, 2013, there were $23.3 million of TDRs still accruing interest, none of which were more than 90 days delinquent.

Some loans modified in a TDR may already be on nonaccrual status and partial charge-offs may have already been taken against the outstanding loan balance. Thus, these loans have already been identified as impaired and have already been evaluated under the Company’s allowance for loan and lease losses (the “Allowance”) methodology. As a result, some loans modified in a TDR may have the financial effect of increasing the specific allowance associated with the loan. The loans modified in a TDR did not have a material effect to our provision for loan and lease losses expense (the “Provision”) and the Allowance during the three and nine months ended September 30, 2014.

 
15

 
The following table presents by class, information related to loans modified in a TDR during the three and nine months ended September 30, 2014 and 2013.
 
 
Number of Contracts
   
Recorded Investment (as of Period End)
   
Increase in the Allowance
 
(Dollars in thousands)
Three Months Ended September 30, 2014
             
Real estate mortgage - residential
3     $ 220     $ -
                   
Three Months Ended September 30, 2013
                 
Real estate:
                 
   Mortgage - residential
1     $ 241     $ -
   Mortgage - commercial
1       9,099       -
   Total
2     $ 9,340     $ -
                   
Nine Months Ended September 30, 2014
                 
Real estate mortgage - residential
12     $ 806     $ -
                   
Nine Months Ended September 30, 2013
                 
Commercial, financial & agricultural
1     $ 564     $ -
Real estate:
                 
   Construction
1       184       -
   Mortgage - residential
4       1,860       -
   Mortgage - commercial
1       9,099       -
   Total
7     $ 11,707     $ -
 
The following table presents by class, loans modified as a TDR within the previous twelve months that subsequently defaulted during the nine months ended September 30, 2013. No loans were modified as a TDR within the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2014 and the three months ended September 30, 2013.
 
 
Nine Months Ended
 
September 30, 2013
 
Number of
Contracts
   Recorded Investment (as of Period End)
 
(Dollars in thousands)
         
Real estate mortgage - residential
                     1
  $
354
 
Credit Quality Indicators

The Company categorizes loans and leases into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans and leases individually by classifying the loans and leases as to credit risk. This analysis includes non-homogeneous loans and leases, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

Special Mention. Loans and leases classified as special mention, while still adequately protected by the borrower’s capital adequacy and payment capability, exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

Substandard. Loans and leases classified as substandard are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.
 
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Doubtful. Loans and leases classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or orderly repayment in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimate loss is deferred until its more exact status may be determined.

Loss. Loans and leases classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

Loans and leases not meeting the criteria above are considered to be pass rated. The following table presents by class and credit indicator, the recorded investment in the Company’s loans and leases as of September 30, 2014 and December 31, 2013:
 
 
Pass
   
Special
Mention
   
Substandard
   
Subtotal
   
Net Deferred
Costs (Income)
   
Total
 
(Dollars in thousands)
September 30, 2014
                               
Commercial, financial & agricultural
$ 412,141     $ 10,361     $ 19,195     $ 441,697     $ 634     $ 442,331
Real estate:
                                           
   Construction
  105,739       -       3,878       109,617       (377 )     109,240
   Mortgage - residential
  1,235,974       437       13,306       1,249,717       2,091       1,251,808
   Mortgage - commercial
  660,795       4,909       31,744       697,448       (874 )     696,574
Consumer
  371,381       -       312       371,693       (582 )     371,111
Leases
  3,691       -       -       3,691       -       3,691
   Total
$ 2,789,721     $ 15,707     $ 68,435     $ 2,873,863     $ 892     $ 2,874,755
                                             
December 31, 2013
                                           
Commercial, financial & agricultural
$ 371,285     $ 21,511     $ 5,569     $ 398,365     $ 351     $ 398,716
Real estate:
                                           
   Construction
  67,435       4,477       4,015       75,927       (311 )     75,616
   Mortgage - residential
  1,113,363       361       21,431       1,135,155       1,418       1,136,573
   Mortgage - commercial
  651,761       20,690       31,349       703,800       (1,033 )     702,767
Consumer
  311,670       -       -       311,670       (982 )     310,688
Leases
  6,241       -       -       6,241       -       6,241
   Total
$ 2,521,755     $ 47,039     $ 62,364     $ 2,631,158     $ (557 )   $ 2,630,601
 
In accordance with applicable Interagency Guidance issued by our primary bank regulators, we define subprime borrowers as typically having weakened credit histories that include payment delinquencies and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers. At September 30, 2014 and December 31, 2013, we did not have any loans that we considered to be subprime.

 
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6.   ALLOWANCE FOR LOAN AND LEASE LOSSES

The following table presents by class, the activity in the Allowance for the periods indicated:
 
 
Commercial,
   
Real estate
                         
 
Financial &
         
Mortgage -
   
Mortgage -
                         
 
Agricultural
   
Construction
   
Residential
   
Commercial
   
Consumer
   
Leases
   
Unallocated
   
Total
 
 
(Dollars in thousands)
 
Three Months Ended September 30, 2014
                                           
Beginning balance
$ 12,255     $ 15,525     $ 19,198     $ 25,885     $ 6,723     $ 13     $ 4,000     $ 83,599  
Provision (credit) for loan                                                              
   and lease losses
  (760 )     (1,728 )     (173 )     (1,372 )     2,313       (2 )     -       (1,722 )
    11,495       13,797       19,025       24,513       9,036       11       4,000       81,877  
Charge-offs
  408       -       -       -       991       -       -       1,399  
Recoveries
  777       1,100       244       14       224       1       -       2,360  
   Net charge-offs (recoveries)
  (369 )     (1,100 )     (244 )     (14 )     767       (1 )     -       (961 )
   Ending balance
$ 11,864     $ 14,897     $ 19,269     $ 24,527     $ 8,269     $ 12     $ 4,000     $ 82,838  
                                                               
Three Months Ended September 30, 2013
                                                         
Beginning balance
$ 9,653     $ 6,460     $ 23,323     $ 37,751     $ 3,848     $ 70     $ 6,000     $ 87,105  
Provision (credit) for loan                                                              
   and lease losses
  3,385       (2,505 )     1,236       (6,581 )     1,292       (16 )     -       (3,189 )
    13,038       3,955       24,559       31,170       5,140       54       6,000       83,916  
Charge-offs
  360       3       63       -       466       -       -       892  
Recoveries
  259       569       91       1,137       146       2       -       2,204  
   Net charge-offs (recoveries)
  101       (566 )     (28 )     (1,137 )     320       (2 )     -       (1,312 )
   Ending balance
$ 12,937     $ 4,521     $ 24,587     $ 32,307     $ 4,820     $ 56     $ 6,000     $ 85,228  
                                                               
Nine Months Ended September 30, 2014
                                                         
Beginning balance
$ 13,196     $ 2,774     $ 25,272     $ 29,947     $ 6,576     $ 55     $ 6,000     $ 83,820  
Provision (credit) for loan                                                              
   and lease losses
  (1,298 )     10,279       (6,731 )     (4,419 )     3,167       (41 )     (2,000 )     (1,043 )
    11,898       13,053       18,541       25,528       9,743       14       4,000       82,777  
Charge-offs
  1,963       -       139       1,041       2,242       8       -       5,393  
Recoveries
  1,929       1,844       867       40       768       6       -       5,454  
   Net charge-offs (recoveries)
  34       (1,844 )     (728 )     1,001       1,474       2       -       (61 )
   Ending balance
$ 11,864     $ 14,897     $ 19,269     $ 24,527     $ 8,269     $ 12     $ 4,000     $ 82,838  
                                                               
Nine Months Ended September 30, 2013
                                                         
Beginning balance
$ 4,987     $ 4,510     $ 27,836     $ 50,574     $ 2,421     $ 85     $ 6,000     $ 96,413  
Provision (credit) for loan                                                              
   and lease losses
  9,230       (2,432 )     (2,957 )     (16,687 )     2,903       (34 )     -       (9,977 )
    14,217       2,078       24,879       33,887       5,324       51       6,000       86,436  
Charge-offs
  2,201       358       857       3,674       1,023       -       -       8,113  
Recoveries
  921       2,801       565       2,094       519       5       -       6,905  
   Net charge-offs (recoveries)
  1,280       (2,443 )     292       1,580       504       (5 )     -       1,208  
   Ending balance
$ 12,937     $ 4,521     $ 24,587     $ 32,307     $ 4,820     $ 56     $ 6,000     $ 85,228  
 
In accordance with GAAP, loans held for sale and other real estate assets are not included in our assessment of the Allowance.

Our Provision was credits of $1.7 million and $1.0 million in the third quarter and first nine months of 2014, respectively, compared to credits of $3.2 million and $10.0 million in the third quarter and first nine months of 2013, respectively.

In determining the amount of our Allowance, we rely on an analysis of our loan portfolio, our experience and our evaluation of general economic conditions, as well as regulatory requirements and input. If our assumptions prove to be incorrect, our current Allowance may not be sufficient to cover future loan losses and we may experience significant increases to our Provision.

 
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7.   SECURITIZATIONS

In prior years, we securitized certain residential mortgage loans with a U.S. Government sponsored entity and continue to service the residential mortgage loans. The servicing assets were recorded at their respective fair values at the time of securitization.

All unsold mortgage-backed securities from prior securitizations were categorized as available for sale securities and were therefore recorded at their fair value of $3.8 million at September 30, 2014 and December 31, 2013. The fair values of these mortgage-backed securities were based on quoted prices of similar instruments in active markets. Unrealized gains of $0.2 million on unsold mortgage-backed securities were recorded in accumulated other comprehensive income (“AOCI”) at September 30, 2014 and December 31, 2013.

8.   OTHER INTANGIBLE ASSETS

Other intangible assets include a core deposit premium and mortgage servicing rights. The following table presents changes in other intangible assets for the nine months ended September 30, 2014:
 
   
Core
   
Mortgage
       
   
Deposit
   
Servicing
       
   
Premium
   
Rights
   
Total
 
   
(Dollars in thousands)
 
                   
Balance, beginning of period
  $ 12,704     $ 20,079     $ 32,783  
Additions
    -       1,601       1,601  
Amortization
    (2,006 )     (1,880 )     (3,886 )
Balance, end of period
  $ 10,698     $ 19,800     $ 30,498  
 
Income generated as the result of new mortgage servicing rights is reported as gains on sales of loans and totaled $0.7 million and $1.6 million for the three and nine months ended September 30, 2014, respectively, compared to $0.5 million and $2.1 million for the three and nine months ended September 30, 2013, respectively. Amortization of mortgage servicing rights was $0.7 million and $1.9 million for the three and nine months ended September 30, 2014, respectively, compared to $1.0 million and $4.0 million for the three and nine months ended September 30, 2013, respectively.

The following table presents the fair market value and key assumptions used in determining the fair market value of our mortgage servicing rights:
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
(Dollars in thousands)
 
             
Fair market value, beginning of period
  $ 21,399     $ 22,356  
Fair market value, end of period
    20,471       20,763  
Weighted average discount rate
    9.5 %     8.0 %
Weighted average prepayment speed assumption
    12.9       14.2  
 
The gross carrying value and accumulated amortization related to our intangible assets are presented below:
 
 
September 30, 2014
   
December 31, 2013
 
Gross
               
Gross
           
 
Carrying
   
Accumulated
         
Carrying
   
Accumulated
     
 
Value
   
Amortization
   
Net
   
Value
   
Amortization
   
Net
 
(Dollars in thousands)
                                 
Core deposit premium
$ 44,642     $ (33,944 )   $ 10,698     $ 44,642     $ (31,938 )   $ 12,704
Mortgage servicing rights
  56,042       (36,242 )     19,800       54,441       (34,362 )     20,079
  $ 100,684     $ (70,186 )   $ 30,498     $ 99,083     $ (66,300 )   $ 32,783
 
 
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Based on the core deposit premium and mortgage servicing rights held as of September 30, 2014, estimated amortization expense for the remainder of fiscal 2014, the next five succeeding fiscal years and all years thereafter are as follows:
 
 
Estimated Amortization Expense
 
Core
   
Mortgage
     
 
Deposit
   
Servicing
     
 
Premium
   
Rights
   
Total
 
(Dollars in thousands)
               
2014 (remainder)
$ 669     $ 1,021     $ 1,690
2015
  2,674       2,205       4,879
2016
  2,674       1,691       4,365
2017
  2,674       1,344       4,018
2018
  2,007       1,067       3,074
2019
  -       843       843
Thereafter
  -       11,629       11,629
  $ 10,698     $ 19,800     $ 30,498
 
We perform an impairment assessment of our other intangible assets whenever events or changes in circumstance indicate that the carrying value of those assets may not be recoverable. Our impairment assessments involve, among other valuation methods, the estimation of future cash flows and other methods of determining fair value. Estimating future cash flows and determining fair values is subject to judgment and often involves the use of significant estimates and assumptions. The variability of the factors we use to perform our impairment tests depend on a number of conditions, including the uncertainty about future events and cash flows. All such factors are interdependent and, therefore, do not change in isolation. Accordingly, our accounting estimates may materially change from period to period due to changing market factors.

9.   DERIVATIVES

We utilize various designated and undesignated derivative financial instruments to reduce our exposure to movements in interest rates including interest rate swaps, interest rate lock commitments and forward sale commitments. We measure all derivatives at fair value on our consolidated balance sheet. In each reporting period, we record the derivative instruments in other assets or other liabilities depending on whether the derivatives are in an asset or liability position. For derivative instruments that are designated as hedging instruments, we record the effective portion of the changes in the fair value of the derivative in AOCI, net of tax, until earnings are affected by the variability of cash flows of the hedged transaction. We immediately recognize the portion of the gain or loss in the fair value of the derivative that represents hedge ineffectiveness in current period earnings. For derivative instruments that are not designated as hedging instruments, changes in the fair value of the derivative are included in current period earnings.

Interest Rate Lock and Forward Sale Commitments

We enter into interest rate lock commitments on certain mortgage loans that are intended to be sold. To manage interest rate risk on interest rate lock commitments, we also enter into forward loan sale commitments. The interest rate locks and forward loan sale commitments are accounted for as undesignated derivatives and are recorded at their respective fair values in other assets or other liabilities, with changes in fair value recorded in current period earnings. These instruments serve to reduce our exposure to movements in interest rates. At September 30, 2014, we were a party to interest rate lock and forward sale commitments on $44.7 million and $21.4 million of mortgage loans, respectively.

The following table presents the location of all assets and liabilities associated with our derivative instruments within the consolidated balance sheet:
 
       
Asset Derivatives
 
Liability Derivatives
Derivatives Not Designated
as Hedging Instruments
 
Balance Sheet
Location
 
Fair Value at
September 30, 2014
 
Fair Value at
December 31, 2013
 
Fair Value at
September 30, 2014
 
Fair Value at
December 31, 2013
       
(Dollars in thousands)
Interest rate contracts
 
Other assets /
               
   
other liabilities
  $ 583   $ 425   $ 76   $ 146
 
 
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The following table presents the impact of derivative instruments and their location within the consolidated statements of income:
 
Derivatives in Cash Flow
Hedging Relationship
 
Amount of Loss Reclassified
from AOCI into Earnings
(Effective Portion)
   
(Dollars in thousands)
Three Months Ended September 30, 2014
   
Interest rate contracts
  $ -
       
Three Months Ended September 30, 2013
     
Interest rate contracts
    -
       
Nine Months Ended September 30, 2014
     
Interest rate contracts
    -
       
Nine Months Ended September 30, 2013
     
Interest rate contracts
    (394)
 
Amounts recognized in AOCI are net of income taxes. Amounts reclassified from AOCI into income are included in interest income in the consolidated statements of income. The ineffective portion has been recognized as other operating income in the consolidated statements of income.
 
Derivatives Not in Cash Flow
Hedging Relationship
 
Location of Gain Recognized
in Earnings on Derivatives
 
Amount of Gain Recognized
in Earnings on Derivatives
       
(Dollars in thousands)
Three Months Ended September 30, 2014
       
Interest rate contracts
 
 Other operating income
  $ 66
           
Three Months Ended September 30, 2013
         
Interest rate contracts
 
 Other operating income
    1,034
           
Nine Months Ended September 30, 2014
         
Interest rate contracts
 
 Other operating income
    419
           
Nine Months Ended September 30, 2013
         
Interest rate contracts
 
 Other operating income
    503
 
10.   SHORT-TERM BORROWINGS AND LONG-TERM DEBT

At September 30, 2014, our bank maintained a $34.4 million line of credit with the Federal Reserve discount window, of which there were no advances outstanding. As of September 30, 2014, certain commercial and commercial real estate loans totaling $73.4 million have been pledged as collateral on our line of credit with the Federal Reserve discount window. The Federal Reserve does not have the right to sell or repledge these loans.

The bank is a member of the Federal Home Loan Bank of Seattle (the “FHLB”) and maintained a $934.6 million line of credit with the FHLB as of September 30, 2014. There was no long-term and short-term borrowings under this arrangement at September 30, 2014, compared to long-term and short-term borrowings of $14,000 and $8.0 million at December 31, 2013, respectively. At September 30, 2014 the bank’s pledged assets to the FHLB included investment securities with a fair value of $1.0 million and certain real estate loans totaling $1.5 billion.

 
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On August 20, 2009, we began deferring regularly scheduled interest payments on our outstanding junior subordinated debentures relating to our trust preferred securities. The terms of the junior subordinated debentures and the trust documents allow us to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. During the deferral period, the respective trusts suspended the declaration and payment of dividends on the trust preferred securities. Also during the deferral period, we may not, among other things and with limited exceptions, pay cash dividends on or repurchase our common stock or make any payment on outstanding debt obligations that rank equally with or junior to the junior subordinated debentures. During the deferral period, we continued to accrue, and reflect in our consolidated financial statements, the deferred interest payments on our junior subordinated debentures. In March 2013, the Company elected to pay all deferred interest on its subordinated debentures and related dividend payments on its trust preferred securities and resume quarterly payments for each outstanding trust. As a result, the deferred accrued interest in the amount of $13.0 million was paid in full.
 
In June 2013, the Company was notified that $10.0 million of the $15.0 million in trust preferred securities of CPB Capital Trust I (the “Trust”) would be auctioned off as part of a larger pooled collateralized debt obligation liquidation. CPF placed a bid of $9.0 million for the securities which was accepted by the trustee and the transaction closed on June 18, 2013. Because our accepted bid of $9.0 million was less than the $10.0 million carrying value, we recognized a gain of $1.0 million related to this transaction on October 7, 2013, when these securities were called. The Company determined that its investment in the Trust did not represent a variable interest and therefore the Company is not the primary beneficiary of the Trust. As a result, consolidation of the Trust by the Company was not required. In October 2013, the Company called the remaining $5.0 million in trust preferred securities of the Trust and in April 2014, the remaining $0.5 million in common stock of the Trust was called. On August 27, 2014, Trust I was cancelled with the state of Delaware.

11.   EQUITY

In June 2013, the U.S. Treasury held a private auction to sell its warrant positions in several financial institutions which included the Company’s warrant to purchase up to 79,288 shares of our common stock at a purchase price of $10 per share. On June 6, 2013, we were notified that we were the winning bidder of the warrant at our bid of $752 thousand. The warrant was being carried as a derivative liability on our balance sheet at $828 thousand at March 31, 2013. Accordingly, we recorded a credit to other noninterest expense of $76 thousand during the first quarter of 2013 related to the gain on the purchase of the warrant. After the completion of this transaction, the U.S. Treasury no longer holds any outstanding shares of our common stock, or any warrants to purchase our common stock they received in connection with our participation in the Troubled Assets Relief Program.

We have generated considerable tax benefits, including net operating loss carry-forwards and federal and state tax credits. Our use of the tax benefits in the future would be significantly limited if we experience an “ownership change” for U.S. federal income tax purposes. In general, an “ownership change” will occur if there is a cumulative increase in the Company’s ownership by “5-percent shareholders” (as defined under U.S. income tax laws) that exceeds 50 percentage points over a rolling three-year period.

On November 23, 2010, our Board of Directors declared a dividend of preferred share purchase rights (“Rights”) in respect to our common stock which were issued pursuant to a Tax Benefits Preservation Plan, dated as of November 23, 2010 (the “Tax Benefits Preservation Plan”), between the Company and Wells Fargo Bank, National Association, as rights agent. Each Right represents the right to purchase, upon the terms and subject to the conditions in the Plan, 1/10,000th of a share of our Junior Participating Preferred Stock, Series C, no par value, for $6.00, subject to adjustment. The Tax Benefits Preservation Plan is designed to reduce the likelihood that the Company will experience an ownership change by discouraging any person from becoming a beneficial owner of 4.99% or more of our common stock (a “Threshold Holder”). On January 29, 2014, our Board of Directors approved an amendment to the Tax Benefits Preservation Plan to extend it for up to an additional two years (until February 18, 2016).

To further protect our tax benefits, on January 26, 2011, our Board of Directors approved an amendment to our restated articles of incorporation to restrict transfers of our stock if the effect of an attempted transfer would cause the transferee to become a Threshold Holder or to cause the beneficial ownership of a Threshold Holder to increase (the “Protective Charter Amendment”). At our annual meeting of shareholders on April 27, 2011, we proposed the amendment which shareholders approved. On January 29, 2014, our Board of Directors approved an amendment to the Protective Charter Amendment to extend it for up to an additional two years (until May 2, 2016). Our shareholders approved the Protective Charter Amendment on April 25, 2014. There is no guarantee, however, that the Tax Benefits Preservation Plan or the Protective Charter Amendment will prevent the Company from experiencing an ownership change.

 
22

 
In 2009, our Board of Directors suspended the payment of all cash dividends on our common stock. Our ability to pay dividends with respect to common stock was restricted until our obligations under our trust preferred securities were brought current. Additionally, our ability to pay dividends depends on our ability to obtain dividends from our bank. As a Hawaii state-chartered bank, Central Pacific Bank may only pay dividends to the extent it has retained earnings as defined under Hawaii banking law (“Statutory Retained Earnings”), which differs from GAAP retained earnings. As of September 30, 2014, the bank had Statutory Retained Earnings of $118.8 million. In 2013, in light of the Company's improved capital position and financial condition, our Board of Directors and management, in consultation with our regulators, reinstated and declared quarterly cash dividends on the Company’s outstanding common stock.

Dividends are payable at the discretion of the Board of Directors and there can be no assurance that the Board of Directors will continue to pay dividends at the same rate, or at all, in the future. Our ability to pay cash dividends to our shareholders is subject to restrictions under federal and Hawaii law, including restrictions imposed by the FRB and covenants set forth in various agreements we are a party to, including covenants set forth in our subordinated debentures.

On February 21, 2014, we announced a tender offer to purchase for cash up to $68.8 million in value of shares of our common stock at a price not greater than $21.00 nor less than $18.50 per share (the “Tender Offer”).
 
The Tender Offer expired on March 21, 2014 and 3,369,850 shares of our common stock were properly tendered and not withdrawn at or below the purchase price of $20.20 per share (“Purchase Price”). In addition, 167,572 shares were tendered through notice of guaranteed delivery at or below the Purchase Price. Based on these results, we accepted for purchase 3,405,888 shares, at the Purchase Price for a total cost of $68.8 million, excluding fees and expenses related to the Tender Offer. The Tender Offer closed on March 28, 2014.

Due to the oversubscription of the Tender Offer, we accepted for purchase on a pro rata basis approximately 96.6% of the shares properly tendered and not properly withdrawn at or below the Purchase Price by each tendering shareholder, except for tenders of odd lots, which were accepted in full, and except for certain conditional tenders automatically regarded as withdrawn pursuant to the terms of the Tender Offer.

On February 20, 2014, we also entered into repurchase agreements (the “Repurchase Agreements”) with each of Carlyle Financial Services Harbor, L.P. (“Carlyle”) and ACMO-CPF, L.L.C. (“Anchorage” and together with Carlyle, the “Lead Investors”), each of whom was the owner of 9,463,095 shares (representing 22.5% of the outstanding shares or 44.9% in the aggregate at that time) of our common stock, pursuant to which we agreed to purchase up to $28.1 million of shares of common stock from each of the Lead Investors at the Purchase Price of the Tender Offer (the “Private Repurchases”) (or an aggregate of $56.2 million of shares). Conditions to the Private Repurchases were satisfied and we purchased 1,391,089 shares from each of Carlyle and Anchorage at the Purchase Price for a total cost of $56.2 million, excluding fees and expenses related to the Private Repurchases. The Private Repurchases closed on April 7, 2014, the eleventh business day following the expiration of the Tender Offer.

The completion of the Tender Offer and the Private Repurchases resulted in the aggregate repurchase by us of 6,188,066 shares totaling $125 million, or 14.7% of our issued and outstanding shares of our common stock prior to the completion of the Tender Offer and the Private Repurchases. Upon completion of the Tender Offer and Private Repurchases, we had approximately 35.9 million shares outstanding.

In January 2008, our Board of Directors authorized the repurchase and retirement of up to 60,000 shares of the Company’s common stock (the “2008 Repurchase Plan”). Repurchases under the 2008 Repurchase Plan may be made from time to time on the open market or in privately negotiated transactions. A total of 55,000 shares remained available for repurchase under the 2008 Repurchase Plan at December 31, 2013. In January 2014, the 2008 Repurchase Plan and the remaining 55,000 shares were superseded by the Tender Offer and Repurchase Agreements with our Lead Investors.

On May 20, 2014, our Board of Directors authorized the repurchase and retirement of up to $30.0 million of the Company’s outstanding common stock (the “2014 Repurchase Plan”). Repurchases under the 2014 Repurchase Plan may be made from time to time on the open market or in privately negotiated transactions. In the second quarter of 2014, 181,200 shares of common stock, at a cost of $3.4 million, were repurchased under this program. We did not repurchase any shares in the third quarter of 2014. A total of $26.6 million remained available for repurchase under the 2014 Repurchase Plan at September 30, 2014.

 
23

 
12.   SHARE-BASED COMPENSATION
 
Restricted Stock Awards and Units

The table below presents the activity of restricted stock awards and units for the nine months ended September 30, 2014:
 
       
Weighted Average
       
Grant Date
 
Shares
   
Fair Value
         
Nonvested at January 1, 2014
835,904     $ 14.75
Changes during the period:
         
  Granted
191,465       18.58
  Vested
(270,040 )     14.84
  Forfeited
(35,368 )     14.62
Nonvested at September 30, 2014
721,961       15.74
 
13.   ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
 
The following table presents the components of other comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013, by component:
 
 
Before Tax
   
Tax Effect
   
Net of Tax
 
 
(Dollars in thousands)
 
Three Months Ended September 30, 2014
               
Net unrealized losses on investment securities:
               
Net unrealized losses arising during the period
$ (2,562 )   $ (897 )   $ (1,665 )
                       
Defined benefit plans:
                     
Amortization of net actuarial losses
  305       100       205  
Amortization of net transition obligation
  4       1       3  
Amortization of prior service cost
  5       1       4  
Defined benefit plans, net
  314       102       212  
                       
Other comprehensive loss
$ (2,248 )   $ (795 )   $ (1,453 )
                       
Three Months Ended September 30, 2013
                     
Net unrealized gains on investment securities:
                     
Net unrealized gains arising during the period
$ 5,476     $ 2,809     $ 2,667  
                       
Defined benefit plans:
                     
Amortization of net actuarial losses
  617       248       369  
Amortization of net transition obligation
  4       1       3  
Amortization of prior service cost
  5       2       3  
Defined benefit plans, net
  626       251       375  
                       
Other comprehensive income
$ 6,102     $ 3,060     $ 3,042  
 
 
24

 
 
Before Tax
   
Tax Effect
   
Net of Tax
 
 
(Dollars in thousands)
 
Nine Months Ended September 30, 2014
               
Net unrealized gains on investment securities:
               
Net unrealized gains arising during the period
$ 29,323     $ 11,744     $ 17,579  
Less: Reclassification adjustment for losses realized in net income
  1,071       429       642  
Net unrealized gains on investment securities
  30,394       12,173       18,221  
                       
Defined benefit plans:
                     
Amortization of net actuarial losses
  915       343       572  
Amortization of net transition obligation
  12       5       7  
Amortization of prior service cost
  15       5       10  
Defined benefit plans, net
  942       353       589  
                       
Other comprehensive income
$ 31,336     $ 12,526     $ 18,810  
                       
Nine Months Ended September 30, 2013
                     
Net unrealized losses on investment securities:
                     
Net unrealized losses arising during the period
$ (38,924 )   $ (13,668 )   $ (25,256 )
                       
Net unrealized gains on derivatives:
                     
Reclassification adjustment for losses realized in net income
  394       (10,599 )     10,993  
                       
Defined benefit plans:
                     
Amortization of net actuarial losses
  1,851       496       1,355  
Amortization of net transition obligation
  12       3       9  
Amortization of prior service cost
  15       4       11  
Defined benefit plans, net
  1,878       503       1,375  
                       
Other comprehensive loss
$ (36,652 )   $ (23,764 )   $ (12,888 )
 
 
 
25

 
The following table presents the changes in each component of AOCI, net of tax, for the three and nine months ended September 30, 2014 and 2013:
 
             
Defined
   
Accumulated Other
 
 
Investment
         
Benefit
   
Comprehensive
 
 
Securities
   
Derivatives
   
Plans
   
Income (Loss)
 
 
(Dollars in thousands)
 
Three Months Ended September 30, 2014
                     
Balance at beginning of period
$ 10,761     $ -     $ (6,343 )   $ 4,418  
                               
Other comprehensive loss before reclassifications
  (1,665 )     -       -       (1,665 )
Amounts reclassified from AOCI
  -       -       212       212  
   Total other comprehensive income (loss)
  (1,665 )     -       212       (1,453 )
                               
Balance at end of period
$ 9,096     $ -     $ (6,131 )   $ 2,965  
                               
Three Months Ended September 30, 2013
                             
Balance at beginning of period
$ (5,183 )   $ -     $ (11,577 )   $ (16,760 )
                               
Other comprehensive income before reclassifications
  2,667       -       -       2,667  
Amounts reclassified from AOCI
  -       -       375       375  
   Total other comprehensive income
  2,667       -       375       3,042  
                               
Balance at end of period
$ (2,516 )   $ -     $ (11,202 )   $ (13,718 )
                               
Nine Months Ended September 30, 2014
                             
Balance at beginning of period
$ (9,125 )   $ -     $ (6,720 )   $ (15,845 )
                               
Other comprehensive income before reclassifications
  17,579       -       -       17,579  
Amounts reclassified from AOCI
  642       -       589       1,231  
   Total other comprehensive income
  18,221       -       589       18,810  
                               
Balance at end of period
$ 9,096     $ -     $ (6,131 )   $ 2,965  
                               
Nine Months Ended September 30, 2013
                             
Balance at beginning of period
$ 22,740     $ (10,993 )   $ (12,577 )   $ (830 )
                               
Other comprehensive loss before reclassifications
  (25,256 )     -       -       (25,256 )
Amounts reclassified from AOCI
  -       10,993       1,375       12,368  
   Total other comprehensive income (loss)
  (25,256 )     10,993       1,375       (12,888 )
                               
Balance at end of period
$ (2,516 )   $ -     $ (11,202 )   $ (13,718 )
 
 
26

 
The following table presents the amounts reclassified out of each component of AOCI for the three and nine months ended September 30, 2014 and 2013:
 
Details about AOCI Components
 
Amount Reclassified
from AOCI
   
Affected Line Item in the Statement Where Net Income is Presented
   
Three Months Ended September 30,
     
   
2014
   
2013
     
   
(Dollars in thousands)
     
Amortization of defined benefit plan items
               
   Net actuarial losses
  $ (305 )   $ (617 )   (1)
   Net transition obligation
    (4 )     (4 )   (1)
   Prior service cost
    (5 )     (5 )   (1)
      (314 )     (626 )  
Total before tax
      102       251    
Tax benefit
Total reclassifications for the period
  $ (212 )   $ (375 )  
Net of tax
                     
   
Nine Months Ended September 30,
     
      2014       2013      
                     
Sale of investment securities available for sale
  $ (1,071 )   $ -    
Investment securities gains
      429       -    
Tax benefit
    $ (642 )   $ -    
Net of tax
                     
Unrealized losses on derivatives
  $ -     $ (394 )  
Interest income
      -       (10,599 )  
Tax expense
    $ -     $ (10,993 )  
Net of tax
                     
Amortization of defined benefit plan items
                   
   Net actuarial losses
  $ (915 )   $ (1,851 )   (1)
   Net transition obligation
    (12 )     (12 )   (1)
   Prior service cost
    (15 )     (15 )   (1)
      (942 )     (1,878 )  
Total before tax
      353       503    
Tax benefit
    $ (589 )   $ (1,375 )  
Net of tax
                     
Total reclassifications for the period
  $ (1,231 )   $ (12,368 )  
Net of tax
                     
(1) These accumulated other comprehensive income components are included in the computation of net periodic pension cost (see Note 14 for additional details).
 
 
27

 
14.   PENSION AND SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS
 
Central Pacific Bank has a defined benefit retirement plan (the “Pension Plan”) which covers certain eligible employees. The plan was curtailed effective December 31, 2002, and accordingly, plan benefits were fixed as of that date. The following table sets forth the components of net periodic benefit cost for the Pension Plan:
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30,
   
September 30,
 
 
2014
   
2013
   
2014
   
2013
 
 
(Dollars in thousands)
 
                       
Interest cost
$ 366     $ 348     $ 1,098     $ 1,044  
Expected return on assets
  (524 )     (470 )     (1,572 )     (1,410 )
Amortization of net actuarial losses
  304       599       912       1,797  
  Net periodic cost
$ 146     $ 477     $ 438     $ 1,431  
 
Our bank also established Supplemental Executive Retirement Plans (“SERPs”), which provide certain officers of our bank with supplemental retirement benefits. The following table sets forth the components of net periodic benefit cost for the SERPs:
 
 
Three Months Ended
   
Nine Months Ended
 
September 30,
   
September 30,
 
2014
   
2013
   
2014
   
2013
 
(Dollars in thousands)
                     
Interest cost
$ 113     $ 103     $ 339     $ 309
Amortization of net transition obligation
  4       4       12       12
Amortization of prior service cost
  5       5       15       15
Amortization of net actuarial losses
  1       18       3       54
  Net periodic cost
$ 123     $ 130     $ 369     $ 390
 
15.   INCOME AND FRANCHISE TAXES

In assessing the need for a valuation allowance on our deferred tax assets (“DTA”), management considers whether it is more likely than not that some portion or all of the DTA will not be realized. The ultimate realization of DTA is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable income and tax-planning strategies in making this assessment.

In the first quarter of 2013, the Company reversed a significant portion of the valuation allowance that was established against our net DTA during the third quarter of 2009. The valuation allowance was established during 2009 due to uncertainty at the time regarding our ability to generate sufficient future taxable income to fully realize the benefit of our net DTA. The quarter ended March 31, 2013 marked our ninth consecutive quarter of profitability. Based on this earnings performance trend, improvements in our financial condition, asset quality and capital ratios, and the expectation of continued profitability, the Company determined that it was more likely than not that a significant portion of our net DTA would be realized. The net impact of reversing the valuation allowance and recording the provision for income tax expense was a net income tax benefit of $119.8 million in the first quarter of 2013.

The Company recorded income tax expense of $5.2 million and $14.6 million in the third quarter and first nine months of 2014, respectively. Income tax expense in the third quarter of 2014 included a 2013 income tax return true-up adjustment of $0.9 million, which was primarily related to the premium paid on the repurchase of preferred stock of our two real estate investment trust subsidiaries in the third quarter of 2013. As of September 30, 2014, the remaining valuation allowance on our net DTA totaled $2.9 million. Net of this valuation allowance, as of September 30, 2014, the Company’s net DTA totaled $110.1 million, compared to $137.2 million as of December 31, 2013, and is included in other assets on our consolidated balance sheets.
 
 
28

 
16.   EARNINGS PER SHARE

The following table presents the information used to compute basic and diluted earnings per common share for the periods indicated:
 
 
Three Months Ended
   
Nine Months Ended
 
September 30,
   
September 30,
 
2014
   
2013
   
2014
   
2013
 
(In thousands, except per share data)
                     
Net income
$ 8,230     $ 10,204     $ 27,188     $ 161,780
                             
Weighted average shares outstanding - basic
  35,863       42,028       37,943       41,934
Dilutive effect of employee stock options and awards
  490       393       497       309
Dilutive effect of deferred salary restricted stock units
  -       -       -       2
Dilutive effect of Treasury warrants
  -       -       -       18
Weighted average shares outstanding - diluted
  36,353       42,421       38,440       42,263
                             
Basic earnings per share
$ 0.23     $ 0.24     $ 0.72     $ 3.86
Diluted earnings per share
$ 0.23     $ 0.24     $ 0.71     $ 3.83
 
A total of 13,864 potentially dilutive securities have been excluded from the dilutive share calculation for the three and nine months ended September 30, 2014, as their effect was antidilutive, compared to 24,937 for the three and nine months ended September 30, 2013.

17.   FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES

Disclosures about Fair Value of Financial Instruments

Fair value estimates, methods and assumptions are set forth below for our financial instruments.

Short-Term Financial Instruments

The carrying values of short-term financial instruments are deemed to approximate fair values. Such instruments are considered readily convertible to cash and include cash and due from banks, interest-bearing deposits in other banks, accrued interest receivable, short-term borrowings, and accrued interest payable.

Investment Securities

The fair value of investment securities is based on market price quotations received from securities dealers. Where quoted market prices are not available, fair values are based on quoted market prices of comparable securities.

Loans

Fair values of loans are estimated based on discounted cash flows of portfolios of loans with similar financial characteristics including the type of loan, interest terms and repayment history. Fair values are calculated by discounting scheduled cash flows through estimated maturities using estimated market discount rates. Estimated market discount rates are reflective of credit and interest rate risks inherent in the Company’s various loan types and are derived from available market information, as well as specific borrower information. The fair value of loans are not based on the notion of exit price.

 
29

 
Loans Held for Sale

The fair value of loans classified as held for sale are generally based upon quoted prices for similar assets in active markets, acceptance of firm offer letters with agreed upon purchase prices, discounted cash flow models that take into account market observable assumptions, or independent appraisals of the underlying collateral securing the loans. We report the fair values of Hawaii and U.S. Mainland construction and commercial real estate loans net of applicable selling costs on our consolidated balance sheets.
 
Other Interest Earning Assets
 
The equity investment in common stock of the FHLB, which is redeemable for cash at par value, is reported at its par value.

Deposit Liabilities

The fair values of deposits with no stated maturity, such as noninterest-bearing demand deposits and interest-bearing demand and savings accounts, are equal to the amount payable on demand. The fair value of time deposits is estimated using discounted cash flow analyses. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Long-Term Debt

The fair value of our long-term debt is estimated by discounting scheduled cash flows over the contractual borrowing period at the estimated market rate for similar borrowing arrangements.

Off-Balance Sheet Financial Instruments

The fair values of off-balance sheet financial instruments are estimated based on the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties, current settlement values or quoted market prices of comparable instruments.

For derivative financial instruments, the fair values are based upon current settlement values, if available. If there are no relevant comparables, fair values are based on pricing models using current assumptions for interest rate swaps and options.

Limitations

Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of future business and the value of assets and liabilities that are not considered financial instruments. For example, significant assets and liabilities that are not considered financial assets or liabilities include deferred tax assets, premises and equipment and intangible assets. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
 
 
30

 
             
Fair Value Measurement Using
             
Quoted Prices in
    Significant      
             
Active Markets
    Other    
Significant
       
Estimated
    for Identical    
Observable
   
Unobservable
 
Carrying
   
Fair
   
Assets
   
Inputs
   
Inputs
 
Amount
   
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
(Dollars in thousands)
September 30, 2014
                         
Financial assets
                         
   Cash and due from banks
$ 76,047     $ 76,047     $ 76,047     $ -     $ -
   Interest-bearing deposits in other banks
  14,074       14,074       14,074       -       -
   Investment securities
  1,426,705       1,420,493       853       1,406,925       12,715
   Loans held for sale
  5,352       5,352       -       -       5,352
   Net loans and leases
  2,791,917       2,745,134       -       72,635       2,672,499
   Accrued interest receivable
  12,722       12,722       12,722       -       -
                                     
Financial liabilities
                                   
   Deposits:
                                   
      Noninterest-bearing deposits
  996,033       996,033       996,033       -       -
      Interest-bearing demand and savings deposits
  2,031,912       2,031,912       2,031,912       -       -
      Time deposits
  1,020,151       1,022,847       -       -       1,022,847
   Long-term debt
  92,785       40,579       -       40,579       -
   Accrued interest payable (included in other liabilities)
  1,078       1,078       1,078       -       -
                                     
Off-balance sheet financial instruments
                                   
   Commitments to extend credit
  672,521       3,363       -       3,363       -
   Standby letters of credit and financial guarantees written
  18,065       135       -       135       -
   Interest rate options
  44,663       537       -       537       -
   Forward interest rate contracts
  21,428       (30 )     -       (30 )     -
                                     
December 31, 2013
                                   
Financial assets
                                   
   Cash and due from banks
$ 45,092     $ 45,092     $ 45,092     $ -     $ -
   Interest-bearing deposits in other banks
  4,256       4,256       4,256       -       -
   Investment securities
  1,660,046       1,646,704       875       1,635,311       10,518
   Loans held for sale
  12,370       12,370       -       -       12,370
   Net loans and leases
  2,546,781       2,430,282       -       64,705       2,365,577
   Accrued interest receivable
  14,072       14,072       14,072       -       -
                                     
Financial liabilities
                                   
   Deposits:
                                   
      Noninterest-bearing deposits
  891,017       891,017       891,017       -       -
      Interest-bearing demand and savings deposits
  1,935,635       1,935,635       1,935,635       -       -
      Time deposits
  1,109,521       1,111,319       -       -       1,111,319
   Short-term debt
  8,015       8,015       -       8,015       -
   Long-term debt
  92,799       39,446       -       39,446       -
   Accrued interest payable (included in other liabilities)
  1,040       1,040       1,040       -       -
                                     
Off-balance sheet financial instruments
                                   
   Commitments to extend credit
  652,717       3,264       -       3,264       -
   Standby letters of credit and financial guarantees written
  1,023       8       -       8       -
   Interest rate options
  37,093       69       -       69       -
   Forward interest rate contracts
  24,244       210       -       210       -
 
 
31

 
Fair Value Measurements

We group our financial assets and liabilities at fair value into three levels based on the markets in which the financial assets and liabilities are traded and the reliability of the assumptions used to determine fair value as follows:

·  
Level 1 – Valuation is based upon quoted prices (unadjusted) for identical assets or liabilities traded in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

·  
Level 2 – Valuation is based upon quoted 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 our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of discounted cash flow models and similar techniques that requires the use of significant judgment or estimation.

We base our fair values on the price that we would expect to receive if an asset were sold or pay to transfer a liability in an orderly transaction between market participants at the measurement date. We also maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.

We use fair value measurements to record adjustments to certain financial assets and liabilities and to determine fair value disclosures. Available for sale securities and derivatives are recorded at fair value on a recurring basis. From time to time, we may be required to record other financial assets at fair value on a nonrecurring basis such as loans held for sale, impaired loans and mortgage servicing rights. These nonrecurring fair value adjustments typically involve application of the lower of cost or fair value accounting or write-downs of individual assets.

There were no transfers of financial assets and liabilities between Level 1 and Level 2 of the fair value hierarchy during the three and nine months ended September 30, 2014.

 
32

 
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013:
 
       
Fair Value at Reporting Date Using
  Fair    
Quoted Prices in Active Markets for Identical Assets
   
Significant Other Observable Inputs
   
Significant Unobservable Inputs
 
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
(Dollars in thousands)
September 30, 2014
                   
Available for sale securities:
                   
   Debt securities:
                   
      States and political subdivisions
$ 190,159     $ -     $ 177,444     $ 12,715
      Corporate securities
  85,552       -       85,552       -
   Mortgage-backed securities:
                           
      U.S. Government sponsored entities
  740,539       -       740,539       -
      Non-agency collateralized mortgage obligations
  167,461       -       167,461       -
  Other
  853       853       -       -
Derivatives - Interest rate contracts
  507       -       507       -
   Total
$ 1,185,071     $ 853     $ 1,171,503     $ 12,715
                             
December 31, 2013
                           
Available for sale securities:
                           
   Debt securities:
                           
      States and political subdivisions
$ 179,357     $ -     $ 168,839     $ 10,518
      Corporate securities
  158,095       -       158,095       -
   Mortgage-backed securities:
                           
      U.S. Government sponsored entities
  927,626       -       927,626       -
      Non-agency collateralized mortgage obligations
  142,046       -       142,046       -
  Other
  875       875       -       -
Derivatives - Interest rate contracts
  279       -       279       -
   Total
$ 1,408,278     $ 875     $ 1,396,885     $ 10,518
 
For the nine months ended September 30, 2014 and 2013, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
 
   
Available for Sale States and Political Subdivisions Debt Securities
 
   
(Dollars in thousands)
 
       
Balance at December 31, 2013
  $ 10,518  
   Principal payments received
    (202 )
   Unrealized net gain included in other comprehensive income
    74  
   Purchases
    2,325  
Balance at September 30, 2014
  $ 12,715  
         
Balance at December 31, 2012
  $ 12,826  
   Principal payments received
    (2,736 )
   Unrealized net loss included in other comprehensive income
    (589 )
   Purchases
    74  
Balance at September 30, 2013
  $ 9,575  
 
 
33

 
Within the state and political subdivisions debt securities category, the Company holds four mortgage revenue bonds issued by the City & County of Honolulu with an aggregate fair value of $12.7 million. The Company estimates the fair value of its mortgage revenue bonds by using a discounted cash flow model to calculate the present value of estimated future principal and interest payments.
 
The significant unobservable input used in the fair value measurement of the Company’s mortgage revenue bonds is the weighted average discount rate. As of September 30, 2014, the weighted average discount rate utilized was 3.92%, which was derived by incorporating a credit spread over the FHLB Fixed-Rate Advance curve. Significant increases (decreases) in the weighted average discount rate could result in a significantly lower (higher) fair value measurement.

For assets measured at fair value on a nonrecurring basis that were recorded at fair value on our balance sheet at September 30, 2014 and December 31, 2013, the following table provides the level of valuation assumptions used to determine the respective fair values:
 
       
Fair Value Measurements Using
       
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Fair Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
(Dollars in thousands)
September 30, 2014
                   
Impaired loans (1)
$ 72,635     $ -     $ 72,635     $ -
Other real estate (2)
  3,596       -       3,596       -
                             
December 31, 2013
                           
Impaired loans (1)
$ 64,705     $ -     $ 64,705     $ -
Other real estate (2)
  5,163       -       5,163       -
                             
(1) Represents carrying value and related write-downs of loans for which adjustments are based
on agreed upon purchase prices for the loans or the appraised value of the collateral.
                             
(2) Represents other real estate that is carried at the lower of carrying value or fair value less costs to sell.
Fair value is generally based upon independent market prices or appraised values of the collateral.
 
18.   SEGMENT INFORMATION

We have the following three reportable segments: Banking Operations, Treasury and All Others. These segments are consistent with our internal functional reporting lines and are managed separately because each unit has different target markets, technological requirements, marketing strategies and specialized skills.

The Banking Operations segment includes construction and real estate development lending, commercial lending, residential mortgage lending, indirect auto lending, trust services, retail brokerage services and our retail branch offices, which provide a full range of deposit and loan products, as well as various other banking services. The Treasury segment is responsible for managing the Company's investment securities portfolio and wholesale funding activities. The All Others segment consists of all activities not captured by the Banking Operations or Treasury segments described above and includes activities such as electronic banking, data processing and management of bank owned properties.

The accounting policies of the segments are consistent with the Company's accounting policies that are described in Note 1 to the consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC. The majority of the Company’s net income is derived from net interest income. Accordingly, management focuses primarily on net interest income, rather than gross interest income and expense amounts, in evaluating segment profitability.

Intersegment net interest income (expense) was allocated to each segment based upon a funds transfer pricing process that assigns costs of funds to assets and earnings credits to liabilities based on market interest rates that reflect interest rate sensitivity and maturity characteristics. All administrative and overhead expenses are allocated to the segments at cost. Cash, investment securities, loans and leases and their related balances are allocated to the segment responsible for acquisition and maintenance of those assets. Segment assets also include all premises and equipment used directly in segment operations.
 
 
34

 
Segment profits and assets are provided in the following table for the periods indicated.
 
   
Banking
                   
   
Operations
   
Treasury
   
All Others
   
Total
 
   
(Dollars in thousands)
 
Three Months Ended September 30, 2014:
                       
   Net interest income
  $ 27,671     $ 7,861     $ -     $ 35,532  
   Intersegment net interest income (expense)
    11,619       (11,231 )     (388 )     -  
   Credit for loan and lease losses
    1,722       -       -       1,722  
   Other operating income
    6,264       1,453       3,746       11,463  
   Other operating expense
    (16,104 )     (509 )     (18,633 )     (35,246 )
   Administrative and overhead expense allocation
    (15,823 )     (268 )     16,091       -  
   Income taxes
    (5,749 )     857       (349 )     (5,241 )
      Net income (loss)
  $ 9,600     $ (1,837 )   $ 467     $ 8,230  
                                 
Three Months Ended September 30, 2013:
                               
   Net interest income
  $ 25,653     $ 8,118     $ -     $ 33,771  
   Intersegment net interest income (expense)
    4,059       (8,414 )     4,355       -  
   Credit for loan and lease losses
    3,189       -       -       3,189  
   Other operating income
    6,706       720       4,504       11,930  
   Other operating expense
    (14,184 )     (2,498 )     (19,830 )     (36,512 )
   Administrative and overhead expense allocation
    (15,394 )     (1,106 )     16,500       -  
   Income taxes
    (1,090 )     28       (1,112 )     (2,174 )
      Net income (loss)
  $ 8,939     $ (3,152 )   $ 4,417     $ 10,204  
                                 
Nine months ended September 30, 2014:
                               
   Net interest income
  $ 81,214     $ 26,020     $ -     $ 107,234  
   Intersegment net interest income (expense)
    23,775       (24,950 )     1,175       -  
   Credit for loan and lease losses
    1,043       -       -       1,043  
   Other operating income
    18,663       3,290       11,658       33,611  
   Other operating expense
    (45,794 )     (1,598 )     (52,672 )     (100,064 )
   Administrative and overhead expense allocation
    (43,361 )     (807 )     44,168       -  
   Income taxes
    (12,439 )     (684 )     (1,513 )     (14,636 )
      Net income
  $ 23,101     $ 1,271     $ 2,816     $ 27,188  
                                 
Nine months ended September 30, 2013:
                               
   Net interest income
  $ 75,445     $ 22,168     $ -     $ 97,613  
   Intersegment net interest income (expense)
    11,859       (21,803 )     9,944       -  
   Credit for loan and lease losses
    9,977       -       -       9,977  
   Other operating income
    20,447       1,719       20,606       42,772  
   Other operating expense
    (43,930 )     (3,359 )     (56,976 )     (104,265 )
   Administrative and overhead expense allocation
    (41,229 )     (1,622 )     42,851       -  
   Income taxes
    118,628       331       (3,276 )     115,683  
      Net income (loss)
  $ 151,197     $ (2,566 )   $ 13,149     $ 161,780  
                                 
 At September 30, 2014:
                               
    Investment securities
  $ -     $ 1,426,705     $ -     $ 1,426,705  
    Loans and leases (including loans held for sale)
    2,880,107       -       -       2,880,107  
    Other
    107,092       232,088       104,277       443,457  
       Total assets
  $ 2,987,199     $ 1,658,793     $ 104,277     $ 4,750,269  
                                 
 At December 31, 2013:
                               
    Investment securities
  $ -     $ 1,660,046     $ -     $ 1,660,046  
    Loans and leases (including loans held for sale)
    2,642,971       -       -       2,642,971  
    Other
    117,655       256,807       63,719       438,181  
       Total assets
  $ 2,760,626     $ 1,916,853     $ 63,719     $ 4,741,198  
 
 
35

 
19.   LEGAL PROCEEDINGS
 
We are involved in legal actions arising in the ordinary course of business. Management, after consultation with our legal counsel, believes the ultimate disposition of those matters will not have a material adverse effect on our consolidated financial statements.
 
 
 
 
36

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

Overview

Central Pacific Financial Corp. (“CPF”) is a Hawaii corporation and a bank holding company. Our principal business is to serve as a holding company for our bank subsidiary, Central Pacific Bank. We refer to Central Pacific Bank herein as “our bank” or “the bank,” and when we say “the Company,” “we,” “us” or “our,” we mean the holding company on a consolidated basis with the bank and our other consolidated subsidiaries.

Central Pacific Bank is a full-service community bank with 36 branches and 111 ATMs located throughout the state of Hawaii. The bank offers a broad range of products and services including accepting time and demand deposits and originating loans, including commercial loans, construction loans, commercial and residential mortgage loans, and consumer loans.

Following our successful capital raises in 2011, we have accomplished a number of key performance objectives through September 30, 2014:

·  
In 2013, our Board of Directors and management, in consultation with our regulators, reinstated and declared quarterly cash dividends on the Company’s outstanding common stock. On October 28, 2014, the Company declared a sixth consecutive quarterly cash dividend of $0.10 per share. The dividend is payable on December 15, 2014 to shareholders of record at the close of business on November 28, 2014.

·  
On March 28, 2014, we completed a tender offer to purchase 3,405,888 shares of common stock at a purchase price of $20.20 per share for a total cost of $68.8 million, excluding fees and expenses. On April 7, 2014, we also completed repurchase agreements with each of our two largest shareholders to privately purchase 1,391,089 shares of common stock at a purchase price of $20.20 per share from each shareholder for a total cost of $56.2 million, excluding fees and expenses.

·  
On May 20, 2014, our Board of Directors authorized the repurchase and retirement of up to $30.0 million of the Company’s outstanding common stock. Through the third quarter of 2014, 181,200 shares of common stock, at a cost of $3.4 million, were repurchased under this program.

·  
We have continued to maintain a strong capital position with tier 1 risk-based capital, total risk-based capital, and leverage capital ratios as of September 30, 2014 of 17.19%, 18.46%, and 11.87 %, respectively, from 20.27%, 21.54%, and 13.68%, respectively, as of December 31, 2013. The decline in the Company’s capital levels from December 31, 2013 was primarily the result of the repurchases of our common stock in the tender offer, repurchase agreements, and repurchase program described above. Our capital ratios continue to exceed the levels required for a “well-capitalized” regulatory designation.

·  
We reported fifteen consecutive profitable quarters with net income totaling $8.2 million and $27.2 million in the third quarter and first nine months of 2014, respectively, and $172.1 million, $47.4 million and $36.6 million for the years ended December 31, 2013, 2012 and 2011, respectively.

·  
We have continued to grow our loan and lease portfolio. Loans and leases, net of deferred income/costs, totaled $2.9 billion at September 30, 2014, and increased by $244.2 million, or 9.3%, from December 31, 2013.

·  
We maintained an allowance for loan and lease losses as a percentage of total loans and leases of 2.88% at September 30, 2014, compared to 3.19% at December 31, 2013. In addition, we maintained an allowance for loan and lease losses as a percentage of nonperforming assets of 182.90% at September 30, 2014, compared to 179.29% at December 31, 2013.

We also remain focused on lowering our efficiency ratio and growing market share within our core Hawaii market. In connection with improving our efficiency ratio, we have completed several initiatives, including (i) outsourcing the data center and hardware for our core information technology system to Fiserv, which is our existing core software application provider; and (ii) implementing a staff right-sizing plan. Additionally, we have begun designing, developing, and implementing our data warehouse and customer relationship management programs, and we are in the process of outsourcing our items processing function.
 
37

 
Basis of Presentation

Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements under “Part I, Item 1. Financial Statements (Unaudited).” The following discussion should also be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 28, 2014.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires that management make certain judgments and use certain estimates and assumptions that affect amounts reported and disclosures made. Accounting estimates are deemed critical when a different estimate could have reasonably been used or where changes in the estimate are reasonably likely to occur from period to period and would materially impact our consolidated financial statements as of or for the periods presented. Management has discussed the development and selection of the critical accounting estimates noted below with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the accompanying disclosures.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses (the “Allowance”) is management’s estimate of credit losses inherent in our loan and lease portfolio at the balance sheet date. We maintain our Allowance at an amount we expect to be sufficient to absorb probable losses inherent in our loan and lease portfolio based on a projection of probable net loan charge-offs. At September 30, 2014, we had an Allowance of $82.8 million, compared to $83.8 million at December 31, 2013.

The Company’s approach to developing the Allowance has three basic elements. These elements include specific reserves for individually impaired loans, a general allowance for loans other than those analyzed as individually impaired, and an unallocated reserve. These three methods are explained below:

Specific Reserve

Individually impaired loans in all loan categories are evaluated using one of three valuation methods as prescribed under ASC 310-10; Fair Value of Collateral, Observable Market Price, or Cash Flow. A loan is generally evaluated for impairment on an individual basis if it meets one or more of the following characteristics: risk-rated as substandard, doubtful or loss, loans on nonaccrual status, troubled debt restructures, or any loan deemed prudent by management to so analyze. If the valuation of the impaired loan is less than the recorded investment in the loan, the deficiency will be charged off against the Allowance or, alternatively, a specific reserve will be established and included in the overall Allowance balance. As of September 30, 2014, this specific reserve represented $2.8 million of the total Allowance, compared to $0.3 million at December 31, 2013.

General Allowance

In determining the general allowance component of the Allowance, the Company utilizes a comprehensive approach to segment the loan portfolio into homogenous groups. Six criteria divide the Company’s loan portfolio into 128 homogenous subsectors. First, loans are divided by general geographic region (U.S. Mainland and Hawaii). Second, loans are subdivided according to FDIC classification (Construction, Commercial Mortgage, Commercial, Financial and Agricultural, Leases, Residential Mortgage, Consumer). Third, loans within the Construction category are further subdivided by collateral type (Commercial and Residential). Fourth, loans within the Residential Mortgage category are further subdivided by ownership type (Investor-owned and Owner-occupied). Fifth, loans are subdivided by State or for some, by County (All Hawaii, Hawaii Island, Kauai, Maui, Oahu, Other Hawaii, All U.S. Mainland, Los Angeles/Orange County CA, Riverside/San Bernardino CA, Sacramento/Placer/El Dorado/Yolo CA, San Diego CA, Washington/Oregon, Other U.S. Mainland). Finally, loans are further subdivided by risk rating (Pass, Special Mention, Substandard, and Doubtful).

 
38

 
For the purpose of determining general allowance loss factors, loss experience is derived from charge-offs and recoveries. From 2010 through 2013, the calculation of subsector loss factors involved the summation of charge-offs and recoveries that occurred within the last eight quarters (for loans secured by real estate) or four quarters (for all other loans) divided by the average loan balance over the last eight or four quarters, respectively. The eight or four quarter period is referred to as the look-back period. We did not apply any weighting schema to our loss experience over the look-back period. A rolling eight quarter period was utilized for FDIC classifications involving real estate collateral to account for prolonged loss recognition and ultimate disposition periods associated with loans secured by real estate. The Company’s rapidly evolving loss experience necessitated the use of shorter loss analysis periods in order to ensure that loss rates would be adequately responsive to changes in loss experience. During that period, the Company considered recent loss data to be more relevant to the period then under analysis. The look-back period was also consistent with commentary provided by our primary banking regulator following our 2010 Safety and Soundness Examination.

During 2012 through 2013, economic conditions stabilized, and improved credit quality trends have contributed to consistent reductions to the Allowance. Given the diminishing loss rates, in the first quarter of 2014 the look-back period was extended to 17 quarters, with the intention of extending the look-back period each quarter thereafter to a total of 24 quarters or six years to incorporate broader loss experience through a more complete economic cycle and reduce the Company’s reliance on proxy loss rates by capturing more of the Company’s own historical loss experience in this extended look-back period. The enhanced methodology does not incorporate data from before 2010 because the Company has reason to believe that anomalous charge-off activity may cause pre-2010 internal loss data to be an inappropriate representation of future loss experience. We believe that this longer look-back period is appropriate in light of the Company’s limited loss experience throughout the recent economic recovery and stabilization. Additionally, as economic conditions have stabilized over 2012 through 2013, decreasing loss rate volatility has diminished the need for shorter loss analysis periods that are more responsive to shifts in loss experience. In our revised approach the losses during the six year look-back period will be weighted to place more emphasis on recent loss experience. The newest two years will be weighted at 40%, the middle two years will be weighted at 33%, and the oldest two years will be weighted at 27%. Also in late 2013, the Company received guidance from its primary banking regulator supporting the use of extended loss analysis periods. The Supervisory Examiner recommended a periodic reassessment of the look-back period and suggested that a look-back period beyond eight quarters may be more reasonable given the then current economic conditions and portfolio performance.

A charge-off occurs when the Company makes the determination that an amount of debt is deemed to be uncollectible. Loans are also charged off when it is probable that a loss has been incurred and it is possible to make a reasonable estimate of the loss. Charge-offs are classified into subsectors according to the underlying loan’s primary geography, loan category, collateral type (if applicable), investment type (if applicable), state/county, and the risk rating of the loan one year prior to the charge-off. The cumulative charge-offs are determined by summing all subsector-specific charge-offs that occurred within the look-back period.

A recovery occurs when a loan that is classified as a bad debt was either partially or fully charged off and has been subsequently recovered. Recoveries are classified according to the subsector of the earliest associated charge-off of the loan within the look-back period. Cumulative recoveries are determined for each subsector by summing the subsector-specific recoveries.

Subsector losses are measured by subtracting each subsector’s cumulative recoveries from their respective cumulative charge-offs. Subsector losses are then divided by the subsector loan balance averaged over the look-back period to determine each subsector’s historical loss rate. The sum of each subsector’s historical loss rate plus a region-specific economic/market qualitative adjustment and category-specific other qualitative adjustment, as discussed in the following “Application of Proxies” section, is then multiplied by the subsector’s period-ending loan balance to determine each subsector’s general allowance provision. The sum of the 128 subsector general allowance provisions represents the general allowance provision of the entire portfolio. As of September 30, 2014, this general allowance represented $76.1 million of the total Allowance, compared to $77.5 million at December 31, 2013.

Unallocated Reserve

The Company may also maintain an unallocated Allowance amount to provide for other credit losses inherent in our loan and lease portfolio that may not have been contemplated in the credit loss factors. The unallocated reserve is a measure to address judgmental estimates that are inevitably imprecise and it reflects an adjustment to the Allowance that is not attributable to specific categories of the loan portfolio. The unallocated reserve is distinct from and not captured in the Company’s qualitative adjustments in the general component of the Allowance. As discussed in the following “Application of Proxies” section, our qualitative adjustments in the general component of our Allowance capture regional changes in personal income and unemployment rates, as well as Company specific conditions. Therefore these qualitative adjustments only capture direct and specific risks to our portfolio, whereas the unallocated reserve is intended to capture broader national and global economic risks that could potentially have a ripple effect on our loan portfolio.

 
39

 
As of September 30, 2014 and December 31, 2013, an unallocated estimate of $4.0 million and $6.0 million, respectively, was based on the Company’s qualitative assessment of the potential impact of any individual or combination of the following conditions: 1) nascent but fleeting trends of progress by the monetary and fiscal policies to stimulate a sustained period of domestic economic recovery; 2) continued economic instability in Europe and other segments of the international economy; 3) volatile oil and commodity prices; 4) inconsistent domestic consumer sentiment; and 5) uncertainty over sequestration, the debt ceiling, and other fiscal and monetary policy matter in light of the unsettled domestic political climate.

Although the Company does not have direct exposure to the economic and political crises impacting Europe and the Middle East, the ripple effect of continuous uncertainty surrounding ultimate resolution, along with quantifiable measures once achieved, may result in increased risk to the Company from the standpoint of consequences to its customer base and impacts on the Hawaii tourism market.

In the second quarter of 2014, the Company adopted an enhancement to the procedures described above which limits the unallocated component of the Allowance as a percentage of the then current general component of the Allowance, rounded upward to the nearest $500,000. This is derived by taking the historical average of the percentage of the unallocated component to the general component over the maximum look back period prescribed in our methodology. The unallocated amount may be maintained at higher levels during times of economic stress conditions on a local or global basis.

Application of Proxies

Our Allowance methodology uses qualitative adjustments for economic/market conditions and Company-specific conditions. The economic/market conditions factor is applied on a regional/geographic basis. The Company-specific condition factor is applied on a category basis. Two key indicators, personal income and unemployment, comprise the economic/market adjustment factor.

Personal income is analyzed by comparing average quarter-to-quarter percentage change trends reported by the U.S. Bureau of Economic Analysis. Specifically, the rolling four quarter average percentage change in personal income is calculated and compared to a baseline historical factor, calculated as the average quarter-to-quarter percentage change over the prior ten years. The difference between the current average change and the historical average change is utilized as the personal income component of the economic/market adjustment factor.

The second component of the economic/market factor, unemployment, is derived by comparing the current quarter unemployment rate, reported by the U.S. Bureau of Labor Statistics, to its ten year historical average. A constant scaling factor is applied to the difference between the current rate and the historical average in order to smooth significant period-to-period fluctuations. The result is utilized as the unemployment component of the economic factor. The personal income factor and unemployment factor are added together to determine each region’s total economic/market adjustment factor.

The general allowance also incorporates qualitative adjustment factors that capture company-specific conditions for which national/regional statistics are not available, or for which significant localized market specific events have not yet been captured within regional statistics or the Company's historical loss experience.

Since we cannot predict with certainty the amount of loan and lease charge-offs that will be incurred and because the eventual level of loan and lease charge-offs are impacted by numerous conditions beyond our control, we use our historical loss experience adjusted for current conditions to determine both our Allowance and Provision. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review our Allowance. The determination of the Allowance requires us to make estimates of losses that are highly uncertain and involves a high degree of judgment. Accordingly, actual results could differ from those estimates. Changes in the estimate of the Allowance and related Provision could materially affect our operating results.

Reserve for Unfunded Loan Commitments

Our process for determining the reserve for unfunded loan commitments is consistent with our process for determining the Allowance and is adjusted for estimated loan funding probabilities. The reserve for unfunded loan commitments is recorded separately through a valuation allowance included in other liabilities. Credit losses for off-balance sheet credit exposures are deducted from the allowance for credit losses on off-balance sheet credit exposures in the period in which the liability is settled. The allowance for credit losses on off-balance sheet credit losses is established by a charge to other operating expense. As of September 30, 2014 and December 31, 2013, our reserve for unfunded loan commitments totaled $1.7 million and $2.1 million, respectively.

 
40

 
Loans Held for Sale

Loans held for sale consists of the following two types: (1) Hawaii residential mortgage loans that are originated with the intent to sell them in the secondary market and (2) non-residential mortgage loans both in Hawaii and the U.S. Mainland that were originated with the intent to be held in our portfolio but were subsequently transferred to the held for sale category. Hawaii residential mortgage loans classified as held for sale are carried at the lower of cost or fair value on an aggregate basis while the non-residential Hawaii and U.S. Mainland loans are recorded at the lower of cost or fair value on an individual basis.

When a non-residential mortgage loan is transferred to the held for sale category, the loan is recorded at the lower of cost or fair value. Any reduction in the loan’s value is reflected as a write-down of the recorded investment resulting in a new cost basis, with a corresponding reduction in the Allowance. In subsequent periods, if the fair value of a loan classified as held for sale is less than its cost basis, a valuation adjustment is recognized in our consolidated statement of income in other operating expense and the carrying value of the loan is adjusted accordingly. The valuation adjustment may be recovered in the event that the fair value increases, which is also recognized in our consolidated statement of income in other operating expense.

The fair value of loans classified as held for sale are generally based upon quoted prices for similar assets in active markets, acceptance of firm offer letters with agreed upon purchase prices, discounted cash flow models that take into account market observable assumptions, or independent appraisals of the underlying collateral securing the loans. We report the fair values of the non-residential mortgage loans net of applicable selling costs on our consolidated balance sheets. At September 30, 2014 and December 31, 2013, all of our loans held for sale were Hawaii residential mortgage loans.

Reserve for Residential Mortgage Loan Repurchase Losses

We sell residential mortgage loans on a “whole-loan” basis to government-sponsored entities (“GSEs” or “Agencies”) Fannie Mae and Freddie Mac and also to non-agency investors. These loan sales occur under industry standard contractual provisions that include various representations and warranties, which typically cover ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, and other similar matters. We may be required to repurchase certain loans sold with identified defects, indemnify the investor, or reimburse the investor for any credit losses incurred. We establish mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate for which we have a repurchase obligation. The reserves are established by a charge to other operating expense in our consolidated statements of operation. At September 30, 2014 and December 31, 2013, this reserve totaled $3.1 million and $2.9 million, respectively, and is included in other liabilities on our consolidated balance sheets.

The repurchase reserve is applicable to loans we originated and sold with representations and warranties, which is representative of the entire sold portfolio. Originations for agency and non-agency for vintages 2005 through September 30, 2014 were approximately $4.6 billion and $4.1 billion, respectively. Representations and warranties relating to borrower fraud generally are enforceable for the life of the loan, whereas early payment default clauses generally expire after 90 days, depending on the sales contract. We estimate that loans outstanding and sold that have early payment default clauses as of September 30, 2014 approximate $80.1 million.

The repurchase loss liability is estimated by origination year to capture certain characteristics of each vintage. To the extent that repurchase demands are made by investors, we may be able to successfully appeal such repurchase demands. However, our appeals success may be affected by the reasons for repurchase demands, the quality of the demands, and our appeals strategies. Repurchase and loss estimates are stratified by vintage, based on actual experience and certain assumptions relative to potential investor demand volume, appeals success rates, and losses recognized on successful repurchase demands.

 
41

 
Loans repurchased during the three and nine months ended September 30, 2014 totaled approximately $0.3 million and $1.0 million, respectively. In 2012, additional reserves were established as an unallocated component in recognition of the emergence of make-whole demands. The establishment of an unallocated component considers anticipated future losses and our lack of historical experience with the make-whole demands. Repurchase activity by vintage and investor type are depicted in the table below.
 
Repurchase Demands, Appeals, Repurchased and Pending Resolution [1]
                 
Nine Months Ended September 30, 2014
                                   
                                               
   
Government Sponsored Entities
   
Non-GSE Investors
Vintage
 
Repurchase Demands
   
Appealed
   
Repurchased
   
Pending Resolution
   
Repurchase Demands
   
Appealed
   
Repurchased
   
Pending Resolution
                                               
2005 and prior
  2     -     2     -     2     -     -     2
2006
  1     -     1     -     1     1     -     -
2007
  -     -     -     -     1     -     -     1
2008
  5     2     2     1     -     -     -     -
2009
  1     -     -     1     -     -     -     -
2010
  -     -     -     -     -     -     -     -
2011
  -     -     -     -     -     -     -     -
2012
  -     -     -     -     -     -     -     -
2013
  1     1     -     -     -     -     -     -
2014
  -     -     -     -     1     -     -     1
Total
  10     3     5     2     5     1     -     4
                                               
[1] Based on repurchase requests received between January 1, 2014 and September 30, 2014.
           
 
The reserve for residential mortgage loan repurchase losses of $3.1 million at September 30, 2014 represents our best estimate of the probable loss that we may incur due to the representations and warranties in our loan sales contracts with investors. This represents a $0.1 million increase from December 31, 2013. The table below shows changes in the repurchase losses liability for the periods indicated.
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30,
   
September 30,
 
 
2014
   
2013
   
2014
   
2013
 
 
(Dollars in thousands)
 
                       
Balance, beginning of period
$ 2,929     $ 3,925     $ 2,949     $ 3,552  
   Change in estimate
  234       (327 )     542       5  
   Utilizations
  (101 )     (226 )     (429 )     (185 )
Balance, end of period
$ 3,062     $ 3,372     $ 3,062     $ 3,372  
 
We believe that our capacity to estimate repurchase losses is improving as we record additional experience. Repurchase losses depend upon economic factors and other external conditions that may change over the life of the underlying loans. Additionally, lack of access to the servicing records of loans sold on a service released basis adds difficulty to the estimation process, thus requiring considerable management judgment. To the extent that future investor repurchase demand and appeals success differ from past experience, we could have increased demands and increased loss severities on repurchases, causing future additions to the repurchase reserve.

Other Intangible Assets

Other intangible assets include a core deposit premium and mortgage servicing rights.

Our core deposit premium is being amortized using the straight-line method over 14 years which approximates the estimated life of the purchased deposits. The carrying value of our core deposit premium is periodically evaluated to estimate the remaining periods of benefit. If these periods of benefit are determined to be less than the remaining amortizable life, an adjustment to reflect such shorter life will be made.
 
42

 
We utilize the amortization method to measure our mortgage servicing rights. Under the amortization method, we amortize our mortgage servicing rights in proportion to and over the period of net servicing income. Income generated as the result of new mortgage servicing rights is reported as gains on sales of loans. Amortization of the servicing rights is reported as amortization of other intangible assets in our consolidated statements of operations. Ancillary income is recorded in other income. Mortgage servicing rights are recorded when loans are sold to third-parties with servicing of those loans retained and we classify our entire mortgage servicing rights into one pool.

Initial fair value of the servicing right is calculated by a discounted cash flow model based on market value assumptions at the time of origination. We assess the servicing right for impairment using current market value assumptions at each reporting period. Critical assumptions used in the discounted cash flow model include mortgage prepayment speeds, discount rates, costs to service and ancillary income. Variations in our assumptions could materially affect the estimated fair values. Changes to our assumptions are made when current trends and market data indicate that new trends have developed. Current market value assumptions based on loan product types (fixed rate, adjustable rate and balloon loans) include average discount rates and national prepayment speeds. Many of these assumptions are subjective and require a high level of management judgment.

Prepayment speeds may be affected by economic factors such as changes in home prices, market interest rates, the availability of alternative credit products to our borrowers and customer payment patterns. Prepayment speeds include the impact of all borrower prepayments, including full payoffs, additional principal payments and the impact of loans paid off due to foreclosure liquidations. As market interest rates decline, prepayment speeds will generally increase as customers refinance existing mortgages under more favorable interest rate terms. As prepayment speeds increase, anticipated cash flows will generally decline resulting in a potential reduction, or impairment, to the fair value of the capitalized mortgage servicing rights. Alternatively, an increase in market interest rates may cause a decrease in prepayment speeds and therefore an increase in fair value of mortgage servicing rights.

The fair value of our mortgage servicing rights is validated by first ensuring the completeness and accuracy of the loan data used in the valuation analysis. Additionally, the critical assumptions which come from independent sources are reviewed and include comparing actual results to forecast assumptions or evaluating the reasonableness of market assumptions in relation to the values and trends of assumptions used by peer banks. The validation process also includes reviewing key metrics such as the fair value as a percentage of the total unpaid principal balance of the mortgages serviced, and the resulting percentage as a multiple of the net servicing fee. These key metrics are tracked to ensure the trends are reasonable, and are periodically compared to peer banks.

We perform an impairment assessment of our other intangible assets whenever events or changes in circumstance indicate that the carrying value of those assets may not be recoverable. Our impairment assessments involve, among other valuation methods, the estimation of future cash flows and other methods of determining fair value. Estimating future cash flows and determining fair values is subject to judgments and often involves the use of significant estimates and assumptions. The variability of the factors we use to perform our impairment tests depend on a number of conditions, including the uncertainty about future events and cash flows. All such factors are interdependent and, therefore, do not change in isolation. Accordingly, our accounting estimates may materially change from period to period due to changing market factors.

Deferred Tax Assets and Tax Contingencies

Deferred tax assets (“DTAs”) and liabilities are recognized for the estimated future tax effects attributable to temporary differences and carryforwards. A valuation allowance may be required if, based on the weight of available evidence, it is more likely than not that some portion or all of the DTAs will not be realized. In determining whether a valuation allowance is necessary, we consider the level of taxable income in prior years, to the extent that carrybacks are permitted under current tax laws, as well as estimates of future taxable income and tax planning strategies that could be implemented to accelerate taxable income, if necessary. If our estimates of future taxable income were materially overstated or if our assumptions regarding the tax consequences of tax planning strategies were inaccurate, some or all of our DTAs may not be realized, which would result in a charge to earnings. In the third quarter of 2009, we established a full valuation allowance against our net DTAs. See “— Results of Operations — Income Taxes” below. The quarter ended March 31, 2013 marked our ninth consecutive quarter of profitability. Based on this earnings performance trend, improvements in our financial condition, asset quality and capital ratios and the expectation of continued profitability, the Company determined that it was more likely than not that our net DTA would be realized. As a result, in the first quarter of 2013, the Company reversed a significant portion of the valuation allowance.

Income tax contingency reserves are established for potential tax liabilities related to uncertain tax positions. Tax benefits are recognized when we determine that it is more likely than not that such benefits will be realized. Where uncertainty exists due to the complexity of income tax statutes and where the potential tax amounts are significant, we generally seek independent tax opinions to support our positions. If our evaluation of the likelihood of the realization of benefits is inaccurate, we could incur additional income tax and interest expense that would adversely impact earnings, or we could receive tax benefits greater than anticipated which would positively impact earnings.
 
43

 
Impact of Recently Issued Accounting Pronouncements on Future Filings

In January 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-01, "Investments – Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects." The provisions of ASU 2014-01 provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The ASU permits entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. ASU 2014-01 is effective for the Company’s reporting period beginning on January 1, 2015. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, "Receivables – Troubled Debt Restructurings by Creditors – Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure." The provisions of ASU 2014-04 provide guidance on when an in substance repossession or foreclosure occurs, which is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan should be derecognized and the real estate property recognized. ASU 2014-04 is effective for the Company’s reporting period beginning on January 1, 2015. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” ASU 2014-09 requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This ASU will replace most existing revenue recognition guidance in GAAP when it becomes effective. ASU 2014-09 is effective for the Company’s reporting period beginning on January 1, 2017. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In June 2014, the FASB issued ASU 2014-11, “Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.” ASU 2014-11 requires two accounting changes. First, the amendments change the accounting for repurchase-to-maturity transactions to secured borrowings. Second, for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. ASU 2014-11 requires disclosures for certain transactions comprising a transfer of a financial asset accounted for as a sale, and an agreement with the same transferee entered into in contemplation of the initial transfer which results in the transferor retaining substantially all of the exposure to the economic return on the transferred financial asset throughout the term of the transaction. ASU 2014-11 also requires additional disclosures for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings. ASU 2014-11 is effective for the Company’s reporting period beginning on January 1, 2015. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In June 2014, the FASB Issued ASU 2014-12, “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance target Could Be Achieved after the Requisite Service Period.” ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for the Company’s reporting period beginning on January 1, 2016. As of September 30, 2014, the Company did not have any share-based payment awards that included performance targets that could be achieved after the requisite service period. As such, we do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In August 2014, the FASB issued ASU 2014-14, “Receivables – Troubled Debt Restructurings by Creditors Subtopic 310-40): Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure.”  ASU 2014-14 requires that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: 1) the loan has a government guarantee that is not separable from the loan before foreclosure; 2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim; and 3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed.  Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance expected to be recovered from the guarantor.  ASU 2014-14 is effective for the Company’s reporting period beginning on January 1, 2015. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

 
44

 
Financial Summary

Net income for the third quarter of 2014 was $8.2 million, or $0.23 per diluted share, compared to $10.2 million, or $0.24 per diluted share, for the third quarter of 2013. Net income for the first nine months of 2014 was $27.2 million, or $0.71 per diluted share, compared to $161.8 million, or $3.83 per diluted share, reported in the first nine months of 2013. Net income in the first nine months of 2013 included a non-cash income tax benefit of $119.8 million related to the reversal of a significant portion of a valuation allowance that was established on the Company’s net DTAs during the third quarter of 2009. Excluding this income tax benefit, net income for the first nine months of 2013 would have been $42.0 million, or $1.00 per diluted share.

The following table shows our net income and diluted earnings per share calculated on a GAAP basis, and then excluding our income tax benefit, which is a non-GAAP disclosure. Management believes that this financial disclosure which excludes the impact of our tax benefit provides useful supplemental information for investors regarding our ongoing operating results.
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
   
(Dollars in thousands, except per share data)
 
                         
GAAP net income
  $ 8,230     $ 10,204     $ 27,188     $ 161,780  
Non-GAAP adjustment:
                               
Release of valuation allowance on net deferred tax assets
    -       -       -       (119,802 )
Non-GAAP net income
  $ 8,230     $ 10,204     $ 27,188     $ 41,978  
                                 
GAAP diluted earnings per share
  $ 0.23     $ 0.24     $ 0.71     $ 3.83  
Non-GAAP adjustment:
                               
Release of valuation allowance on net deferred tax assets
    -       -       -       (2.83 )
Non-GAAP diluted earnings per share
  $ 0.23     $ 0.24     $ 0.71     $ 1.00  
 
Total credit costs, which includes the Provision, gains on sales of foreclosed assets, write-downs of foreclosed assets, and the change in the reserve for unfunded commitments, amounted to a credit of $0.3 million in the three months ended September 30, 2014, and a credit of $0.9 million in the nine months ended September 30, 2014, compared to credits of $3.5 million and $20.7 million in the three months and nine months ended September 30, 2013, respectively.

The following table presents annualized returns on average assets, average shareholders’ equity, average tangible equity and basic and diluted earnings per share for the periods indicated. Average tangible equity is calculated as average shareholders’ equity less average intangible assets, which excludes mortgage servicing rights. Average intangible assets were $11.1 million and $11.8 million for the three and nine months ended September 30, 2014, respectively, and $13.7 million and $14.4 million for the comparable prior year periods.
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
                         
Return on average assets
    0.69 %     0.87 %     0.76 %     4.73 %
Return on average shareholders' equity
    5.78       6.34       6.01       35.51  
Return on average tangible equity
    5.90       6.48       6.13       36.37  
Basic earnings per common share
  $ 0.23     $ 0.24     $ 0.72     $ 3.86  
Diluted earnings per common share
    0.23       0.24       0.71       3.83  
 
Material Trends
 
During the first nine months of 2014, the U.S. economy continued to expand at a moderate pace. Labor market conditions have gradually improved with the national unemployment rate declining to 5.9% in September 2014, compared to 7.2% in September 2013. Additionally, measures of consumer spending and consumer confidence are rising moderately and the national housing market has stabilized.

 
45

 
Despite the generally improving trend in the national economy, there are risks and uncertainties that could hinder continued economic recovery. Foreign economies continue to slow and can have a negative impact on the U.S. economy. Also, it is unclear what impact, if any, the Federal Reserve’s recent decision to end its asset purchase program may have on the national economy and market interest rates.

During the third quarter of 2014, the five-year U.S. Treasury Note traded in a range from 1.54% to 1.83%, as compared to the December 31, 2013 rate of 1.74%. Generally, lower market interest rates will exert downward pressure on our net interest income and net interest margin.

The majority of our operations are concentrated in the state of Hawaii. As a result, our performance is significantly influenced by conditions in the banking industry, macroeconomic conditions and the real estate markets in Hawaii. A favorable business environment is generally characterized by expanding gross state product, low unemployment and rising personal income; while an unfavorable business environment is characterized by the reverse.

The Hawaii Department of Business Economic Development & Tourism (“DBEDT”) projects stable economic growth in 2014 and beyond. Key economic indicators in the state have made positive strides during the first nine months of the year. DBEDT projects both real personal income and real gross state product to end the year up 2.6%.

The Department of Labor and Industrial Relations reported that Hawaii’s seasonally adjusted annual unemployment rate improved to 4.2% in September 2014, compared to 4.7% in September 2013. In addition, Hawaii’s unemployment rate in September 2014 remained below the national seasonally adjusted unemployment rate of 5.9%. DBEDT projects Hawaii’s seasonally adjusted annual unemployment rate to end the year at 4.4%.

While the labor market condition continues to improve, visitor arrivals and spending have stabilized. According to the Hawaii Tourism Authority (“HTA”), 6.2 million visitors visited the state in the first nine months of 2014. This was a slight increase of 0.5% from the number of visitor arrivals in the first nine months of 2013. Total spending by visitors, however, increased to $11.1 billion in the first nine months of 2014, an increase of $221.3 million, or 2.0%, from the first nine months of 2013. According to DBEDT, total visitor arrivals and visitor spending are expected to gain 0.7% and 2.6% in 2014, respectively.

Historically, real estate lending has been a primary focus for us, including construction, residential mortgage and commercial mortgage loans. As a result, we are dependent on the strength of Hawaii’s real estate market. According to the Honolulu Board of Realtors, Oahu unit sales volume increased just slightly by 0.2% for single-family homes and 0.7% for condominiums for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The median sales price for single-family homes on Oahu for the month ended September 30, 2014 was $678,500, representing an increase of 0.5% from the prior year. The median sales price for condominiums on Oahu for the month ended September 30, 2014 was $347,000, representing a slight decrease of 0.3% compared to the same prior year period. We believe the Hawaii real estate market will continue to show improvements during the remainder of 2014, however, there can be no assurance that this will occur.

As we have seen in the past, our operating results are significantly impacted by: (i) the economy in Hawaii, and to a significantly lesser extent, California, and (ii) the composition of our loan portfolio. Loan demand, deposit growth, Provision, asset quality, noninterest income and noninterest expense are all affected by changes in economic conditions. If the residential and commercial real estate markets we have exposure to deteriorate as they did in 2008 through 2010, our results of operations would be negatively impacted.

 
46

 
Results of Operations

Net Interest Income

Net interest income, when expressed as a percentage of average interest earning assets, is referred to as “net interest margin.” Interest income, which includes loan fees and resultant yield information, is expressed on a taxable equivalent basis using an assumed income tax rate of 35%. A comparison of net interest income on a taxable equivalent basis (“net interest income”) for the three and nine months ended September 30, 2014 and 2013 is set forth below.
 
 
Three Months Ended September 30,
 
2014
   
2013
 
Average
   
Average
   
Amount
   
Average
   
Average
   
Amount
 
Balance
   
Yield/Rate
   
of Interest
   
Balance
   
Yield/Rate
   
of Interest
 
(Dollars in thousands)
Assets
                               
Interest earning assets:
                               
  Interest-bearing deposits in other banks
$ 14,128     0.25 %   $ 9     $ 33,973     0.25 %   $ 21
  Taxable investment securities (1)
  1,267,621     2.45       7,752       1,588,412     2.04       8,119
  Tax-exempt investment securities (1)
  178,488     3.45       1,541       177,319     3.44       1,526
  Loans and leases, including loans held for sale (2)
  2,848,983     3.96       28,364       2,439,459     4.31       26,414
  Federal Home Loan Bank stock
  44,888     0.10       12       46,989     0.10       12
    Total interest earning assets
  4,354,108     3.45       37,678       4,286,152     3.36       36,092
Nonearning assets
  391,406                     385,384              
    Total assets
$ 4,745,514                   $ 4,671,536              
                                         
Liabilities and Equity
                                       
Interest-bearing liabilities:
                                       
  Interest-bearing demand deposits
$ 786,078     0.05 %   $ 96     $ 730,534     0.05 %   $ 91
  Savings and money market deposits
  1,225,969     0.07       225       1,197,911     0.08       227
  Time deposits under $100,000
  252,848     0.44       280       278,583     0.43       302
  Time deposits $100,000 and over
  797,410     0.17       349       793,136     0.18       369
  Short-term borrowings
  12,924     0.30       10       3,648     0.32       3
  Long-term debt
  92,787     2.77       647       108,269     2.92       795
    Total interest-bearing liabilities
  3,168,016     0.20       1,607       3,112,081     0.23       1,787
Noninterest-bearing deposits
  942,361                     856,410              
Other liabilities
  66,019                     57,083              
    Total liabilities
  4,176,396                     4,025,574              
Shareholders' equity
  569,118                     643,874              
Non-controlling interests
  -                     2,088              
  Total equity
  569,118                     645,962              
    Total liabilities and equity
$ 4,745,514                   $ 4,671,536              
                                         
Net interest income
              $ 36,071                   $ 34,305
                                         
Net interest margin
        3.30 %                   3.19 %      
 
 
 
47

 
 
Nine Months Ended September 30,
 
2014
   
2013
 
Average
   
Average
   
Amount
   
Average
   
Average
   
Amount
 
Balance
   
Yield/Rate
   
of Interest
   
Balance
   
Yield/Rate
   
of Interest
 
(Dollars in thousands)
Assets
                               
Interest earning assets:
                               
  Interest-bearing deposits in other banks
$ 12,832     0.25 %   $ 24     $ 95,381     0.25 %   $ 178
  Taxable investment securities (1)
  1,377,840     2.49       25,726       1,528,169     1.97       22,534
  Tax-exempt investment securities (1)
  178,369     3.45       4,609       177,636     3.53       4,706
  Loans and leases, including loans held for sale (2)
  2,759,928     4.03       83,287       2,341,500     4.41       77,362
  Federal Home Loan Bank stock
  45,473     0.10       35       47,433     0.03       12
    Total interest earning assets
  4,374,442     3.47       113,681       4,190,119     3.34       104,792
Nonearning assets
  380,154                     374,846              
    Total assets
$ 4,754,596                   $ 4,564,965              
                                         
Liabilities and Equity
                                       
Interest-bearing liabilities:
                                       
  Interest-bearing demand deposits
$ 755,302     0.05 %   $ 277     $ 702,662     0.05 %   $ 259
  Savings and money market deposits
  1,221,100     0.07       672       1,183,101     0.07       663
  Time deposits under $100,000
  257,727     0.42       808       289,420     0.47       1,015
  Time deposits $100,000 and over
  819,744     0.17       1,072       746,241     0.20       1,135
  Short-term borrowings
  37,989     0.29       82       1,230     0.32       3
  Long-term debt
  92,792     2.77       1,923       108,273     3.04       2,457
    Total interest-bearing liabilities
  3,184,654     0.20       4,834       3,030,927     0.24       5,532
Noninterest-bearing deposits
  913,879                     841,663              
Other liabilities
  52,848                     77,548              
    Total liabilities
  4,151,381                     3,950,138              
Shareholders' equity
  603,195                     607,525              
Non-controlling interests
  20                     7,302              
  Total equity
  603,215                     614,827              
    Total liabilities and equity
$ 4,754,596                   $ 4,564,965              
                                         
Net interest income
              $ 108,847                   $ 99,260
                                         
Net interest margin
        3.32 %                   3.16 %      
                                         
(1)  At amortized cost.
                                       
(2)  Includes nonaccrual loans.
                                       
 
Net interest income expressed on a taxable-equivalent basis of $36.1 million for the third quarter of 2014, increased by $1.8 million, or 5.1%, from the third quarter of 2013, while taxable-equivalent net interest income for the first nine months of 2014 increased by $9.6 million, or 9.7%, to $108.8 million from the comparable prior year period. The current quarter increase was primarily attributable to a significant increase in average loans and leases and a 41 basis point (“bp”) increase in average yields earned on our taxable investment securities, partially offset by the 35 bp decline in average yields earned on our loans and leases. The increase in net interest income for the current quarter also reflects a 9 bp increase in average yields earned on our interest-earning assets and a 3 bp decline in average rates paid on our interest-bearing liabilities.

For the nine months ended September 30, 2014, the increase over the same year-ago period was primarily attributable to a significant increase in average loans and leases and a 52 bp increase in average yields earned on our taxable investment securities, partially offset by the 38 bp decline in average yields earned on our loans and leases. The increase in net interest income also reflects a 13 bp increase in average yields earned on our interest-earning assets and a 4 bp decline in average rates paid on our interest-bearing liabilities.
 
48

 
In the fourth quarter of 2013, we executed a bond swap where we sold $271.5 million in lower-yielding available-for-sale agency debentures and agency mortgage-backed securities with an average net yield of 1.87% and a weighted average life of 2.9 years and reinvested the majority of the proceeds in $242.5 million of higher-yielding agency mortgage-backed securities, non-agency commercial mortgage-backed securities, and corporate bond securities with an average yield of 3.21% and a weighted average life of 7.4 years. This transaction contributed to the significant increase in average yields earned on our taxable investment securities.
 
Interest Income

Taxable-equivalent interest income of $37.7 million for the third quarter of 2014 increased by $1.6 million, or 4.4%, from the third quarter of 2013. The increase was primarily attributable to a significant increase in average loans and leases and a significant increase in average yields earned on our taxable investment securities, partially offset by a decrease in average yields earned on our loans and leases balances as described above and a decrease in average taxable investment securities. Average loans and leases increased by $409.5 million compared to the third quarter of 2013, accounting for approximately $4.4 million of the current quarter’s increase. In addition, average yields earned on taxable investment securities increased by 41 bp in the current quarter, increasing interest income by approximately $1.6 million. Average yields earned on loans and leases, however, decreased by 35 bp in the current quarter, lowering interest income by approximately $2.1 million, and average taxable investment securities decreased by $320.8 million, resulting in a decrease in interest income of $1.6 million.

For the nine months ended September 30, 2014, taxable-equivalent interest income increased by $8.9 million, or 8.5%, from the nine months ended September 30, 2013. Consistent with the third quarter, the year-to-date increase was primarily attributable to a significant increase in average loans and leases and a significant increase in average yields earned on our taxable investment securities, partially offset by a decrease in average yields earned on our loans and leases balances. Average loans and leases increased by $418.4 million compared to the first nine months of 2013, accounting for approximately $13.8 million of the year-to-date increase. In addition, average yields earned on taxable investment securities increased by 52 bp in the first nine months of 2014, increasing interest income by approximately $6.0 million. These increases were offset by a 38 bp decrease in average yields earned on loans and leases in the first nine months of 2014, lowering interest income by approximately $6.7 million and a decrease in average taxable investment securities of $150.3 million, resulting in a decrease in interest income of $2.2 million.

Interest Expense

Interest expense of $1.6 million for the third quarter of 2014 decreased by $0.2 million, or 10.1%, from the comparable prior year quarter. The decrease was primarily attributable to the decline in average long-term debt of $15.5 million, resulting in a decrease in interest expense of $0.1 million in the current quarter. The decrease in average long-term debt was primarily due to the repurchase of $15.0 million in trust preferred securities of CPB Capital Trust I in the fourth quarter of 2013.

For the nine months ended September 30, 2014, interest expense decreased by $0.7 million, or 12.6%, from the nine months ended September 30, 2013. The decrease was primarily attributable to the $15.5 million decrease in average long-term debt and the 27 bp decline in average rates paid on long-term debt, which resulted in a decrease in interest expense of $0.4 million and $0.2 million, respectively. Consistent with the third quarter, the year-to-date decrease in average long-term debt was primarily due to the repurchase of $15.0 in trust preferred securities of CPB Capital Trust I in the fourth quarter of 2013.

Net Interest Margin

Our net interest margin was 3.30% for the third quarter of 2014, compared to 3.19% for the third quarter of 2013. Our net interest margin was 3.32% for the first nine months of 2014, compared to 3.16% for the first nine months of 2013. As described above, the increases in the net interest margin reflected the bond swap in the fourth quarter of 2013, and the increase in average loans and leases.

Since the fourth quarter of 2008, the Federal Reserve has maintained an accommodative monetary policy with a target range for the federal funds rate of 0% to 0.25%. During the third quarter of 2014, the five-year U.S. Treasury Note traded in a range from 1.54% to 1.83%, as compared to the December 31, 2013 rate of 1.74%. Generally, lower market interest rates will exert downward pressure on our net interest income and net interest margin.

To support our net interest margin, we plan to continue to shift our interest earning assets from investment securities to higher yielding loans. Yet we still are experiencing competitive market pressures in pricing and are selectively shortening duration on assets to help mitigate interest rate risk. Given these offsetting factors, we expect the net interest margin to remain fairly stable over the near term.
 
 
49

 
Provision for Loan and Lease Losses

Our Provision was a credit of $1.7 million and $1.0 million during the third quarter and first nine months of 2014, respectively, compared to a credit of $3.2 million and $10.0 million in the comparable prior year periods. Our net recoveries were $1.0 million and $0.6 million during the third quarter and first nine months of 2014, respectively, compared to net recoveries of $1.3 million and net charge-offs of $1.2 million in the third quarter and first nine months of 2013, respectively.

The credit to the provision for loan and lease losses in the third quarter was primarily attributable to net loan recoveries of $1.0 million.

Other Operating Income

Total other operating income of $11.5 million for the third quarter of 2014 decreased by $0.5 million, or 3.9%, from the comparable prior year period. The decrease from the year-ago quarter was primarily due to unrealized gains on loans held for sale and interest rate locks of $1.0 million in the year-ago quarter compared to $0.1 million in the current quarter, lower other service charges and fees of $0.5 million, and lower equity in earnings of unconsolidated subsidiaries of $0.5 million, partially offset by a partial recovery of a previous counterparty loss on a financing transaction of $0.5 million, income recovered on nonaccrual loans previously charged-off of $0.5 million, higher service charges on deposits accounts of $0.3 million, higher net gains on sales of residential mortgage loans of $0.2 million, and higher income from bank-owned life insurance of $0.2 million due to death benefits received.

For the nine months ended September 30, 2014, total other operating income of $33.6 million decreased by $9.2 million, or 21.4%, from the comparable prior year period. The decrease was primarily due to lower net gains on sales of foreclosed properties of $7.6 million and lower net gains on sales of residential mortgage loans of $4.3 million, partially offset by income recovered on nonaccrual loans previously written-off of $1.1 million, higher service charges on deposit accounts of $1.1 million, and higher income from bank-owned life insurance of $0.8 million. The lower net gains on sales of foreclosed properties are due primarily to the sale of a U.S. Mainland construction asset in the second quarter of 2013 at a gain of $7.2 million.

Other Operating Expense

Total other operating expense for the third quarter of 2014 was $35.2 million, compared to $36.5 million in the comparable prior year period. The decrease from the year-ago quarter was primarily attributable to lower salaries and employee benefits of $2.6 million and a premium paid on the repurchase of preferred stock of our two real estate investment trust subsidiaries in the year-ago quarter of $1.9 million, partially offset by higher foreclosed asset expense of $1.4 million and costs related to the consolidation and relocation of our two Waikiki branches of $1.3 million. The lower salaries and employee benefits is primarily due to a staff right-sizing initiative that began in 2013 and included a voluntary early retirement program and a reduction of select positions. In the year-ago quarter there was $1.3 million in severance, early retirement and retention expenses related to this initiative, compared to $0.3 million in the current quarter.

For the nine months ended September 30, 2014, total other operating expense was $100.1 million, compared to $104.3 million in the comparable prior year period. The decrease was primarily attributable to lower salaries and employee benefits of $5.4 million, lower amortization of intangible assets of $2.1 million, and the aforementioned premium paid on the repurchase of preferred stock of our two real estate investment trust subsidiaries in the year-ago quarter of $1.9 million, partially offset by a credit to the reserve for unfunded loan commitments of $3.1 million in the comparable prior year period compared to a credit of $0.4 million in the first nine months of 2014, higher computer and software expense of $1.4 million, and the aforementioned Waikiki branch consolidation and relocation costs of $1.3 million.

Income Taxes

In the first quarter of 2013, the Company reversed a significant portion of the valuation allowance that was established against our net DTA during the third quarter of 2009. The valuation allowance was established during 2009 due to uncertainty at the time regarding our ability to generate sufficient future taxable income to fully realize the benefit of our net DTA. The quarter ended March 31, 2013 marked our ninth consecutive quarter of profitability. Based on this earnings performance trend, improvements in our financial condition, asset quality and capital ratios, and the expectation of continued profitability, the Company determined that it was more likely than not that a significant portion of our net DTA would be realized. The net impact of reversing the valuation allowance and recording the provision for income tax expense was a net income tax benefit of $119.8 million in the first quarter of 2013. In the second and third quarter of 2013, the Company recorded income tax expense of $1.9 million and $2.2 million, respectively.

 
50

 
In the third quarter of 2014, the Company recorded income tax expense of $5.2 million. Income tax expense in the third quarter of 2014 included a 2013 income tax return true-up adjustment of $0.9 million, which was primarily related to the aforementioned premium paid on the repurchase of preferred stock of our two real estate investment trust subsidiaries in the third quarter of 2013. For the nine months ended September 30, 2014, the Company recorded income tax expense of $14.6 million. As of September 30, 2014, the remaining valuation allowance on our net DTA totaled $2.9 million. Net of this valuation allowance, as of September 30, 2014, the Company’s net DTA totaled $110.1 million, compared to a net DTA of $137.2 million as of December 31, 2013, and is included in other assets on our consolidated balance sheets.
 
Financial Condition

Total assets at September 30, 2014 of $4.75 billion increased by $9.1 million from $4.74 billion at December 31, 2013.

Investment Securities

Investment securities of $1.4 billion at September 30, 2014 decreased by $233.3 million, or 14.1%, from December 31, 2013. In the second quarter of 2014, $162.2 million in available-for-sale securities were sold as part of a balance sheet optimization strategy designed to improve our interest rate risk profile. Investment securities sold in the second quarter had a weighted average life of 5.7 years, average yield of 2.68% and resulted in a gain of $0.2 million. There were no investment securities sold in the first and third quarters of 2014.

Loans and Leases

Loans and leases, net of deferred income/costs, of $2.9 billion at September 30, 2014 increased by $244.2 million, or 9.3%, from December 31, 2013. The increase was due to an increase in the residential mortgage, consumer, commercial, and construction loan portfolios of $115.2 million, $60.4 million, $43.6 million, and $33.6 million, respectively, partially offset by a decrease in the commercial mortgage loan and leases portfolios of $6.2 million and $2.6 million, respectively. The net increase in the portfolio also reflect the transfer of four portfolio loans to other real estate totaling $1.8 million and charge-offs of loans and leases totaling $5.4 million.

Nonperforming Assets, Accruing Loans Delinquent for 90 Days or More, Restructured Loans Still Accruing Interest

The following table sets forth nonperforming assets, accruing loans delinquent for 90 days or more and restructured loans still accruing interest as of the dates indicated.
 
 
51

 
 
September 30,
   
December 31,
 
 
2014
   
2013
 
 
(Dollars in thousands)
 
Nonperforming Assets:
         
Nonaccrual loans (including loans held for sale):
         
  Commercial, financial and agricultural
$ 15,625     $ 3,533  
  Real estate:
             
    Construction
  324       4,015  
    Mortgage-residential
  12,691       20,271  
    Mortgage-commercial
  13,056       13,769  
      Total nonaccrual loans
  41,696       41,588  
               
Other real estate:
             
  Real estate:
             
    Construction
  1,804       3,770  
    Mortgage - residential
  1,685       1,184  
    Mortgage - commercial
  107       209  
Other real estate
  3,596       5,163  
      Total nonperforming assets
  45,292       46,751  
               
Accruing loans delinquent for 90 days or more:
             
  Consumer
  62       -  
  Leases
  -       15  
      Total accruing loans delinquent for 90 days or more
  62       15  
               
Restructured loans still accruing interest:
             
  Commercial, financial and agricultural
  373       406  
  Real estate:
             
    Construction
  918       3,857  
    Mortgage-residential
  17,980       16,508  
    Mortgage-commercial
  10,671       2,502  
      Total restructured loans still accruing interest
  29,942       23,273  
               
Total nonperforming assets, accruing loans delinquent for 90
             
  days or more and restructured loans still accruing interest
$ 75,296     $ 70,039  
               
Total nonaccrual loans as a percentage of loans and leases
  1.45 %     1.58 %
               
Total nonperforming assets as a percentage of loans and leases
             
  and other real estate
  1.57 %     1.77 %
               
Total nonperforming assets and accruing loans delinquent for 90 days
             
  or more as a percentage of loans and leases and other real estate
  1.58 %     1.77 %
               
Total nonperforming assets, accruing loans delinquent for 90
             
  days or more, and restructured loans still accruing interest as a
             
  percentage of loans and leases and other real estate
  2.62 %     2.66 %
               
Year-to-date changes in nonperforming assets:
             
Balance at December 31, 2013
$ 46,751          
Additions
  26,309          
Reductions:
             
  Payments
  (8,787 )        
  Return to accrual status
  (15,571 )        
  Sales of foreclosed real estate
  (2,013 )        
  Charge-offs and/or writedowns
  (1,397 )        
Total reductions
  (27,768 )        
Balance at September 30, 2014
$ 45,292          
 
52

 
Nonperforming assets, which includes nonaccrual loans and leases and other real estate, totaled $45.3 million at September 30, 2014, compared to $46.8 million at December 31, 2013. There were no nonperforming loans classified as held for sale at September 30, 2014 and December 31, 2013. The decrease in nonperforming assets from December 31, 2013 was attributable to $15.6 million in loans restored to accrual status, $8.8 million in repayments, $2.0 million in sales of foreclosed properties, and $1.4 million in charge-offs of nonaccrual loans and write-downs of other real estate, partially offset by $26.3 million in gross additions.

Net changes to nonperforming assets by category included net decreases in U.S. Mainland commercial assets totaling $7.3 million, Hawaii residential mortgage assets totaling $7.1 million, Hawaii construction assets totaling $4.8 million, U.S. Mainland construction assets totaling $0.8 million, and Hawaii commercial assets totaling $0.6 million, offset by a net increase in U.S. Mainland commercial assets totaling $12.7 million and Hawaii commercial mortgage assets of $6.4 million. The net decrease in U.S. Mainland commercial mortgage assets included the restoration of an $8.8 million loan to accrual status. The net increase in U.S. Mainland commercial assets included the addition of two loans to a single borrower to nonaccrual status totaling $12.7 million and the net increase in Hawaii commercial mortgage assets included the addition of twelve loans to a single borrower to nonaccrual status totaling $8.3 million.

Troubled debt restructurings (“TDRs”) included in nonperforming assets at September 30, 2014 consisted of 39 Hawaii residential mortgage loans with a combined principal balance of $7.6 million, a Hawaii commercial loan with a principal balance of $0.4 million, and a Hawaii construction and development loan with a principal balance of $0.2 million. Concessions made to the original contractual terms of these loans consisted primarily of the deferral of interest and/or principal payments due to deterioration in the borrowers’ financial condition. The principal balances on these TDRs had matured and/or were in default at the time of restructure and we have no commitments to lend additional funds to any of these borrowers. There were $29.9 million of TDRs still accruing interest at September 30, 2014, none of which were more than 90 days delinquent.

 
53

 
Allowance for Loan and Lease Losses

The following table sets forth certain information with respect to the Allowance as of the dates and for the periods indicated:
 
 
Three Months Ended
   
Nine Months Ended
 
 
September 30,
   
September 30,
 
 
2014
   
2013
   
2014
   
2013
 
 
(Dollars in thousands)
 
Allowance for loan and lease losses:
                     
   Balance at beginning of period
$ 83,599     $ 87,105     $ 83,820     $ 96,413  
                               
   Provision (credit) for loan and lease losses
  (1,722 )     (3,189 )     (1,043 )     (9,977 )
                               
   Charge-offs:
                             
   Commercial, financial and agricultural
  408       360       1,963       2,201  
   Real estate:
                             
      Construction
  -       3       -       358  
      Mortgage-residential
  -       63       139       857  
      Mortgage-commercial
  -       -       1,041       3,674  
   Consumer
  991       466       2,242       1,023  
   Leases
  -       -       8       -  
      Total charge-offs
  1,399       892       5,393       8,113  
                               
   Recoveries:
                             
   Commercial, financial and agricultural
  777       259       1,929       921  
   Real estate:
                             
      Construction
  1,100       569       1,844       2,801  
      Mortgage-residential
  244       91       867       565  
      Mortgage-commercial
  14       1,137       40       2,094  
   Consumer
  224       146       768       519  
   Leases
  1       2       6       5  
      Total recoveries
  2,360       2,204       5,454       6,905  
                               
   Net charge-offs (recoveries)
  (961 )     (1,312 )     (61 )     1,208  
                               
   Balance at end of period
$ 82,838     $ 85,228     $ 82,838     $ 85,228  
                               
Annualized ratio of net charge-offs (recoveries)
                             
   to average loans and leases
  (0.13 )%     (0.22 )%     0.00 %     0.07 %
 
Our Allowance at September 30, 2014 totaled $82.8 million, a decrease of $1.0 million, or 1.2%, from December 31, 2013. The decrease in our Allowance was a direct result of a credit to the Provision of $1.0 million, offset by $0.1 million in net loan recoveries.

Our Allowance as a percentage of our total loan portfolio decreased from 3.19% at December 31, 2013 to 2.88% at September 30, 2014. Our Allowance as a percentage of our nonperforming assets increased from 179.29% at December 31, 2013 to 182.90% at September 30, 2014.

Depending on the overall performance of the local and national economies, the strength of the Hawaii real estate markets and the accuracy of our assumptions and judgments concerning our loan portfolio, further adverse credit migration may continue due to the upcoming maturity of additional loans, the possibility of further declines in collateral values and the potential impact of continued financial stress on our borrowers, sponsors and guarantors as they attempt to endure the challenges of the current economic environment. While we have seen signs of stabilization, we cannot determine when, or if, the recent signs of an economic recovery will continue.

In accordance with GAAP, loans held for sale and other real estate assets are not included in our assessment of the Allowance.

 
54

 
Deposits

Total deposits of $4.0 billion at September 30, 2014 reflected an increase of $111.9 million, or 2.8%, from December 31, 2013. The increase was primarily attributable to increases in noninterest-bearing demand deposits, interest-bearing demand deposits, and savings and money market deposits of $105.0 million, $73.7 million, and $22.6 million, respectively. These increases were partially offset by a decrease in time deposits of $89.4 million.

Core deposits, which we define as demand deposits, savings and money market deposits, and time deposits less than $100,000, totaled $3.3 billion at September 30, 2014 and increased by $183.6 million from December 31, 2013.

Capital Resources

In order to ensure adequate levels of capital, we conduct an ongoing assessment of projected sources and uses of capital in conjunction with an analysis of the size and quality of our assets, the level of risk and regulatory capital requirements. As part of this ongoing assessment, the Board of Directors reviews our capital position on an ongoing basis to ensure it is adequate, including, but not limited to, need for raising additional capital or returning capital to our shareholders, including the ability to declare cash dividends or repurchase our securities.

Common Stock

Shareholders’ equity totaled $569.0 million at September 30, 2014, compared to $660.1 million at December 31, 2013. The decrease in total shareholders’ equity was attributable to: 1) the purchase of 3,405,888 shares for a total cost of $68.8 million, excluding fees and expenses related to a tender offer, 2) the purchase of 2,782,178 shares for a total cost of $56.2 million, excluding fees and expenses related to repurchase agreements with our two largest shareholders, 3) the repurchase of 181,200 shares of common stock, at a cost of $3.4 million, under our repurchase program, and 4) cash dividends paid of $9.8 million, partially offset by $27.2 million and $18.8 million in net income and other comprehensive income, respectively, recognized during the first nine months of 2014. Since the beginning of the year, we have repurchased approximately 15.13% of our common stock outstanding.

Holding Company Capital Resources

CPF is required to act as a source of strength to the bank under the Dodd-Frank Act. CPF is obligated to pay its expenses and payments on its junior subordinated debentures which fund payments on the outstanding trust preferred securities. CPF deferred the payment of dividends on our TARP preferred stock and trust preferred securities (along with interest on the related junior subordinated debentures) beginning in the third quarter of 2009. As mentioned in the previous section, in March 2013, the Company elected to resume quarterly payments for each outstanding trust and all deferred interest on its subordinated debentures and related dividend payments on its trust preferred securities were paid in full.

As a Hawaii state-chartered bank, the bank may only pay dividends to the extent it has retained earnings as defined under Hawaii banking law (“Statutory Retained Earnings”), which differs from GAAP retained earnings. As of September 30, 2014, the bank had Statutory Retained Earnings of $118.8 million. In 2013, in light of the Company's improved capital position and financial condition, our Board of Directors and management, in consultation with our regulators, reinstated and declared quarterly cash dividends on the Company’s outstanding common stock. CPF had sufficient cash on hand to fund the 2013 dividends, thus the bank did not pay a dividend to CPF. On October 28, 2014, the Company’s Board of Directors declared a cash dividend of $0.10 per share on the Company’s outstanding common stock, payable on December 15, 2014 to shareholders of record at the close of business on November 28, 2014.

Dividends are payable at the discretion of the Board of Directors and there can be no assurance that the Board of Directors will continue to pay dividends at the same rate, or at all, in the future. Our ability to pay cash dividends to our shareholders is subject to restrictions under federal and Hawaii law, including restrictions imposed by the FRB and covenants set forth in various agreements we are a party to, including covenants set forth in our subordinated debentures.

On February 21, 2014, we announced a tender offer to purchase for cash up to $68.8 million in value of shares of our common stock at a price not greater than $21.00 nor less than $18.50 per share (the “Tender Offer”).

The Tender Offer expired on March 21, 2014 and 3,369,850 shares of our common stock were properly tendered and not withdrawn at or below the purchase price of $20.20 per share (“Purchase Price”). In addition, 167,572 shares were tendered through notice of guaranteed delivery at or below the Purchase Price. Based on these results, we accepted for purchase 3,405,888 shares, at the Purchase Price for a total cost of $68.8 million, excluding fees and expenses related to the Tender Offer. The Tender Offer closed on March 28, 2014.
 
55

 
Due to the oversubscription of the Tender Offer, we accepted for purchase on a pro rata basis approximately 96.6% of the shares properly tendered and not properly withdrawn at or below the Purchase Price by each tendering shareholder, except for tenders of odd lots, which were accepted in full, and except for certain conditional tenders automatically regarded as withdrawn pursuant to the terms of the Tender Offer.

On February 20, 2014, we also entered into repurchase agreements (the “Repurchase Agreements”) with each of Carlyle Financial Services Harbor, L.P. (“Carlyle”) and ACMO-CPF, L.L.C. (“Anchorage” and together with Carlyle, the “Lead Investors”), each of whom was the owner of 9,463,095 shares (representing 22.5% of the outstanding shares or 44.9% in the aggregate at that time) of our common stock, pursuant to which we agreed to purchase up to $28.1 million of shares of common stock from each of the Lead Investors at the Purchase Price of the Tender Offer (the “Private Repurchases”) (or an aggregate of $56.2 million of shares). Conditions to the Private Repurchases were satisfied and we purchased 1,391,089 shares from each of Carlyle and Anchorage at the Purchase Price for a total cost of $56.2 million, excluding fees and expenses related to the Private Repurchases. The Private Repurchases closed on April 7, 2014, the eleventh business day following the expiration of the Tender Offer.

The completion of the Tender Offer and the Private Repurchases resulted in the aggregate repurchase by us of 6,188,066 shares totaling $125 million, or 14.7% of our issued and outstanding shares of our common stock prior to the completion of the Tender Offer and the Private Repurchases. Upon completion of the Tender Offer and Private Repurchases, we had approximately 35.9 million shares outstanding.

On May 20, 2014, our Board of Directors authorized the repurchase and retirement of up to $30.0 million of the Company’s outstanding common stock (the “2014 Repurchase Plan”). Repurchases under the 2014 Repurchase Plan may be made from time to time on the open market or in privately negotiated transactions. In the second quarter of 2014, 181,200 shares of common stock, at a cost of $3.4 million, were repurchased under this program. We did not repurchase any shares under this program in the third quarter of 2014. A total of $26.6 million remained available for repurchase under the 2014 Repurchase Plan at September 30, 2014.

On March 21, 2014, CPF received its first dividend from the bank since September 2008 of $125.0 million in order to meet its obligations under the Tender Offer and Private Repurchases. In the second and third quarters of 2014, CPF received dividends from the bank totaling $16.1 million and $9.6 million, respectively. As of September 30, 2014, on a stand-alone basis, CPF had an available cash balance of approximately $30.5 million in order to meet its ongoing obligations.

Trust Preferred Securities

We have five statutory trusts, CPB Capital Trust I, CPB Capital Trust II, CPB Statutory Trust III, CPB Capital Trust IV and CPB Statutory Trust V, which issued a total of $105.0 million in trust preferred securities. Our obligations with respect to the issuance of the trust preferred securities constitute a full and unconditional guarantee by the Company of each trust’s obligations with respect to its trust preferred securities. Subject to certain exceptions and limitations, we may elect from time to time to defer subordinated debenture interest payments, which would result in a deferral of dividend payments on the related trust preferred securities, for up to 20 consecutive quarterly periods without default or penalty.

We began deferring interest and dividend payments on the subordinated debentures and the trust preferred securities in the third quarter of 2009. In March 2013, the Company elected to pay all deferred interest on its subordinated debentures and related dividend payments on its trust preferred securities and resume quarterly payments for each outstanding trust. As a result, the deferred accrued interest in the amount of $13.0 million was paid in full in March 2013 and the Company resumed quarterly payments on all five statutory trusts.

In June 2013, the Company was notified that $10.0 million of the $15.0 million in trust preferred securities of CPB Capital Trust I (“Trust I”) would be auctioned off as part of a larger pooled collateralized debt obligation liquidation. The Company placed a bid of $9.0 million for the securities which was accepted by the trustee and the transaction closed on June 18, 2013. Because our accepted bid of $9.0 million was less than the $10.0 million carrying value, we recognized a gain of $1.0 million related to this transaction on October 7, 2013, when these securities were called. The Company determined that its investment in Trust I did not represent a variable interest and therefore the Company was not the primary beneficiary of Trust I. As a result, consolidation of Trust I by the Company was not required. In October 2013, the Company called the remaining $5.0 million in trust preferred securities of Trust I. On April 7, 2014, $0.5 million in common stock of Trust I were called and no shares remained outstanding. On August 26, 2014, Trust I was cancelled with the state of Delaware.

 
56

 
Regulatory Capital Ratios

General capital adequacy regulations adopted by the FRB and FDIC require an institution to maintain a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization to be in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. For a further discussion of the effect of forthcoming changes in required regulatory capital ratios, see the discussion in our Form 10-K “Business — Supervision and Regulation.”

FDIC-insured institutions must maintain leverage, Tier 1 and total risk-based capital ratios of at least 5%, 6% and 10%, respectively, and not be subject to a regulatory capital directive to be considered “well capitalized” under the prompt corrective action provisions of the FDIC Improvement Act of 1991. The Company’s and the bank’s leverage capital, Tier 1 and total risk-based capital ratios as of September 30, 2014 were above the levels required for a “well capitalized” regulatory designation.

The following table sets forth the Company’s and the bank’s capital ratios, as well as the minimum capital adequacy requirements applicable to all financial institutions as of the dates indicated.
 
               
Minimum Required
   
Minimum Required
               
for Capital
   
to be
 
Actual
   
Adequacy Purposes
   
Well Capitalized
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
(Dollars in thousands)
Company
                                     
At September 30, 2014:
                                     
   Leverage capital
$ 550,130     11.9 %     $ 185,321     4.0 %     $ 231,651     5.0 %
   Tier 1 risk-based capital
  550,130     17.2         128,035     4.0         192,052     6.0  
   Total risk-based capital
  590,741     18.5         256,070     8.0         320,087     10.0  
                                             
At December 31, 2013:
                                           
   Leverage capital
$ 632,724     13.7 %     $ 184,995     4.0 %     $ 231,244     5.0 %
   Tier 1 risk-based capital
  632,724     20.3         124,854     4.0         187,282     6.0  
   Total risk-based capital
  672,374     21.5         249,709     8.0         312,136     10.0  
                                             
Central Pacific Bank
                                           
At September 30, 2014:
                                           
   Leverage capital
$ 521,449     11.3 %     $ 185,226     4.0 %     $ 231,533     5.0 %
   Tier 1 risk-based capital
  521,449     16.3         127,941     4.0         191,912     6.0  
   Total risk-based capital
  561,981     17.6         255,882     8.0         319,853     10.0  
                                             
At December 31, 2013:
                                           
   Leverage capital
$ 610,753     13.2 %     $ 184,736     4.0 %     $ 230,920     5.0 %
   Tier 1 risk-based capital
  610,753     19.6         124,608     4.0         186,912     6.0  
   Total risk-based capital
  650,273     20.9         249,216     8.0         311,520     10.0  
 
Liquidity and Borrowing Arrangements

Our objective in managing liquidity is to maintain a balance between sources and uses of funds in order to economically meet the cash requirements of customers for loans and deposit withdrawals and participate in lending and investment opportunities as they arise. We monitor our liquidity position in relation to changes in loan and deposit balances on a daily basis to ensure maximum utilization, maintenance of an adequate level of readily marketable assets and access to short-term funding sources.

 
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Core deposits have historically provided us with a sizeable source of relatively stable and low cost funds, but are subject to competitive pressure in our market. In addition to core deposit funding, we also have access to a variety of other short-term and long-term funding sources, which include proceeds from maturities of our investment securities, as well as secondary funding sources such as the FHLB, secured repurchase agreements, federal funds borrowings and the Federal Reserve discount window, available to meet our liquidity needs. While we historically have had access to these alternative funding sources, access to these sources is not guaranteed and may be influenced by market conditions, our financial position, and the terms of the respective agreements with such sources, as discussed below.

The bank is a member of and maintained a $934.6 million line of credit with the FHLB as of September 30, 2014. There was no short-term and long-term borrowings under this arrangement at September 30, 2014, respectively, compared to $8.0 million and $14,000 at December 31, 2013, respectively.

As of September 30, 2014, the bank’s pledged assets to the FHLB included investment securities with a fair value of $1.0 million and certain real estate loans totaling $1.5 billion. These assets can be used to secure future advances in accordance with the collateral provisions of the Advances, Security and Deposit Agreement with the FHLB.

Besides its line of credit with the FHLB, the bank also maintained a $34.4 million line of credit with the Federal Reserve discount window. There were no borrowings under this arrangement at September 30, 2014 and December 31, 2013. Advances under this arrangement would have been secured by certain commercial and commercial real estate loans with a carrying value of $73.4 million at September 30, 2014. The Federal Reserve does not have the right to sell or repledge these loans.

Our ability to maintain adequate levels of liquidity is dependent on our ability to continue to improve our risk profile, maintain our capital base, and comply with the provisions of our agreement with the regulators. Beyond the challenges specific to our situation, our liquidity may also be negatively impacted by weakness in the financial markets and industry-wide reductions in liquidity.

Contractual Obligations

Information regarding our contractual obligations is provided in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2013. There have been no material changes in our contractual obligations since December 31, 2013.

Regulatory Matters

On October 9, 2012, the bank entered into a Memorandum of Understanding (the “Compliance MOU”) with the FDIC to improve the bank’s compliance management system (“CMS”). Under the Compliance MOU, we are required to, among other things, (i) improve the Board of Directors’ oversight of the bank’s CMS; (ii) ensure the establishment and implementation of the bank’s CMS is commensurate with the complexity of the bank’s operations; (iii) perform a full review of all compliance policy and procedures, then revise and adopt policy and procedures to ensure compliance with all consumer protection regulations; (iv) enhance the bank’s training program relating to consumer protection and fair lending regulations; (v) develop and implement an effective internal monitoring program to ensure compliance with all applicable laws and regulations; (vi) strengthen the compliance audit function to ensure that the compliance audits are appropriately and comprehensively scoped; (vii) develop and implement internal controls for the bank’s third-party payment processing activity; (viii) strengthen the Board of Directors and senior management’s oversight of third-party relationships and (ix) enhance the bank’s overdraft payment program  The bank believes it has fully complied with all of the requirements of the Compliance MOU. In addition, the bank received an “Outstanding” rating in the FDIC’s 2012 Community Reinvestment performance evaluation that measures how financial institutions support their communities in the areas of lending, investment and service.

We cannot provide any assurance on whether or when the Company and the bank will be in full compliance with the Compliance MOU or whether or when the Compliance MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators that restrict our activities and may also impose higher capital ratios or other requirements on our business. The requirements and restrictions of the Compliance MOU are judicially enforceable and the Company or the bank's failure to comply with such requirements and restrictions may subject the Company and the bank to additional regulatory restrictions including: the imposition of additional regulatory requirements or orders; limitations on our activities; the imposition of civil monetary penalties; and further directives which affect our business, including, in the most severe circumstances, termination of the bank’s deposit insurance or appointment of a conservator or receiver for the bank.
 
58

 
Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency rates, commodity prices and equity prices. Our primary market risk exposure is interest rate risk that occurs when rate-sensitive assets and rate-sensitive liabilities mature or reprice during different periods or in differing amounts. Asset/liability management attempts to coordinate our rate-sensitive assets and rate-sensitive liabilities to meet our financial objectives. The Asset/Liability Committee (“ALCO”) monitors interest rate risk through the use of interest rate sensitivity gap, net interest income and market value of portfolio equity simulation, and rate shock analyses. Adverse interest rate risk exposures are managed through the shortening or lengthening of the duration of assets and liabilities.

The primary analytical tool we use to measure and manage our interest rate risk is a simulation model that projects changes in net interest income (“NII”) as market interest rates change. Our ALCO policy requires that simulated changes in NII should be within certain specified ranges, or steps must be taken to reduce interest rate risk. The results of the model indicate that the mix of rate-sensitive assets and liabilities at September 30, 2014 would not result in a fluctuation of NII that would exceed the established policy limits.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report and pursuant to Rule 13a-15 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the Company's management, including the Chief Executive Officer and Principal Financial and Accounting Officer, conducted an evaluation of the effectiveness and design of the Company’s disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based on that evaluation and the identification of a material weakness in the Company's internal control over financial reporting as described in the Company's Annual Report on Form 10-K for the year ended December 31, 2013, the Company's Chief Executive Officer and Principal Financial and Accounting Officer have concluded, as of the end of the period of covered by this report, that the Company's disclosure controls and procedures were not effective. See further discussion below.

Changes in Internal Control over Financial Reporting

There have been no changes in the Company's internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting, except as follows. The Company previously reported a material weakness in internal control over financial reporting as of December 31, 2013, as reported in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Subsequent to management's determination of the material weakness, management promptly began taking the following remedial actions to address the reported material weakness:

·  
The Company has created a step-by-step checklist of the key elements of the allowance for loan and lease losses methodology with references to appropriate data sources to ensure the completeness and accuracy of all inputs;

·  
The Company has established a more comprehensive review and approval procedure for the allowance for loan and lease losses calculation, including a detailed review of the completeness and accuracy of all inputs and the resulting calculation; and

·  
The Company has continued to engage an independent third-party to review the allowance for loan and lease losses methodology and calculation for conformity with U.S. generally accepted accounting principles and regulatory compliance and to validate the accuracy of the information used in the analysis.

Management anticipates that these remedial actions will strengthen the Company's internal control over financial reporting and will, over time, address the material weakness that was identified as of December 31, 2013. Because some of these remedial actions will continue to take place on a quarterly basis, their successful implementation may need to be evaluated over several quarters before management is able to conclude that the material weakness has been remediated.
 
59

 
PART II.   OTHER INFORMATION

Item 1A. Risk Factors

There have been no material changes from the Risk Factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the SEC on February 28, 2014.

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

Recent Sales of Unregistered Securities

During the second quarter of 2014, we discovered that common stock that was not registered with the SEC was sold to certain participants, through their investment in our unitized common stock fund, in the Central Pacific Bank 401(k) Retirement Savings Plan (the “Plan”). Under terms of the Plan, participants may invest Plan contributions for an interest in the common stock fund which is primarily comprised of shares of our common stock, and to a lesser extent, cash. The unregistered shares of our common stock held in the common stock fund are purchased by our Plan trustee from the open market; hence, these purchases do not represent any additional equity dilution of our outstanding shares. We do not receive any proceeds from these transactions.

Under applicable federal securities laws, certain participants may have a right to rescind, and to require us to repurchase, their purchases of our common stock (through their investment in the common stock fund) for an amount equal to the price paid for the securities, plus interest. Generally, the federal statute of limitations applicable to such rescission rights is one year. Additionally, we may be subject to potential civil and other penalties by regulatory authorities as a result of this registration issue.

Based on our estimates, we do not believe the amount of potential liability associated with the securities subject to rescission rights is material to our financial condition or results of operations. As of September 30, 2014, we estimate that there were 6,053 shares of our common stock in the Plan that were purchased within a one-year period would potentially be subject to rescission rights. These securities continue to be reflected in stockholders' equity in our balance sheet.

On June 18, 2014, we filed a new registration statement on Form S-8 to register 250,000 shares for future sales of our common stock through our common stock fund under the Plan.

Issuer Purchases of Equity Securities

On February 21, 2014, we publicly announced our Tender Offer. The Tender Offer expired on March 21, 2014 and 3,369,850 shares of our common stock were properly tendered and not withdrawn at or below the purchase price of $20.20 per share. In addition, 167,572 shares were tendered through notice of guaranteed delivery at or below the Purchase Price. Based on these results, we accepted for purchase 3,405,888 shares, at the Purchase Price for a total cost of $68.8 million, excluding fees and expenses related to the Tender Offer. The Tender Offer closed on March 28, 2014.

On February 20, 2014, we also entered into repurchase agreements (the “Repurchase Agreements”) with each of Carlyle Financial Services Harbor, L.P. (“Carlyle”) and ACMO-CPF, L.L.C. (“Anchorage” and together with Carlyle, the “Lead Investors”), each of whom was the owner of 9,463,095 shares (representing 22.5% of the outstanding shares or 44.9% in the aggregate at that time) of our common stock, pursuant to which we agreed to purchase up to $28.1 million of shares of common stock from each of the Lead Investors at the Purchase Price of the Tender Offer (the “Private Repurchases”) (or an aggregate of $56.2 million of shares). Conditions to the Private Repurchases were satisfied and we purchased 1,391,089 shares from each of Carlyle and Anchorage at the Purchase Price for a total cost of $56.2 million, excluding fees and expenses related to the Private Repurchases. The Private Repurchases closed on April 7, 2014, the eleventh business day following the expiration of the Tender Offer.

On May 20, 2014, our Board of Directors authorized the repurchase and retirement of up to $30.0 million of the Company’s outstanding common stock (the “2014 Repurchase Plan”). Repurchases under the 2014 Repurchase Plan may be made from time to time on the open market or in privately negotiated transactions. In the second quarter of 2014, 181,200 shares of common stock, at a cost of $3.4 million, were repurchased under this program. We did not repurchase any shares under this program in the third quarter of 2014. A total of $26.6 million remained available for repurchase under the 2014 Repurchase Plan at September 30, 2014.
 
 
60

 
Item 6. Exhibits
 
Exhibit No.
 
 
Document
     
31.1
 
Rule 13a-14(a) Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 *
     
31.2
 
Rule 13a-14(a) Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 *
     
32.1
 
Section 1350 Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002 **
     
32.2
 
Section 1350 Certification of Chief Financial Officer in accordance with 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 Extension Calculation Linkbase Document*
     
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document*
     
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document*
     
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document*


*             Filed herewith.

**
Furnished herewith.

 
 
61

 
SIGNATURES

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

 
CENTRAL PACIFIC FINANCIAL CORP.
 
(Registrant)
   
   
Date:  November 4, 2014
/s/ John C. Dean
 
John C. Dean
 
Chief Executive Officer
   
Date:  November 4, 2014
/s/ Denis K. Isono
 
Denis K. Isono
 
Executive Vice President and Chief Financial Officer
   
 
 
 
 
 
 
62

 
Central Pacific Financial Corp.
Exhibit Index
 
Exhibit No.
 
Description
     
31.1
 
Rule 13a-14(a) Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
     
31.2
 
Rule 13a-14(a) Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
     
32.1
 
Section 1350 Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002
     
32.2
 
Section 1350 Certification of Chief Financial Officer in accordance with 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 Extension Calculation Linkbase Document
     
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
     
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
     
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document

 
 
63