10-Q 1 form10-q.htm FORM 10-Q 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 June 30, 2011

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 0-10777
 
 
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 £
Non-accelerated filer £
Smaller reporting company T

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 August 1, 2011 was 41,738,830 shares.
 
 


 

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES

Table of Contents

Part I.
Financial Information
   
Item I.
Financial Statements (Unaudited)
   
 
Consolidated Balance Sheets
June 30, 2011 and December 31, 2010
   
 
Consolidated Statements of Operations
Three and six months ended June 30, 2011 and 2010
   
 
Consolidated Statements of Cash Flows
Six months ended June 30, 2011 and 2010
   
 
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 1.
Legal Proceedings
   
Item 1A.
Risk Factors
   
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, earnings 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” 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 limited to: the impact of local, national, and international economies and events (including natural disasters such as wildfires, tsunamis 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; the impact of regulatory actions on the Company including the Bank MOU (as defined below) which replaced the Consent Order (as defined below) by the Federal Deposit Insurance Corporation and the Hawaii Division of Financial Institutions and the BSA MOU (as defined below); the impact of legislation affecting the banking industry (including the Emergency Economic Stabilization Act of 2008 and the Dodd-Frank Wall Street Reform and Consumer Protection Act); the impact of competitive products, services, pricing, and other competitive forces; movements in interest rates; loan delinquency rates and changes in asset quality; volatility in the financial markets and uncertainties concerning the availability of debt or equity financing; and a general deterioration or malaise in economic conditions, including the continued destabilizing factors in the financial industry and continued deterioration of the real estate market, as well as the impact of levels of consumer and business confidence in the state of the economy and in financial institutions in general and in particular our bank. 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 the Company’s Form 10-Q for the last fiscal quarter. The Company does not update any of its forward-looking statements.
 
 
 
3

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
 
(Unaudited)
 
           
 
June 30,
   
December 31,
 
 
2011
   
2010
 
 
(Dollars in thousands)
 
Assets
         
Cash and due from banks
$ 68,986     $ 61,725  
Interest-bearing deposits in other banks
  384,477       729,014  
Investment securities:
             
   Available for sale, at fair value
  1,400,380       702,517  
   Held to maturity (fair value of $1,631 at June 30, 2011 and $2,913 at December 31, 2010)
  1,578       2,828  
      Total investment securities
  1,401,958       705,345  
               
Loans held for sale
  22,290       69,748  
               
Loans and leases
  2,046,747       2,169,444  
  Less allowance for loan and lease losses
  166,934       192,854  
      Net loans and leases
  1,879,813       1,976,590  
               
Premises and equipment, net
  54,702       57,390  
Accrued interest receivable
  11,711       11,279  
Investment in unconsolidated subsidiaries
  13,477       14,856  
Other real estate
  42,863       57,507  
Other intangible assets
  43,526       44,639  
Bank-owned life insurance
  142,980       142,296  
Federal Home Loan Bank stock
  48,797       48,797  
Income tax receivable
  2,400       2,223  
Other assets
  13,753       16,642  
      Total assets
$ 4,131,733     $ 3,938,051  
               
Liabilities and Equity
             
Deposits:
             
   Noninterest-bearing demand
$ 687,468     $ 611,744  
   Interest-bearing demand
  521,047       639,548  
   Savings and money market
  1,115,339       1,089,813  
   Time
  906,466       791,842  
      Total deposits
  3,230,320       3,132,947  
               
Short-term borrowings
  1,385       202,480  
Long-term debt
  409,076       459,803  
Other liabilities
  57,178       66,766  
      Total liabilities
  3,697,959       3,861,996  
               
Equity:
             
   Preferred stock, no par value, authorized 1,000,000 shares; issued and outstanding
             
      none at June 30, 2011 and 135,000 shares at December 31, 2010
  -       130,458  
   Common stock, no par value, authorized 185,000,000 shares, issued and outstanding
             
      41,738,830 shares at June 30, 2011 and 1,527,000 shares at December 31, 2010
  784,207       404,167  
   Surplus
  64,350       63,308  
   Accumulated deficit
  (420,569 )     (517,316 )
   Accumulated other comprehensive loss
  (4,206 )     (14,565 )
      Total shareholders' equity
  423,782       66,052  
   Non-controlling interest
  9,992       10,003  
      Total equity
  433,774       76,055  
      Total liabilities and equity
$ 4,131,733     $ 3,938,051  
               
See accompanying notes to consolidated financial statements.
 
4

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
(Unaudited)
 
                         
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(Amounts in thousands, except per share data)
 
2011
   
2010
   
2011
   
2010
 
                   
Interest income:
                       
  Interest and fees on loans and leases
  $ 26,464     $ 35,788     $ 55,030     $ 73,100  
  Interest and dividends on investment securities:
                               
    Taxable interest
    7,241       3,653       12,462       11,754  
    Tax-exempt interest
    179       190       363       705  
    Dividends
    -       2       3       5  
  Interest on deposits in other banks
    300       467       689       797  
    Total interest income
    34,184       40,100       68,547       86,361  
                                 
Interest expense:
                               
  Interest on deposits:
                               
    Demand
    161       250       293       508  
    Savings and money market
    500       1,487       1,232       3,136  
    Time
    1,902       3,808       4,279       7,789  
  Interest on short-term borrowings
    -       306       204       495  
  Interest on long-term debt
    2,642       5,053       5,359       10,168  
    Total interest expense
    5,205       10,904       11,367       22,096  
                                 
    Net interest income
    28,979       29,196       57,180       64,265  
Provision (credit) for loan and lease losses
    (8,784 )     20,412       (10,359 )     79,249  
    Net interest income (loss) after provision for loan and lease losses
    37,763       8,784       67,539       (14,984 )
                                 
Other operating income:
                               
  Service charges on deposit accounts
    2,449       2,982       5,063       6,189  
  Other service charges and fees
    4,444       3,850       8,502       7,335  
  Income from fiduciary activities
    739       811       1,500       1,622  
  Equity in earnings of unconsolidated subsidiaries
    38       102       165       131  
  Fees on foreign exchange
    149       175       286       331  
  Investment securities gains
    261       -       261       831  
  Loan placement fees
    82       92       184       177  
  Net gain on sales of residential loans
    1,005       1,332       3,203       3,277  
  Income from bank-owned life insurance
    980       1,890       2,170       3,074  
  Other
    790       1,503       2,103       2,534  
    Total other operating income
    10,937       12,737       23,437       25,501  
                                 
Other operating expense:
                               
  Salaries and employee benefits
    15,442       14,408       30,475       29,244  
  Net occupancy
    3,410       3,310       6,768       6,607  
  Equipment
    1,154       1,305       2,284       2,782  
  Amortization of other intangible assets
    1,629       1,581       3,176       2,989  
  Communication expense
    922       846       1,803       2,058  
  Legal and professional services
    3,592       5,416       6,052       11,066  
  Computer software expense
    929       873       1,812       1,776  
  Advertising expense
    830       764       1,666       1,603  
  Goodwill impairment
    -       -       -       102,689  
  Foreclosed asset expense
    (791 )     403       1,451       5,935  
  Write down of assets
    3,090       166       4,655       940  
  Other
    10,282       8,554       17,984       19,152  
    Total other operating expense
    40,489       37,626       78,126       186,841  
                                 
     Income (loss) before income taxes
    8,211       (16,105 )     12,850       (176,324 )
Income tax expense
    -       -       -       -  
     Net income (loss)
    8,211       (16,105 )     12,850       (176,324 )
Preferred stock dividends, accretion of discount and
                               
   conversion of preferred stock to common stock
    -       2,096       (83,897 )     4,170  
     Net income (loss) available to common shareholders
  $ 8,211     $ (18,201 )   $ 96,747     $ (180,494 )
                                 
Per common share data:
                               
   Basic earnings (loss) per share
  $ 0.20     $ (12.01 )   $ 3.22     $ (119.18 )
   Diluted earnings (loss) per share
    0.20       (12.01 )     3.15       (119.18 )
                                 
Shares used in computation:
                               
  Basic shares
    40,700       1,515       30,059       1,514  
  Diluted shares
    41,078       1,515       30,733       1,514  
                                 
See accompanying notes to consolidated financial statements.
 
   
5

 
CENTRAL PACIFIC FINANCIAL CORP. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
(Unaudited)
 
           
 
Six Months Ended June 30,
 
 
2011
   
2010
 
 
(Dollars in thousands)
 
Cash flows from operating activities:
         
Net income (loss)
$ 12,850     $ (176,324 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
             
Provision (credit) for loan and lease losses
  (10,359 )     79,249  
Depreciation and amortization
  3,472       3,933  
Goodwill impairment
  -       102,689  
Write down of assets
  4,655       940  
Write down of other real estate, net of gain on sale
  (1,599 )     5,935  
Amortization of other intangible assets
  3,176       2,989  
Net amortization of investment securities
  3,137       1,001  
Share-based compensation
  1,042       (232 )
Net gain on investment securities
  (261 )     (831 )
Net change in trading securities
  -       25,217  
Deferred income tax expense
  -       2,439  
Net gain on sales of residential loans
  (3,203 )     (3,277 )
Proceeds from sales of loans held for sale
  307,958       481,093  
Originations of loans held for sale
  (292,597 )     (440,278 )
Equity in earnings of unconsolidated subsidiaries
  (165 )     (131 )
Increase in cash surrender value of bank-owned life insurance
  (842 )     (2,784 )
Decrease (increase) in income tax receivable
  (177 )     862  
Net change in other assets and liabilities
  644       889  
Net cash provided by operating activities
  27,731       83,379  
               
Cash flows from investing activities:
             
Proceeds from maturities of and calls on investment securities available for sale
  182,915       203,337  
Proceeds from sales of investment securities available for sale
  5,324       439,435  
Purchases of investment securities available for sale
  (877,800 )     (173,558 )
Proceeds from maturities of and calls on investment securities held to maturity
  1,240       954  
Net loan principal repayments
  102,598       218,976  
Proceeds from sales of loans originated for investment
  26,721       56,605  
Proceeds from sale of other real estate
  24,724       14,040  
Proceeds from bank-owned life insurance
  158       2,069  
Purchases of premises and equipment
  (784 )     (856 )
Distributions from unconsolidated subsidiaries
  523       714  
Contributions to unconsolidated subsidiaries
  -       (227 )
Net cash provided by (used in) investing activities
  (534,381 )     761,489  
               
Cash flows from financing activities:
             
Net increase (decrease) in deposits
  97,373       (360,342 )
Proceeds from long-term debt
  -       50,000  
Repayments of long-term debt
  (50,441 )     (65,572 )
Net decrease in short-term borrowings
  (201,095 )     (40,721 )
Net proceeds from issuance of common stock and stock option exercises
  323,537       -  
Other, net
  -       73  
Net cash provided by (used in) financing activities
  169,374       (416,562 )
               
Net increase (decrease) in cash and cash equivalents
  (337,276 )     428,306  
Cash and cash equivalents at beginning of period
  790,739       488,367  
Cash and cash equivalents at end of period
$ 453,463     $ 916,673  
               
Supplemental disclosure of cash flow information:
             
Cash paid during the period for:
             
Interest
$ 11,543     $ 21,921  
Income taxes
  8       -  
Cash received during the period for:
             
Income taxes
  -       1,068  
Supplemental disclosure of noncash investing and financing activities:
             
Net change in common stock held by directors' deferred compensation plan
$ 16     $ 6  
Net reclassification of loans to other real estate
  8,481       26,788  
Net transfer of loans to loans held for sale
  1,256       26,434  
Net transfer of investment securities available for sale to trading
  -       49,126  
Dividends accrued on preferred stock
  969       3,504  
Accretion of preferred stock discount
  204       666  
Preferred stock and accrued unpaid dividends converted to common stock
  142,988       -  
Common stock received in exchange for preferred stock and accrued unpaid dividends
  56,201       -  
               
See accompanying notes to consolidated financial statements.
 
   
6

 
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, 2010. 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.

As discussed in our 2010 Form 10-K and our independent auditor’s report dated February 9, 2011, at the time of the filing of our 2010 Form 10-K, there was substantial doubt about our ability to continue as a going concern. Since the filing of our 2010 Form 10-K, we have completed a number of significant milestones as part of our recovery plan, including the completion of a $325 million capital raise in February 2011 (the “Private Placement”) and a $20 million common stock rights offering. Upon completion of these milestones, which are described more fully in Note 11, there is no longer substantial doubt about our ability to continue as a going concern.

2.  REGULATORY MATTERS

In May 2011, the regulatory Consent Order (the “Consent Order”) that Central Pacific Bank (“the bank” or “our bank”) entered into with the Federal Deposit Insurance Corporation (the “FDIC”) and the Hawaii Division of Financial Institutions (the “DFI”) on December 9, 2009 was lifted. In place of the Consent Order, the Board of Directors of the bank entered into a Memorandum of Understanding (the “Bank MOU”) with the FDIC and DFI effective May 5, 2011. The Bank MOU continues a number of the same requirements previously required by the Consent Order, including the maintenance of an adequate allowance for loan and lease losses, improvement of our asset quality, limitations on credit extensions, maintenance of qualified management and the prohibition on cash dividends to Central Pacific Financial Corp. (“CPF”), among other matters. In addition, the Bank MOU requires the bank to further reduce classified assets below the level previously required by the Consent Order. The Bank MOU lowers the minimum leverage capital ratio that the bank is required to maintain from 10% in the Consent Order to 8% and does not mandate a minimum total risk-based capital ratio.

In addition to the Bank MOU, the Company continues to be subject to a Written Agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (the “FRBSF”) and DFI dated July 2, 2010, which superseded in its entirety the Memorandum of Understanding that the Company entered into on April 1, 2009 with the FRBSF and DFI. Among other matters, the Agreement provides that unless we receive the consent of the FRBSF and DFI, we cannot: (i) pay dividends; (ii) receive dividends or payments representing a reduction in capital from Central Pacific Bank; (iii) directly or through any non-bank subsidiaries make any payments on subordinated debentures or trust preferred securities; (iv) directly or through any non-bank subsidiaries incur, increase or guarantee any debt; or (v) purchase or redeem any shares of our stock. The Agreement also requires that our Board of Directors fully utilize the Company’s financial and managerial resources to ensure that the bank complies with the Bank MOU and any other supervisory action taken by the bank’s regulators. We were also required to submit to the FRBSF an acceptable capital plan and cash flow projection.

On February 9, 2011, the bank entered into a separate Memorandum of Understanding (the “BSA MOU”) with the FDIC and DFI relating to compliance with the Bank Secrecy Act (the “BSA”). Under the BSA MOU, we are required to (i) fully comply with the BSA and anti-money laundering requirements, (ii) implement a plan to ensure such compliance, including improving and maintaining an adequate system of internal controls, bolstering policies on customer due diligence, providing for comprehensive independent testing to validate compliance and maintaining an adequate compliance staff, (iii) correct all deficiencies identified by our regulators and (iv) provide them with progress reports.
 
 
 
7

 
Even though the Consent Order has been replaced by the Bank MOU, the bank remains subject to a number of requirements as described above. We cannot assure you whether or when the Company and the bank will be in full compliance with the agreements with the regulators or whether or when the Bank MOU, the Agreement or the BSA MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators that restrict our activities and may also continue to impose capital ratios requirements. The requirements and restrictions of the Bank MOU, the Agreement and the BSA 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 a new consent order, the imposition of civil monetary penalties; the termination of insurance of deposits; the issuance of removal and prohibition orders against institution-affiliated parties; the appointment of a conservator or receiver for the bank; the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party, if we again fall below the capital ratio requirement; and the enforcement of such actions through injunctions or restraining orders.

3.   RECENT ACCOUNTING PRONOUNCEMENTS

In July 2010, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2010-20, Receivables (Topic 310), Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This ASU requires a greater level of disaggregated information about the credit quality of loan and leases and the allowance for loan and lease losses. This ASU also requires additional disclosures related to past due information, credit quality indicators and information related to loans modified in a troubled debt restructuring. We adopted this ASU effective January 1, 2011 and the adoption of this statement did not have a material impact on our consolidated financial statements.

4.   INVESTMENT SECURITIES

A summary of available for sale and held to maturity investment securities are as follows:
 
       
Gross
   
Gross
   
 
 
Amortized
   
unrealized
   
unrealized
   
Estimated
 
cost
   
gains
   
losses
   
fair value
 
(Dollars in thousands)
June 30, 2011
                   
Available for Sale
                   
   U.S. Government sponsored entities debt securities
$ 382,777     $ 2,033     $ (30 )   $ 384,780
   States and political subdivisions
  12,443       -       -       12,443
   U.S. Government sponsored entities mortgage-backed securities
  990,018       13,344       (1,216 )     1,002,146
   Non-agency collateralized mortgage obligations
  17       -       -       17
   Other
  972       22       -       994
      Total
$ 1,386,227     $ 15,399     $ (1,246 )   $ 1,400,380
                             
Held to Maturity
                           
   U.S. Government sponsored entities mortgage-backed securities
$ 1,578     $ 53     $ -     $ 1,631
                             
December 31, 2010
                           
Available for Sale
                           
   U.S. Government sponsored entities debt securities
$ 202,192     $ 306     $ (643 )   $ 201,855
   States and political subdivisions
  12,619       -       -       12,619
   U.S. Government sponsored entities mortgage-backed securities
  483,647       6,653       (3,336 )     486,964
   Non-agency collateralized mortgage obligations
  17       -       -       17
   Other
  1,057       5       -       1,062
      Total
$ 699,532     $ 6,964     $ (3,979 )   $ 702,517
                             
Held to Maturity
                           
   States and political subdivisions
$ 500     $ 4     $ -     $ 504
   U.S. Government sponsored entities mortgage-backed securities
  2,328       81       -       2,409
      Total
$ 2,828     $ 85     $ -     $ 2,913
 
 
8

 
The amortized cost and estimated fair value of investment securities at June 30, 2011 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.
 
 
June 30, 2011
 
Amortized
Cost
   
Estimated
Fair Value
 
(Dollars in thousands)
Available for Sale
       
  Due in one year or less
$ 15,197     $ 15,213
  Due after one year through five years
  373,315       375,302
  Due after five years through ten years
  1,467       1,467
  Due after ten years
  5,241       5,241
  Mortage-backed securities
  990,018       1,002,146
  Other
  989       1,011
    Total
$ 1,386,227     $ 1,400,380
             
Held to Maturity
           
  Mortage-backed securities
$ 1,578     $ 1,631
 
We sold certain available for sale investment securities during the three months ended June 30, 2011 for gross proceeds of $5.3 million. We did not sell any available for sale securities during the first quarter of 2011. Gross realized gains and losses on the sales of the available for sale investment securities during the three months ended June 30, 2011 were $0.3 million and nil, respectively. The specific identification method was used as the basis for determining the cost of all securities sold.

As part of our recovery plan, we sold certain available for sale investment securities during the first half of 2010 for gross proceeds of $439.4 million. We did not sell any available for sale investment securities during the second quarter of 2010. Gross realized gains and losses on the sales of the available for sale investment securities during the six months ended June 30, 2010 were $9.6 million and $8.8 million, respectively.

Investment securities of $861.1 million and $613.5 million at June 30, 2011 and December 31, 2010, respectively, were pledged to secure public funds on deposit, securities sold under agreements to repurchase 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 11 and 18 investment securities which were in an unrealized loss position at June 30, 2011 and December 31, 2010, 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 June 30, 2011:
                                   
U.S. Government sponsored entities
                                   
   debt securities
  $ 29,812     $ (30 )   $ -     $ -     $ 29,812     $ (30 )
U.S. Government sponsored entities
                                               
   mortgage-backed securities
    167,111       (1,216 )     -       -       167,111       (1,216 )
   Total temporarily impaired securities
  $ 196,923     $ (1,246 )   $ -     $ -     $ 196,923     $ (1,246 )
                                                 
At December 31, 2010:
                                               
U.S. Government sponsored entities
                                               
   debt securities
  $ 83,973     $ (643 )   $ -     $ -     $ 83,973     $ (643 )
U.S. Government sponsored entities
                                               
   mortgage-backed securities
    194,756       (3,336 )     -       -       194,756       (3,336 )
Non-agency collateralized mortgage obligations
    17       -       -       -       17       -  
   Total temporarily impaired securities
  $ 278,746     $ (3,979 )   $ -     $ -     $ 278,746     $ (3,979 )
 
 
 
9

 
Unrealized losses for all investment securities are reviewed to determine whether the losses are deemed “other-than-temporary impairment” (“OTTI”). 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 and disruptions in the credit and financial markets. 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.

5.   LOANS AND LEASES

Loans and leases, excluding loans held for sale, consisted of the following:
 
 
June 30,
   
December 31,
 
 
2011
   
2010
 
 
(Dollars in thousands)
 
           
Commercial, financial and agricultural
$ 198,007     $ 207,900  
Real estate:
             
  Construction
  241,753       314,530  
  Mortgage - residential
  761,998       747,870  
  Mortgage - commercial
  714,306       761,710  
Consumer
  110,946       112,950  
Leases
  22,535       28,163  
    2,049,545       2,173,123  
Unearned income
  (2,798 )     (3,679 )
  Total loans and leases
$ 2,046,747     $ 2,169,444  
 
During the six months ended June 30, 2011, we transferred one loan, which was non-performing, with a carrying value of $1.3 million, to the held-for-sale category. No loans were purchased during the six months ended June 30, 2011. During the six months ended June 30, 2010, we transferred loans with a carrying value of $26.4 million, to the held-for-sale category and sold portfolio loans with a carrying value of $49.3 million. No loans were purchased during the six months ended June 30, 2010.
 

 
 
10

 
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 June 30, 2011:
 
 
Commercial,
 
Real estate
             
 
financial & agricultural
 
Construction
 
Mortgage -
residential
 
Mortgage -
commercial
 
Consumer
 
Leases
 
Total
 
 
(Dollars in thousands)
 
Allowance for loan and lease losses:
                           
   Ending balance attributable to loans:
                           
      Individually evaluated for impairment
$ 105   $ 5,926   $ 5   $ 596   $ -   $ -   $ 6,632  
      Collectively evaluated for impairment
  12,522     46,564     28,421     65,037     2,971     787     156,302  
    12,627     52,490     28,426     65,633     2,971     787     162,934  
      Unallocated
                                      4,000  
         Total ending balance
$ 12,627   $ 52,490   $ 28,426   $ 65,633   $ 2,971   $ 787   $ 166,934  
                                           
Loans and leases:
                                         
   Individually evaluated for impairment
$ 356   $ 129,269   $ 59,289   $ 18,137   $ -   $ -   $ 207,051  
   Collectively evaluated for impairment
  197,651     112,484     702,709     696,169     110,946     22,535     1,842,494  
    198,007     241,753     761,998     714,306     110,946     22,535     2,049,545  
   Unearned income
  96     (286 )   (1,249 )   (1,359 )   -     -     (2,798 )
         Total ending balance
$ 198,103   $ 241,467   $ 760,749   $ 712,947   $ 110,946   $ 22,535   $ 2,046,747  
 
 
 
 
 
11

 
The following table presents by class, loans individually evaluated for impairment as of June 30, 2011 and December 31, 2010:
 
 
Unpaid Principal Balance
   
Recorded Investment
   
Allowance Allocated
 
(Dollars in thousands)
June 30, 2011
             
With no related allowance recorded:
             
Real estate:
             
   Construction
$ 105,063     $ 81,076     $ -
   Mortgage - residential
  67,419       59,208       -
   Mortgage - commercial
  8,640       8,640       -
      Total impaired loans with no related allowance recorded
  181,122       148,924       -
With an allowance recorded:
                   
Commercial, financial & agricultural
  1,055       356       105
Real estate:
                   
   Construction
  92,854       48,193       5,926
   Mortgage - residential
  81       81       5
   Mortgage - commercial
  11,223       9,497       596
      Total impaired loans with an allowance recorded
  105,213       58,127       6,632
Total
$ 286,335     $ 207,051     $ 6,632
                     
December 31, 2010
                   
With no related allowance recorded:
                   
Real estate:
                   
   Construction
$ 112,675     $ 85,571     $ -
   Mortgage - residential
  66,203       58,333       -
   Mortgage - commercial
  10,917       10,917       -
      Total impaired loans with no related allowance recorded
  189,795       154,821       -
With an allowance recorded:
                   
Commercial, financial & agricultural
  1,184       485       81
Real estate:
                   
   Construction
  104,429       59,384       18,197
   Mortgage - residential
  3,681       3,256       89
   Mortgage - commercial
  7,746       7,088       1,158
      Total impaired loans with an allowance recorded
  117,040       70,213       19,525
Total
$ 306,835     $ 225,034     $ 19,525
 
The average recorded investment in impaired loans was $206.6 million and $214.2 million during the three and six months ended June 30, 2011, respectively. Interest income recognized on impaired loans was $0.3 million and $0.6 million during the three and six months ended June 30, 2011, respectively.

 
12

 
The following table presents by class, the recorded investment in nonaccrual loans and accruing loans delinquent for 90 days or more as of June 30, 2011 and December 31, 2010:
 
 
Nonaccrual
   
Accruing loans delinquent for 90 days or more
 
(Dollars in thousands)
June 30, 2011
       
Commercial, financial & agricultural
$ 578     $ -
Real estate:
           
   Construction
  129,275       -
   Mortgage - residential
  58,204       -
   Mortgage - commercial
  18,428       -
Consumer
  -       4
   Total
$ 206,485     $ 4
             
December 31, 2010
           
Commercial, financial & agricultural
$ 982     $ -
Real estate:
           
   Construction
  182,073       6,550
   Mortgage - residential
  47,560       1,800
   Mortgage - commercial
  14,464       -
Consumer
  225       181
   Total
$ 245,304     $ 8,531
 
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 June 30, 2011 and December 31, 2010:
 
 
30 - 59 Days
Past Due
 
60 - 89 Days
Past Due
 
Greater than 90
Days Past Due
 
Nonaccrual
Loans
 
Total
Past Due
 
Loans & Leases
Not Past Due
 
Total
 
(Dollars in thousands)
June 30, 2011
                         
Commercial, financial & agricultural
$ 197   $ 274   $ -   $ 578   $ 1,049   $ 197,054   $ 198,103
Real estate:
                                       
   Construction
  -     127     -     129,275     129,402     112,065     241,467
   Mortgage - residential
  181     1,424     -     58,204     59,809     700,940     760,749
   Mortgage - commercial
  -     719     -     18,428     19,147     693,800     712,947
Consumer
  429     109     4     -     542     110,404     110,946
Leases
  2     10     -     -     12     22,523     22,535
   Total
$ 809   $ 2,663   $ 4   $ 206,485   $ 209,961   $ 1,836,786   $ 2,046,747
                                         
December 31, 2010
                                       
Commercial, financial & agricultural
$ 495   $ 252   $ -   $ 982   $ 1,729   $ 206,251   $ 207,980
Real estate:
                                       
   Construction
  12,551     118     6,550     182,073     201,292     112,493     313,785
   Mortgage - residential
  4,183     7,494     1,800     47,560     61,037     685,224     746,261
   Mortgage - commercial
  273     3,169     -     14,464     17,906     742,400     760,306
Consumer
  620     444     181     225     1,470     111,479     112,949
Leases
  100     -     -     -     100     28,063     28,163
   Total
$ 18,222   $ 11,477   $ 8,531   $ 245,304   $ 283,534   $ 1,885,910   $ 2,169,444
 
 
13

 
Restructured loans included in nonperforming assets at June 30, 2011 consisted of 116 Hawaii residential mortgage loans with a combined principal balance of $47.6 million, seven Hawaii construction and development loans with a combined principal balance of $37.2 million, and one Hawaii commercial loan with a principal balance of $0.4 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 restructured loans were matured and/or in default at the time of restructure and we have no commitments to lend additional funds to any of these borrowers. There were $1.8 million of restructured loans still accruing interest at June 30, 2011, none of which were more than 90 days delinquent. At December 31, 2010, there were $14.2 million of restructured loans still accruing interest, including two residential mortgage loans totaling $0.8 million that were more than 90 days delinquent.

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 loans and leases with an outstanding balance greater than $0.5 million or $1.0 million, depending on loan type, and 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.

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.
 
 
 
14

 
Loans and leases not meeting the criteria above that are analyzed individually as part of the process described above are considered to be pass rated loans and leases. Loans and leases listed as not rated are either less than $0.5 million or are included in groups of homogeneous loan pools. The following table presents by class and credit indicator, the recorded investment in the Company’s loans and leases as of June 30, 2011 and December 31, 2010:
 
 
Pass
 
Special
Mention
 
Substandard
 
Doubtful
 
Loss
 
Not Rated
 
Less: Unearned Income
 
Total
 
(Dollars in thousands)
June 30, 2011
                             
Commercial, financial
                             
   & agricultural
$ 113,027   $ 8,987   $ 16,876   $ -   $ -   $ 59,117   $ (96 ) $ 198,103
Real estate:
                                             
   Construction
  55,501     14,085     166,080     -     -     6,087     286     241,467
   Mortgage - residential
  67,987     11,705     64,016     -     -     618,290     1,249     760,749
   Mortgage - commercial
  536,163     84,146     58,634     -     -     35,363     1,359     712,947
Consumer
  4,310     214     69     -     -     106,353     -     110,946
Leases
  20,142     575     1,818     -     -     -     -     22,535
   Total
$ 797,130   $ 119,712   $ 307,493   $ -   $ -   $ 825,210   $ 2,798   $ 2,046,747
                                               
December 31, 2010
                                             
Commercial, financial
                                             
   & agricultural
$ 109,619   $ 22,529   $ 19,370   $ -   $ -   $ 56,382   $ (80 ) $ 207,980
Real estate:
                                             
   Construction
  44,488     41,330     215,187     5,789     -     7,736     745     313,785
   Mortgage - residential
  70,747     17,475     55,533     -     -     604,115     1,609     746,261
   Mortgage - commercial
  557,511     67,639     97,871     2,883     -     35,806     1,404     760,306
Consumer
  5,778     307     769     -     14     106,082     1     112,949
Leases
  21,761     4,039     2,363     -     -     -     -     28,163
   Total
$ 809,904   $ 153,319   $ 391,093   $ 8,672   $ 14   $ 810,121   $ 3,679   $ 2,169,444
 
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 June 30, 2011 and December 31, 2010, we did not have any loans that we considered to be subprime.

6.   ALLOWANCE FOR LOAN AND LEASE LOSSES

The following table presents the changes in the allowance for loan and lease losses (the “Allowance”) for the periods indicated:
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Dollars in thousands)
 
                       
   Balance, beginning of period
$ 178,010     $ 211,646     $ 192,854     $ 205,279  
   Provision (credit) for loan and lease losses
  (8,784 )     20,412       (10,359 )     79,249  
    169,226       232,058       182,495       284,528  
                               
   Charge-offs
  (6,194 )     (30,742 )     (24,325 )     (90,710 )
   Recoveries
  3,902       643       8,764       8,141  
      Net charge-offs
  (2,292 )     (30,099 )     (15,561 )     (82,569 )
   Balance, end of period
$ 166,934     $ 201,959     $ 166,934     $ 201,959  
 
 
15

 
Our provision for loan and lease losses (the “Provision”) was a credit of $8.8 million and $10.4 million in the second quarter and first half of 2011, respectively, compared to a charge of $20.4 million and $79.2 million in the second quarter and first half of 2010, respectively. The decrease in both our Provision and Allowance is directly attributable to continued improvement in our credit risk profile as evidenced by declines in both nonperforming assets and net charge-offs.

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 June 30, 2011
                               
Beginning balance
$ 11,134   $ 59,078   $ 30,823   $ 68,991   $ 2,451   $ 1,533   $ 4,000   $ 178,010  
Provision (credit) for loan                                                
   and lease losses
  1,094     (6,137 )   (1,365 )   (2,482 )   852     (746 )   -     (8,784 )
    12,228     52,941     29,458     66,509     3,303     787     4,000     169,226  
Charge-offs
  (455 )   (3,000 )   (1,263 )   (879 )   (597 )   -     -     (6,194 )
Recoveries
  854     2,549     231     3     265     -     -     3,902  
   Net charge-offs
  399     (451 )   (1,032 )   (876 )   (332 )   -     -     (2,292 )
   Ending balance
$ 12,627   $ 52,490   $ 28,426   $ 65,633   $ 2,971   $ 787   $ 4,000   $ 166,934  
                                                 
Six Months Ended June 30, 2011
                                               
Beginning balance
$ 13,426   $ 76,556   $ 31,830   $ 64,308   $ 3,155   $ 1,579   $ 2,000   $ 192,854  
Provision (credit) for loan                                                
   and lease losses
  (224 )   (13,123 )   (1,036 )   2,388     428     (792 )   2,000     (10,359 )
    13,202     63,433     30,794     66,696     3,583     787     4,000     182,495  
Charge-offs
  (1,861 )   (16,858 )   (3,299 )   (1,105 )   (1,202 )   -     -     (24,325 )
Recoveries
  1,286     5,915     931     42     590     -     -     8,764  
   Net charge-offs
  (575 )   (10,943 )   (2,368 )   (1,063 )   (612 )   -     -     (15,561 )
   Ending balance
$ 12,627   $ 52,490   $ 28,426   $ 65,633   $ 2,971   $ 787   $ 4,000   $ 166,934  
 
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 increases to our Provision.

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. The fair value of the servicing assets was determined using a discounted cash flow model based on market value assumptions at the time of securitization and is amortized in proportion to and over the period of net servicing income.

All unsold mortgage-backed securities were categorized as available for sale securities and were therefore recorded at their fair value of $9.8 million and $10.0 million at June 30, 2011 and December 31, 2010, respectively. The fair values of these mortgage-backed securities were based on quoted prices of similar instruments in active markets. Unrealized gains of $0.3 million and $34 thousand on unsold mortgage-backed securities were recorded in accumulated other comprehensive loss (“AOCL”) at June 30, 2011 and December 31, 2010, respectively.

8.   GOODWILL AND OTHER INTANGIBLE ASSETS

During the first quarter of 2010, we determined that an impairment test on our remaining goodwill was required because of the uncertainty regarding our ability to continue as a going concern at that time combined with the fact that our market capitalization remained depressed. As a result of that impairment test, we determined that the remaining goodwill associated with our Hawaii Market reporting unit was impaired and we recorded a non-cash impairment charge of $102.7 million. Since that time, we had no goodwill remaining on our consolidated balance sheet.

 
16

 
Prior to the first quarter of 2010, we reviewed the carrying amount of goodwill for impairment on an annual basis and performed additional assessments on a quarterly basis whenever indicators of impairment were evident. Goodwill attributable to each of our reporting units was tested for impairment by comparing their respective fair values to their carrying values. When determining fair value, we utilized a discounted cash flow methodology for our Commercial Real Estate reporting unit and versions of the guideline company, guideline transaction and discounted cash flow methodologies for our Hawaii Market reporting unit. Absent any impairment indicators, we performed our annual goodwill impairment tests during the fourth quarter of each fiscal year.

Similar to our process for evaluating our goodwill for impairment, we also 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 assessment of goodwill and other intangible assets 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, including assumptions about the future growth and potential volatility in revenues and costs, capital expenditures, industry economic factors and future business strategy. The variability of the factors we use to perform the goodwill impairment test depends on a number of conditions, including 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. If we had used other assumptions and estimates or if different conditions occur in future periods, including, but not limited to, changes in other reporting units or operating segments, future operating results could be materially impacted.

Other intangible assets include a core deposit premium, mortgage servicing rights, customer relationships and non-compete agreements. The following table presents changes in other intangible assets for the six months ended June 30, 2011:
 
 
Core
   
Mortgage
                   
 
Deposit
   
Servicing
   
Customer
   
Non-Compete
       
 
Premium
   
Rights
   
Relationships
   
Agreements
   
Total
 
 
(Dollars in thousands)
 
                             
Balance, beginning of period
$ 20,727     $ 22,712     $ 1,050     $ 150     $ 44,639  
Additions
  -       2,063       -       -       2,063  
Amortization
  (1,337 )     (1,739 )     (70 )     (30 )     (3,176 )
Balance, end of period
$ 19,390     $ 23,036     $ 980     $ 120     $ 43,526  
 
Income generated as the result of new mortgage servicing rights is reported as gains on sales of loans and totaled $0.7 million and $2.1 million for the three and six months ended June 30, 2011, respectively, compared to $1.4 million and $3.0 million for the three and six months ended June 30, 2010, respectively. Amortization of mortgage servicing rights was $0.9 million and $1.7 million for the three and six months ended June 30, 2011, respectively, compared to $0.9 million and $1.6 million for the three and six months ended June 30, 2010, respectively.

The following table presents the fair market value and key assumptions used in determining the fair market value of our mortgage servicing rights:
 
 
Six Months Ended June 30,
 
2011
 
2010
 
(Dollars in thousands)
           
Fair market value, beginning of period
$ 23,709     $ 23,019  
Fair market value, end of period
  23,190       22,144  
Weighted average discount rate
  8.5 %     8.5 %
Weighted average prepayment speed assumption
  14.5       14.1  
 
 
 
17

 
The gross carrying value and accumulated amortization related to our intangible assets are presented below:
 
 
June 30, 2011
   
December 31, 2010
 
Gross
               
Gross
           
 
Carrying
   
Accumulated
         
Carrying
   
Accumulated
     
 
Value
   
Amortization
   
Net
   
Value
   
Amortization
   
Net
 
(Dollars in thousands)
                                 
Core deposit premium
$ 44,642     $ (25,252 )   $ 19,390     $ 44,642     $ (23,915 )   $ 20,727
Mortgage servicing rights
  43,730       (20,694 )     23,036       41,667       (18,955 )     22,712
Customer relationships
  1,400       (420 )     980       1,400       (350 )     1,050
Non-compete agreements
  300       (180 )     120       300       (150 )     150
  $ 90,072     $ (46,546 )   $ 43,526     $ 88,009     $ (43,370 )   $ 44,639
 
Based on the core deposit premium, mortgage servicing rights, customer relationships and non-compete agreements held as of June 30, 2011, estimated amortization expense for the remainder of fiscal 2011, the next five succeeding fiscal years and all years thereafter are as follows:
 
 
Estimated Amortization Expense
       
Mortgage
                 
 
Core Deposit
   
Servicing
   
Customer
   
Non-Compete
     
 
Premium
   
Rights
   
Relationships
   
Agreements
   
Total
 
(Dollars in thousands)
                           
2011 (remainder)
$ 1,337     $ 1,081     $ 70     $ 30     $ 2,518
2012
  2,674       2,777       140       60       5,651
2013
  2,674       2,283       140       30       5,127
2014
  2,674       1,913       140       -       4,727
2015
  2,674       1,594       140       -       4,408
2016
  2,674       1,323       140       -       4,137
Thereafter
  4,683       12,065       210       -       16,958
  $ 19,390     $ 23,036     $ 980     $ 120     $ 43,526
 
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 AOCL, 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 Swap

In January 2008, we entered into a derivative transaction to hedge future cash flows from a portion of our then existing variable rate loan portfolio. Under the terms of the arrangement, we would receive payments equal to a fixed interest rate of 6.25% from January 2008 through January 2013 from the counterparty on a notional amount of $400 million. In return, we would pay the counterparty a floating rate, namely our prime rate, on the same notional amount. The purpose of the derivative transaction was to minimize the risk of fluctuations in interest payments received on our variable rate loan portfolio. The derivative transaction was designated as a cash flow hedge.

On September 1, 2009, we terminated the derivative transaction with the counterparty at its then fair market value of $18.0 million. As a result of the termination, we recorded an unrealized gain related to hedge effectiveness of $12.5 million as a component of AOCL and $5.5 million of hedge ineffectiveness as other operating income. The unrealized gain is being recognized into income over the original contract period through January 2013 using the effective yield method and we expect to reclassify $2.2 million of this gain into earnings within the next 12 months.
 
18

 
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 lock 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 June 30, 2011, we were a party to interest rate lock and forward sale commitments on $33.4 million and $17.8 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
June 30, 2011
   
Fair Value at
December 31, 2010
   
Fair Value at
June 30, 2011
   
Fair Value at
December 31, 2010
       
(Dollars in thousands)
Interest rate contracts
 
Other assets /
                     
   
other liabilities
  $ 160     $ 1,035     $ 285     $ 523
 
The following table presents the impact of derivative instruments and their location within the consolidated statements of operations:
 
Derivatives in Cash Flow
Hedging Relationship
 
Amount of Gain Reclassified
from AOCL into Earnings
(Effective Portion)
   
(Dollars in thousands)
Three Months Ended June 30, 2011
   
Interest rate contracts
  $ 801
       
Three Months Ended June 30, 2010
     
Interest rate contracts
    1,721
       
Six Months Ended June 30, 2011
     
Interest rate contracts
    1,917
       
Six Months Ended June 30, 2010
     
Interest rate contracts
    3,611
 
Amounts recognized in AOCL are net of income taxes. Amounts reclassified from AOCL into income are included in interest income in the consolidated statements of operations. The ineffective portion has been recognized as other operating income in the consolidated statements of operations.
 
Derivatives not in Cash Flow
Hedging Relationship
 
Location of Gain (Loss) Recognized
in Earnings on Derivatives
 
Amount of Gain
(Loss) Recognized in
Earnings on Derivatives
 
       
(Dollars in thousands)
 
Three Months Ended June 30, 2011
         
Interest rate contracts
 
 Other operating income
  $ (106 )
             
Three Months Ended June 30, 2010
           
Interest rate contracts
 
 Other operating income
    873  
             
Six Months Ended June 30, 2011
           
Interest rate contracts
 
 Other operating income
    173  
             
Six Months Ended June 30, 2010
           
Interest rate contracts
 
 Other operating income
    1,092  
 
19

 
10.  SHORT-TERM BORROWINGS AND LONG-TERM DEBT

At June 30, 2011, our bank maintained a $30.9 million line of credit with the Federal Reserve discount window, of which there were no advances outstanding. As of June 30, 2011, certain commercial real estate loans totaling $123.8 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. Future advances under this arrangement are subject to approval of the Federal Reserve. Furthermore, all terms and maturities of advances under this arrangement are at the discretion of the Federal Reserve and are generally limited to overnight borrowings. Since September 2009, our bank was no longer eligible to access the Federal Reserve’s primary credit facility but maintained access to its secondary facility. There was no change in the level of credit available to the bank; however, future advances will have higher borrowing costs under the secondary facility.

The bank is a member of and maintained a $646.7 million line of credit with the FHLB as of June 30, 2011. Long-term borrowings under this arrangement totaled $300.8 million at June 30, 2011, compared to $200.0 million and $351.3 million of short-term and long-term borrowings, respectively, at December 31, 2010. There were no short-term borrowings under this arrangement at June 30, 2011. FHLB advances outstanding at June 30, 2011 were secured by investment securities with a fair value of $320.6 million and certain real estate loans totaling $576.3 million in accordance with the collateral provisions of the Advances, Security and Deposit Agreement with the FHLB. Approximately $345.9 million was undrawn under this arrangement at June 30, 2011. The FHLB has no obligation to make future advances to the bank.

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, which currently stands at eight consecutive quarters, the respective trusts have 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 will continue to accrue, and reflect in our consolidated financial statements, the deferred interest payments on our junior subordinated debentures. Accrued interest on our outstanding junior subordinated debentures relating to our trust preferred securities was $6.7 million and $5.1 million at June 30, 2011 and December 31, 2010, respectively. With the recent completion of our recapitalization, we may seek regulatory approval to pay all deferred payments under our trust preferred securities.

11.   EQUITY

As previously announced, we completed a number of significant transactions as part of our recapitalization during the first half of 2011, including:

·  
on February 2, 2011, we effected a one-for-twenty reverse stock split of our common stock (the “Reverse Stock Split”). Except as otherwise specified, the share and per share amounts for historical periods have been restated to give the effect to the Reverse Stock Split;

·  
on February 18, 2011, we completed the Private Placement with investments from (1) affiliates of each of The Carlyle Group (“Carlyle”) and Anchorage Capital Group, L.L.C. (together with Carlyle, the “Lead Investors”) pursuant to investment agreements with each of the Lead Investors and (2) various other investors, including certain of our directors and officers, pursuant to subscription agreements with each of such investors;

·  
concurrently with the closing of the Private Placement, we completed the TARP Exchange of 135,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, no par value per share and liquidation preference $1,000 per share, held by the United States Department of the Treasury (the “Treasury”), and accrued and unpaid dividends thereon for 5,620,117 common shares. We also amended the warrant held by the Treasury (the “Amended TARP Warrant”) to, among other things, reduce the exercise price from $255.40 per share to $10 per share. The warrant grants the Treasury the right to purchase 79,288 common shares, subject to adjustment; and

·  
on May 6, 2011, we completed a $20 million common stock rights offering which allowed shareholders of record as of the close of business on February 17, 2011 or their transferees to purchase newly issued common shares at $10.00 per share.

The TARP Exchange resulted in a non-cash increase in net income available to common shareholders of $85.1 million as the book value of the preferred stock plus accrued and unpaid dividends was greater than the estimated fair value of the common stock issued to the Treasury of $56.2 million and the fair value of the Amended TARP Warrant at the time of the TARP Exchange. This accounting treatment had no effect on our total shareholders’ equity or our regulatory capital position.
 
20

 
In addition to adjusting the exercise price of the Amended TARP Warrant, its terms were revised to include a “down-round” provision allowing for the future adjustment to the exercise price for any subsequent issuances of common stock by the Company. Subject to certain exceptions, if the Company subsequently issues common stock, or rights or shares convertible into common stock, at a per share price lower than the $10 exercise price of the warrant, the exercise price of the warrant will be reduced to the per share common stock amount received in connection with the issuance and the number of shares of common stock subject to the warrant will be increased. This provision resulted in the warrant being carried as a derivative liability as compared to a common stock equivalent for balance sheet purposes as it possesses the characteristics of a freestanding derivative financial instrument as defined by Accounting Standards Codification (“ASC”) 815-10-15-83, Accounting for Derivatives and Hedging, and similar to the example illustrated in ASC 815-40-55-33 and -34. As a derivative liability, the warrant is carried at fair value, with subsequent remeasurements recorded through the current period's earnings. The initial value attributed to the warrant was $1.7 million, with the fair value estimated using the Black-Scholes options pricing model, with the following assumptions: 67% volatility, a risk-free rate of 3.59%, a yield of 1.45% and an estimated life of 10 years. From February 18, 2011 through March 31, 2011, this instrument’s estimated fair value decreased, which resulted in the recognition of $0.5 million recorded in other noninterest income during the first quarter of 2011.  From March 31, 2011 through June 30, 2011, this instrument’s estimated fair value decreased further, which resulted in the recognition of an additional $0.5 million recorded in other noninterest income during the second quarter of 2011.

On June 22, 2011, the Treasury completed a public underwritten offering of 2,850,000 shares of our common stock it received in the TARP Exchange. The Company did not receive any proceeds from this offering. The Treasury continues to hold 2,770,117 shares of our common stock and a warrant to purchase 79,288 shares of our common stock.

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 is subject to obtaining approval from the FRBSF, DFI and Treasury, and is restricted until our obligations under our trust preferred securities are brought current. Additionally, our ability to pay dividends depends on our ability to obtain dividends from our bank. In addition to obtaining approval from the FDIC and DFI, Hawaii law only permits Central Pacific Bank to pay dividends out of retained earnings. Given that the bank had an accumulated deficit of $468.0 million at June 30, 2011, the bank is prohibited from paying any dividends until this deficit is eliminated. Accordingly, we do not anticipate that the bank will be permitted to pay dividends for the foreseeable future.
 
12.  SHARE-BASED COMPENSATION

Stock Option Activity

The following is a summary of stock option activity for the Company’s stock option plans for the six months ended June 30, 2011:
 
       
Weighted Average
 
Shares
   
Exercise Price
         
Outstanding at January 1, 2011
41,934     $ 432.17
Changes during the period:
         
  Forfeited
(113 )     79.00
Outstanding at June 30, 2011
41,821       433.12
 
Restricted Stock Awards and Units

The table below presents the activity of restricted stock awards and units for the six months ended June 30, 2011:
 
       
Weighted Average
       
Grant Date
 
Shares
   
Fair Value
         
Nonvested at January 1, 2011
300     $ 718.00
Changes during the period:
         
  Granted
1,022,341       14.70
  Vested
(21,128 )     14.27
  Forfeited
(4,050 )     14.71
Nonvested at June 30, 2011
997,463       14.92
 
 
21

 
Performance Shares and Stock Appreciation Rights

No performance shares or SARs were granted under the 2005 LTIP and 2008 LTIP during the six months ended June 30, 2011.

The table below presents activity of performance shares under both the 2005 LTIP and 2008 LTIP for the six months ended June 30, 2011:
 
       
Weighted Average
 
Shares
   
Exercise Price
         
Outstanding at January 1, 2011
2,442     $ 377.60
Changes during the period:
         
  Vested
(531 )     377.60
  Forfeited
(1,911 )     377.60
Outstanding at June 30, 2011
-        
 
The table below presents activity of SARs under both the 2005 LTIP and 2008 LTIP for the six months ended June 30, 2011:
 
       
Weighted Average
 
Shares
   
Exercise Price
         
Outstanding at January 1, 2011
4,608     $ 377.60
Changes during the period:
         
  Forfeited
(4,608 )     377.60
Outstanding at June 30, 2011
-        
 
13.  ACCUMULATED OTHER COMPREHENSIVE LOSS

Components of accumulated other comprehensive loss, net of taxes, were as follows:
 
 
June 30,
   
December 31,
 
 
2011
   
2010
 
 
(Dollars in thousands)
 
           
Unrealized gain on available for sale investment securities
$ 14,153     $ 2,985  
Unrealized loss on derivatives
  (9,242 )     (7,324 )
Pension adjustments
  (9,117 )     (10,226 )
  Accumulated other comprehensive loss, net of tax
$ (4,206 )   $ (14,565 )
 
Components of comprehensive income (loss), net of taxes, for the periods indicated were as follows:
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Dollars in thousands)
 
                       
Net income (loss)
$ 8,211     $ (16,105 )   $ 12,850     $ (176,324 )
Unrealized gain on investment securities
  10,177       3,975       11,168       1,978  
Unrealized loss on derivatives
  (802 )     (1,721 )     (1,918 )     (3,611 )
Pension adjustments
  554       516       1,109       960  
  Comprehensive income (loss)
$ 18,140     $ (13,335 )   $ 23,209     $ (176,997 )
 
 
22

 
14.  PENSION 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
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Dollars in thousands)
 
                       
Interest cost
$ 417     $ 437     $ 834     $ 874  
Expected return on assets
  (457 )     (428 )     (914 )     (856 )
Amortization of unrecognized loss
  550       514       1,100       1,028  
  Net periodic cost
$ 510     $ 523     $ 1,020     $ 1,046  
 
The fair values of the defined benefit retirement plan as of June 30, 2011 and December 31, 2010 by asset category were as follows:
 
 
Level 1
   
Level 2
   
Level 3
   
Total
 
(Dollars in thousands)
June 30, 2011
                   
Money market accounts
$ 627     $ -     $ -     $ 627
Mutual funds
  7,493       -       -       7,493
Government obligations
  -       4,211       -       4,211
Common stocks
  5,724       -       -       5,724
Preferred stocks
  589       -       -       589
Corporate bonds and debentures
  -       4,154       -       4,154
Limited partnerships
  -       1,170       -       1,170
  $ 14,433     $ 9,535     $ -     $ 23,968
                             
December 31, 2010
                           
Money market accounts
$ 724     $ -     $ -     $ 724
Mutual funds
  7,425       -       -       7,425
Government obligations
  -       3,535       -       3,535
Common stocks
  5,317       -       -       5,317
Preferred stocks
  554       -       -       554
Corporate bonds and debentures
  -       3,482       -       3,482
Limited partnerships
  -       2,183       -       2,183
  $ 14,020     $ 9,200     $ -     $ 23,220
 
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
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Dollars in thousands)
 
                       
Service cost
$ -     $ 7     $ -     $ 18  
Interest cost
  103       108       206       216  
Amortization of unrecognized transition obligation
  4       4       8       8  
Amortization of prior service cost
  5       (7 )     10       (14 )
Amortization of unrecognized (gain) loss
  (4 )     5       (8 )     10  
  Net periodic cost
$ 108     $ 117     $ 216     $ 238  
 
 
23

 
15.  INCOME TAXES

The valuation allowance for net deferred tax assets at June 30, 2011 and December 31, 2010 was $172.4 million and $178.8 million, respectively. The $6.4 million decrease in our valuation allowance during the first half of 2011 was attributable to a decrease in our net deferred tax assets resulting from the net operating income recognized in the first half of 2011. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets 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. Based upon the Company’s cumulative three year loss position and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will be unable to realize the benefits of these deductible differences. The amount of the net deferred tax asset considered realizable, however, could change if estimates of future taxable income during the carryforward period change.

16.  EARNINGS (LOSS) PER SHARE

The following table presents the information used to compute basic and diluted earnings (loss) per common share for the periods indicated:
 
 
Three Months Ended
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(In thousands, except per share data)
 
                       
Net income (loss)
$ 8,211     $ (16,105 )   $ 12,850     $ (176,324 )
Preferred stock dividends, accretion of discount and
                             
   conversion of preferred stock to common stock
  -       2,096       (83,897 )     4,170  
Net income (loss) available to common shareholders
$ 8,211     $ (18,201 )   $ 96,747     $ (180,494 )
                               
Weighted average shares outstanding - basic
  40,700       1,515       30,059       1,514  
Dilutive effect of employee stock options and awards
  349       -       648       -  
Dilutive effect of deferred salary restricted stock units
  3       -       2       -  
Dilutive effect of Treasury warrants
  26       -       24       -  
Weighted average shares outstanding - diluted
  41,078       1,515       30,733       1,514  
                               
Basic earnings (loss) per share
$ 0.20     $ (12.01 )   $ 3.22     $ (119.18 )
Diluted earnings (loss) per share
$ 0.20     $ (12.01 )   $ 3.15     $ (119.18 )
 
A total of 41,821 potentially dilutive securities have been excluded from the dilutive share calculation for the three and six months ended June 30, 2011, as their effect was antidilutive, compared to 142,382 for the three and six months ended June 30, 2010.

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, the majority of 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.

 
24

 
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.

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 based on the higher of the discounted value of contractual cash flows or its carrying value. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-Term Borrowings and Long-Term Debt

The fair value for a portion of our short-term borrowings is estimated by discounting scheduled cash flows using rates currently offered for securities of similar remaining maturities. The fair value of our long-term debt, primarily FHLB advances, 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.
 
 
25

 
 
June 30, 2011
   
December 31, 2010
 
 
Carrying/
         
Carrying/
       
 
notional
   
Estimated
   
notional
   
Estimated
 
 
amount
   
fair value
   
amount
   
fair value
 
 
(Dollars in thousands)
 
Financial assets
                     
   Cash and due from banks
$ 68,986     $ 68,986     $ 61,725     $ 61,725  
   Interest-bearing deposits in other banks
  384,477       384,477       729,014       729,014  
   Investment securities
  1,401,958       1,402,011       705,345       705,430  
   Net loans and leases, including loans held for sale
  1,902,103       1,825,194       2,046,338       1,985,261  
   Accrued interest receivable
  11,711       11,711       11,279       11,279  
                               
Financial liabilities
                             
   Deposits:
                             
      Noninterest-bearing deposits
  687,468       687,468       611,744       611,744  
      Interest-bearing demand and savings deposits
  1,636,386       1,636,386       1,729,361       1,729,361  
      Time deposits
  906,466       906,708       791,842       793,333  
        Total deposits
  3,230,320       3,230,562       3,132,947       3,134,438  
   Short-term borrowings
  1,385       1,385       202,480       202,351  
   Long-term debt
  409,076       332,619       459,803       407,175  
   Accrued interest payable (included in other liabilities)
  9,352       9,352       9,528       9,528  
                               
Off-balance sheet financial instruments
                             
   Commitments to extend credit
  441,800       2,209       415,005       2,075  
   Standby letters of credit and financial guarantees written
  12,863       96       11,056       83  
   Interest rate options
  33,428       (114 )     63,994       (170 )
   Forward interest rate contracts
  17,820       (12 )     40,658       682  
   Forward foreign exchange contracts
  -       -       1,889       1,891  
 
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.
 
 
26

 
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010:
 
       
Fair Value at Reporting Date 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)
June 30, 2011
                   
Available for sale securities:
                   
  U.S. Government sponsored entities debt securities
$ 384,780     $ -     $ 384,780     $ -
  States and political subdivisions
  12,443       -       -       12,443
  U.S. Government sponsored entities mortgage-backed securities
  1,002,146       -       1,002,146       -
  Non-agency collateralized mortgage obligations
  17       -       -       17
  Other
  994       994       -       -
Derivatives:
                           
  Interest rate contracts
  (126 )     -       (126 )     -
  Amended TARP Warrant
  (753 )     -       (753 )     -
   Total
$ 1,399,501     $ 994     $ 1,386,047     $ 12,460
                             
December 31, 2010
                           
Available for sale securities:
                           
  U.S. Government sponsored entities debt securities
$ 201,855     $ -     $ 201,855     $ -
  States and political subdivisions
  12,619       -       -       12,619
  U.S. Government sponsored entities mortgage-backed securities
  486,964       -       486,964       -
  Non-agency collateralized mortgage obligations
  17       -       -       17
  Other
  1,062       1,062       -       -
Derivatives:
                           
  Interest rate contracts
  512       -       512       -
   Total
$ 703,029     $ 1,062     $ 689,331     $ 12,636
 
For the six months ended June 30, 2011 and 2010, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
 
 
Available for sale securities
   
Available for sale non-
agency collateralized
mortgage obligations (1)
 
 
(Dollars in thousands)
 
           
Balance at December 31, 2010
$ 12,619     $ 17  
   Principal payments received
  (176 )     -  
Balance at June 30, 2011
$ 12,443     $ 17  
               
Balance at December 31, 2009
$ 13,778     $ 46,469  
   Principal payments received
  (195 )     (1,052 )
   Realized net losses included in net loss
  -       (7,275 )
   Unrealized net gains included in other comprehensive loss
  -       6,222  
   Sales
  -       (44,347 )
Balance at June 30, 2010
$ 13,583     $ 17  
               
(1) Represents available for sale non-agency collateralized mortgage obligations previously classified as
 
      Level 2 for which the market became inactive during 2008; therefore the fair value measurement was
 
     derived from discounted cash flow models using unobservable inputs and assumptions.
 
 
 
27

 
For assets measured at fair value on a nonrecurring basis that were recorded at fair value on our balance sheet at June 30, 2011 and December 31, 2010, 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)
June 30, 2011
                   
Impaired loans (1)
$ 200,419     $ -     $ 200,419     $ -
Other real estate (2)
  42,863       -       42,863       -
                             
December 31, 2010
                           
Loans held for sale (1)
$ 35,300     $ -     $ 35,300     $ -
Impaired loans (1)
  205,509       -       205,509       -
Other real estate (2)
  57,507       -       57,507       -
                             
(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 three reportable segments: Commercial Real Estate, Hawaii Market and Treasury. The segments reported are consistent with internal functional reporting lines. They are managed separately because each unit has different target markets, technological requirements, marketing strategies and specialized skills.

The Commercial Real Estate segment includes construction and real estate development lending in Hawaii, California and Washington. The Hawaii Market segment includes retail branch offices, commercial lending, residential mortgage lending and servicing, indirect auto lending, trust services and retail brokerage services. A full range of deposit and loan products and various other banking services are offered. The Treasury segment is responsible for managing the Company's investment securities portfolio and wholesale funding activities. The All Others category 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, 2010 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.
 
 
 
28

 
Segment profits (losses) and assets are provided in the following table for the periods indicated.
 
 
Commercial
   
Hawaii
                   
 
Real Estate
   
Market
   
Treasury
   
All Others
   
Total
 
 
(Dollars in thousands)
 
Three months ended June 30, 2011:
                           
   Net interest income
$ 6,578     $ 16,727     $ 5,674     $ -     $ 28,979  
   Intersegment net interest income (expense)
  (4,339 )     15,423       (5,074 )     (6,010 )     -  
   Credit (provision) for loan and lease losses
  20,411       (11,627 )     -       -       8,784  
   Other operating income
  224       8,668       1,704       341       10,937  
   Other operating expense
  (4,073 )     (22,387 )     (138 )     (13,891 )     (40,489 )
   Administrative and overhead expense allocation
  (984 )     (12,066 )     (127 )     13,177       -  
      Net income (loss)
$ 17,817     $ (5,262 )   $ 2,039     $ (6,383 )   $ 8,211  
                                       
Three months ended June 30, 2010:
                                     
   Net interest income
$ 12,279     $ 16,491     $ 426     $ -     $ 29,196  
   Intersegment net interest income (expense)
  (8,271 )     8,158       1,276       (1,163 )     -  
   Provision for loan and lease losses
  (1,800 )     (18,612 )     -       -       (20,412 )
   Other operating income
  254       9,838       2,662       (17 )     12,737  
   Other operating expense
  (4,371 )     (20,565 )     (352 )     (12,338 )     (37,626 )
   Administrative and overhead expense allocation
  (1,195 )     (10,178 )     (114 )     11,487       -  
      Net income (loss)
$ (3,104 )   $ (14,868 )   $ 3,898     $ (2,031 )   $ (16,105 )
                                       
Six months ended June 30, 2011:
                                     
   Net interest income
$ 14,319     $ 33,410     $ 9,451     $ -     $ 57,180  
   Intersegment net interest income (expense)
  (9,140 )     30,650       (6,297 )     (15,213 )     -  
   Credit (provision) for loan and lease losses
  21,611       (11,252 )     -       -       10,359  
   Other operating income
  492       18,775       3,343       827       23,437  
   Other operating expense
  (8,501 )     (43,405 )     (227 )     (25,993 )     (78,126 )
   Administrative and overhead expense allocation
  (1,923 )     (22,829 )     (252 )     25,004       -  
      Net income (loss)
$ 16,858     $ 5,349     $ 6,018     $ (15,375 )   $ 12,850  
                                       
Six months ended June 30, 2010:
                                     
   Net interest income
$ 25,611     $ 33,060     $ 5,594     $ -     $ 64,265  
   Intersegment net interest income (expense)
  (18,212 )     17,828       (440 )     824       -  
   Provision for loan and lease losses
  (42,100 )     (37,149 )     -       -       (79,249 )
   Other operating income
  469       19,650       5,520       (138 )     25,501  
   Goodwill impairment
  -       (102,689 )     -       -       (102,689 )
   Other operating expense (excluding goodwill impairment)
  (14,984 )     (42,475 )     (1,017 )     (25,676 )     (84,152 )
   Administrative and overhead expense allocation
  (2,410 )     (20,257 )     (216 )     22,883       -  
      Net income (loss)
$ (51,626 )   $ (132,032 )   $ 9,441     $ (2,107 )   $ (176,324 )
                                       
 At June 30, 2011:
                                     
    Investment securities
$ -     $ -     $ 1,401,958     $ -     $ 1,401,958  
    Loans and leases (including loans held for sale)
  565,875       1,503,162       -       -       2,069,037  
    Other
  (69,796 )     32,833       624,934       72,767       660,738  
       Total assets
$ 496,079     $ 1,535,995     $ 2,026,892     $ 72,767     $ 4,131,733  
                                       
 At December 31, 2010:
                                     
    Investment securities
$ -     $ -     $ 705,345     $ -     $ 705,345  
    Loans and leases (including loans held for sale)
  699,344       1,539,848       -       -       2,239,192  
    Other
  (49,396 )     6,228       958,665       78,017       993,514  
       Total assets
$ 649,948     $ 1,546,076     $ 1,664,010     $ 78,017     $ 3,938,051  
 
 
 
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19.  LEGAL PROCEEDINGS

Overdraft Litigation

In March 2011, the Company and the bank were named as defendants in a putative class action captioned as Gregory and Camila Peterson, individually and on behalf of all others similarly situated, Plaintiffs, v. Central Pacific Bank, Central Pacific Financial Corp. and Doe Defendants 1-50, Defendants, Case No. 11-1-0457-03 VLC, in the First Circuit Court of Hawaii in Honolulu. The complaint asserts claims for unconscionability, conversion, unjust enrichment, and violations of Hawaii’s Uniform Deceptive Trade Practice Act, relating to the bank’s overdraft practices and fees. Plaintiffs seek declaratory relief, restitution, disgorgement, damages, interest, costs and attorneys’ fees. As of the date of this filing, we are in discussions with the plaintiffs to resolve the matter and the parties have agreed to perform additional diligence in an attempt to reach an acceptable outcome. Because this diligence is ongoing, at this time, we are not able to estimate the amount of costs or a reasonable range of potential costs that the Company may need to incur to resolve this matter.

Other Litigation

We are involved in other 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.
 
 
 
30

 
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 34 branches and 120 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. The bank also has a loan production office in California. As part of our recovery plan, which is described more fully under “—Capital Resources” below, we plan to continue to reduce our exposure to the Mainland.

Recent Events

On April 12, 2011, we announced that the registration statement registering the common shares issued to certain investors in our $325 million capital raise completed in February 2011 (the “Private Placement”) was declared effective by the U.S. Securities and Exchange Commission (“SEC”). The registration statement covers the offer and sale by certain selling shareholders of up to 18,487,715 shares of common stock, no par value per share, which includes 79,288 shares underlying a warrant issued to the United States Department of the Treasury (the “Treasury”). The Company will not receive any proceeds from the sale of common shares by any selling shareholder.

On April 20, 2011, following regulatory approval, we announced the appointments of Crystal K. Rose as Chair of the Board of Directors of CPF and Central Pacific Bank (“CPB”) and John C. Dean, former Executive Chairman of CPF and CPB, as President and Chief Executive Officer (“CEO”) of CPF and CPB. Mr. Dean continues to serve as a director of both the CPF and CPB boards.

In May 2011, we completed our previously announced rights offering (the “Rights Offering”) totaling approximately $20 million whereby shareholders of record as of close of business on February 17, 2011, and their transferees purchased approximately 2,000,000 newly-issued common shares following the expiration of the offering on May 6, 2011 at the same price per share paid by the investors in the Private Placement. The Rights Offering was part of our recapitalization plan.

On June 22, 2011, the Treasury completed a public underwritten offering of 2,850,000 shares of our common stock it received in the TARP Exchange. The Company did not receive any proceeds from this offering. The Treasury continues to hold 2,770,117 shares of our common stock and a warrant to purchase 79,288 shares of our common stock.

Regulatory Matters

In May 2011, the regulatory Consent Order (the “Consent Order”) that the bank entered into with the Federal Deposit Insurance Corporation (the “FDIC”) and the Hawaii Division of Financial Institutions (the “DFI”) on December 9, 2009 was lifted. In place of the Consent Order, the Board of Directors of the bank entered into a Memorandum of Understanding (the “Bank MOU”) with the FDIC and DFI effective May 5, 2011. The Bank MOU continues a number of the same requirements previously required by the Consent Order, including the maintenance of an adequate allowance for loan and lease losses, improvement of our asset quality, limitations on credit extensions, maintenance of qualified management and the prohibition on cash dividends to CPF, among other matters. In addition, the Bank MOU requires the bank to further reduce classified assets below the level previously required by the Consent Order. The Bank MOU lowers the minimum leverage capital ratio that the bank is required to maintain from 10% in the Consent Order to 8% and does not mandate a minimum total risk-based capital ratio.

In addition to the Bank MOU, the Company continues to be subject to a Written Agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (the “FRBSF”) and DFI dated July 2, 2010, which superseded in its entirety the Memorandum of Understanding that the Company entered into on April 1, 2009 with the FRBSF and DFI. Among other matters, the Agreement provides that unless we receive the consent of the FRBSF and DFI, we cannot: (i) pay dividends; (ii) receive dividends or payments representing a reduction in capital from the bank; (iii) directly or through our non-bank subsidiaries make any payments on subordinated debentures or trust preferred securities; (iv) directly or through any non-bank subsidiaries incur, increase or guarantee any debt; or (v) purchase or redeem any shares of our stock. The Agreement requires that our Board of Directors fully utilize the Company's financial and managerial resources to ensure that the bank complies with the Bank MOU and any other supervisory action taken by the bank’s regulators. We were also required to submit to the FRBSF an acceptable capital plan and cash flow projection.
 
31

 
On February 9, 2011, the bank entered into a separate Memorandum of Understanding (the “BSA MOU”) with the FDIC and DFI relating to compliance with the Bank Secrecy Act (the “BSA”). Under the BSA MOU, the bank is required to (i) fully comply with the BSA and anti-money laundering requirements, (ii) implement a plan to ensure such compliance, including improving and maintaining an adequate system of internal controls, bolstering policies on customer due diligence, providing for comprehensive independent testing to validate compliance, and maintaining an adequate compliance staff, (iii) correct all deficiencies identified by our regulators and (iv) provide them with progress reports.

Even though the Consent Order has been replaced by the Bank MOU, the bank remains subject to a number of requirements as described above. We cannot assure you whether or when the Company and the bank will be in full compliance with the agreements with the regulators or whether or when the Bank MOU, the Agreement and the BSA MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators that restrict our activities and may also continue to impose capital ratios requirements. The requirements and restrictions of the Bank MOU, the Agreement and the BSA 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 a new consent order; the imposition of civil monetary penalties; the termination of insurance of deposits; the issuance of removal and prohibition orders against institution-affiliated parties; the appointment of a conservator or receiver for the bank; the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party, if we again fall below the capital ratio requirements; and the enforcement of such actions through injunctions or restraining orders.

Legislative Matters

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act resulted in sweeping changes in the regulation of financial institutions aimed at strengthening the sound operation of the financial services sector. The Dodd-Frank Act includes the following provisions that, among other things:

 
Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and, for large financial institutions, enforcing compliance with federal consumer financial laws. At the federal level, the FDIC will continue to examine us for compliance with such laws.

 
Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (the “DIF”) and increase the floor of the size of the DIF.

 
Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.

 
Require the FDIC and Federal Reserve System (“FRB”) to seek to make their respective capital requirements for state nonmember banks and bank holding companies countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

 
Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions.

 
Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000 and provide unlimited federal deposit insurance until December 31, 2012 for non-interest bearing demand transaction accounts at all insured depository institutions.

 
Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 
Increase the authority of the Federal Reserve to examine us and any of our non-bank subsidiaries.

 
Authorize the FDIC to assess the cost of examinations (the FDIC does not currently assess fees for examining Central Pacific Bank).

 
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Some of these provisions may have the consequence of increasing our expenses, decreasing our revenues, and changing the activities in which we choose to engage. The environment in which banking organizations will now operate, including legislative and regulatory changes affecting capital, liquidity, supervision, permissible activities, corporate governance and compensation, changes in fiscal policy and steps to eliminate government support for banking organizations, may have long-term effects on the business model and profitability of banking organizations that cannot now be foreseen. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities do not apply to our debt and equity instruments issued before May 19, 2010, as we are grandfathered under an exception for depositary institution holding companies with total consolidated assets of less than $15 billion as of December 31, 2009. The specific impact of the Dodd-Frank Act on our current activities or new financial activities we may consider in the future, our financial performance and the markets in which we operate will depend on the manner in which the relevant agencies develop and implement the required rules and the reaction of market participants to these regulatory developments. Although some rules under the Dodd-Frank Act have become effective, many aspects of the Dodd-Frank Act are still subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us, our customers or the financial industry more generally.

Recovery Plan Progress

As previously disclosed, we adopted and implemented a recovery plan in March 2010 to improve our financial health by completing a significant recapitalization, reducing our credit risk exposure and returning to profitability by focusing on our core businesses and traditional markets in Hawaii.

As of June 30, 2011, we have accomplished a number of key milestones in our recovery plan, including:

·  
On February 18, 2011, we successfully completed the $325 million Private Placement. Concurrently with the completion of the Private Placement, we exchanged our TARP preferred stock and accrued and unpaid dividends thereon for common stock (the “TARP Exchange”).

·  
On May 6, 2011, we sucessfully completed the $20 million Rights Offering.

·  
The Consent Order was lifted and replaced with the Bank MOU.

·  
We significantly improved our tier 1 risk-based capital, total risk-based capital, and leverage capital ratios as of June 30, 2011 to 22.48%, 23.80%, and 13.13%, respectively, from 7.64%, 8.98%, and 4.42%, respectively, as of December 31, 2010. Our capital ratios currently exceed the minimum level required by the Bank MOU and are above the levels required for a “well-capitalized” regulatory designation.

·  
We reported two consecutive profitable quarters with net income of $8.2 million and $4.6 million in the second and first quarters of 2011, respectively.

·  
We reduced our nonperforming assets by $53.5 million to $249.3 million at June 30, 2011 from $302.8 million at December 31, 2010.

·  
We reduced our construction and development loan portfolio (excluding owner-occupied loans) as of June 30, 2011 to $226.5 million, or 11.1% of our total loan portfolio. At December 31, 2010, this portfolio totaled $299.9 million, or 13.8% of our total loan portfolio.

·  
We maintained an allowance for loan and lease losses as a percentage of total loans and leases of 8.16% at June 30, 2011, compared to 8.89% at December 31, 2010. In addition, we maintained an allowance for loan and lease losses as a percentage of nonperforming assets of 66.95% at June 30, 2011, compared to 63.69% at December 31, 2010.

·  
We reduced total outstanding borrowings with the Federal Home Loan Bank of Seattle (the “FHLB”) to $301.0 million at June 30, 2011 from $551.3 million at December 31, 2010.

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).”

 
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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.

For loans classified as impaired, an estimated impairment loss is calculated. To estimate loan charge-offs on other loans, we evaluate the level and trend of nonperforming and potential problem loans and historical loss experience. We also consider other relevant economic conditions and borrower-specific risk characteristics, including current repayment patterns of our borrowers, the fair value of collateral securing specific loans, changes in our lending and underwriting standards and general economic factors, nationally and in the markets we serve, including the real estate market generally and the residential and commercial construction markets in particular. Estimated loss rates are determined by loan category and risk profile, and an overall required Allowance is calculated, which includes amounts for imprecision and uncertainty. Based on our estimate of the level of Allowance required, a provision for loan and lease losses (the “Provision”) is recorded to maintain the Allowance at an appropriate level.

Our policy is to charge a loan off in the period in which the loan is deemed to be uncollectible. We consider a loan to be uncollectible when it is probable that a loss has been incurred and the Company can make a reasonable estimate of the loss. In these instances, the likelihood of and/or timeframe for recovery of the amount due is uncertain, weak, or protracted.

Our process for determining the reserve for unfunded commitments is consistent with our process for determining the Allowance and is adjusted for estimated loan funding probabilities. Reserves for unfunded commitments are 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.

In the second quarter of 2011, we recorded a credit to the Provision of $8.8 million. We had an Allowance, as a percentage of total loans and leases, of 8.16% at June 30, 2011, compared to 8.89% at December 31, 2010. Although our credit risk profile has improved in recent quarters and general economic trends and market conditions have shown signs of stabilization to some degree, as further described in the “Material Trends” section below, concerns over the global and U.S. economies still remain.  Accordingly, it is possible that the Hawaii or California real estate markets could begin to deteriorate further. If this occurs, it would result in an increase in loan delinquencies, an increase in loan charge-offs or a need for additional increases in our Allowance; any of which would require an increase in our Provision. Even if economic conditions improve or stay the same, it is possible that we may experience material credit losses and in turn, increases to our Allowance and Provision, due to the elevated risk still inherent in our existing loan portfolio resulting from our high concentration of commercial real estate and construction loans.

Additionally, when establishing our Allowance, we made certain assumptions and judgments with respect to the quality of our loan portfolio. As the economy began to deteriorate in the second half of 2007 and real estate values declined, we found that many of the assumptions and judgments that we made at the time needed to be materially changed in subsequent periods, which resulted in rapid negative credit migration and substantial losses in fiscal 2008, 2009, and 2010. Because of the potential volatility that still exists in the marketplace, we are not able to predict the potential increases that we may need to incur in our Allowance if real estate values do not improve or continue to decline in the markets that we serve, or if the financial condition of our borrowers declines or fails as a result of their continued exposure to the real estate markets and other financial stresses.

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 the Allowance and Provision. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review our Allowance. Such agencies may require that we recognize additions to the Allowance based on their judgments about information available to them at the time of their examination. Accordingly, actual results could differ from those estimates. Changes in the estimate of the Allowance and related Provision could materially affect our operating results. The determination of the Allowance requires us to make estimates of losses that are highly uncertain and involves a high degree of judgment.
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Loans Held for Sale

Loans held for sale consists of Hawaii residential mortgage loans, as well as Hawaii and Mainland construction and commercial real estate loans. 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 Hawaii and Mainland construction and commercial real estate loans are recorded at the lower of cost or fair value on an individual basis.

Loans originated with the intent to be held in our portfolio are subsequently transferred to held for sale when a decision is made to sell these loans. At the time of a loan’s transfer to the held for sale account, 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 operations 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 operations 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 Hawaii and mainland construction and commercial real estate loans net of applicable selling costs on our consolidated balance sheets.

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 of losses for loans for which we could have repurchase obligation. The reserves are established by a charge to other operating expense in our consolidated statements of operation. At June 30, 2011 and December 31, 2010, this reserve totaled $6.7 million and $5.0 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 June 30, 2011 were approximately $3.1 billion and $2.8 billion, respectively. Outstanding balances for agency and non-agency (estimated) for vintages 2005 through 2011 as of June 30, 2011 were $2.3 billion and $1.7 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 outstanding loans sold that have early payment default clauses as of June 30, 2011 total approximately $95.5 million.

The repurchase loss liability is estimated by origination year to capture certain characteristics of each vintage, e.g., economic and housing market conditions, mortgage loan defaults, underwriting standards, etc. Expected repurchases by vintage are based on estimates of current and future investor demand, which are further derived from economic factors, investor demand strategies and other external conditions. To the extent that repurchase demands are made by investors, we may be able to 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. Loss rate estimates include assumptions about the quality of the sold portfolio, as well as economic and other external factors.

Currently, repurchase demands relate primarily to 2007 and 2008 vintages, during which, debt-to-income ratios and loan-to-values tended to be higher, as the GSEs relaxed enforcement of underwriting standards for conforming loans. During 2010, we experienced an increase in repurchase activity for these older vintage loans, as measured by the number of investor file requests, repurchase demands, and actual repurchases. We believe the increase in repurchase activity relates to continued weak economic conditions as investors continued to experience elevated levels of defaulted loans.

Loans repurchased during the three and six months ended June 30, 2011 totaled approximately $4.2 million and $4.8 million, respectively.
 
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The reasons for repurchases have varied, from misrepresentation to income and documentation errors. Due to the limited amount of historical repurchase activity, we continue to analyze repurchase data for emerging material trends. The number of repurchase requests by vintage and investor type, as well as appeals and repurchases are depicted in table below.
 
Repurchase Demands, Appeals, Repurchases [1]
                             
Six months ended June 30, 2011
                                   
                                               
   
Government Sponsored Entities
   
Non-GSE Investors
Vintage
 
Repurchase Demands
   
Appealed
   
Repurchased
   
Pending
Resolution
   
Repurchase Demands
   
Appealed
   
Repurchased
   
Pending
Resolution
                                               
2005 and prior
  3     -     1     2     -     -     -     -
2006
  2     -     -     2     -     -     -     -
2007
  -     -     -     -     4     -     2     2
2008
  6     1     -     5     7     -     2     5
2009
  5     -     1     4     -     -     -     -
2010
  9     3     1     5     -     -     -     -
2011
  3     2     -     1     -     -     -     -
Total
  28     6     3     19     11     -     4     7
                                               
[1] Based on repurchase requests received between January 1, 2011 and June 30, 2011.
 
The reserve for residential mortgage loan repurchase losses of $6.7 million at June 30, 2011, represents our best estimate of the probable loss that we may incur for various representations and warranties in our loan sales contracts with investors. This represents an increase of $1.7 million from December 31, 2010, which was necessary in our estimation, due to the increase in repurchase activity, and uncertainty and risk around future activity and losses. The table below shows changes in the repurchase losses liability since initial establishment.
 
 
Six Months Ended June 30,
   
Year Ended December 31,
 
2011
   
2010
   
2010
   
2009
   
2008
 
(Dollars in thousands)
                           
Balance, beginning of period
$ 5,014     $ 183     $ 183     $ 22     $ -
  Change in estimate
  2,840       150       6,071       161       22
  Utilizations
  (1,198 )     -       (1,240 )     -       -
Balance, end of period
$ 6,656     $ 333     $ 5,014     $ 183     $ 22
 
Our ability to predict repurchase losses is adversely impacted by the lack of significant historical precedent, as well as the lack of access to the servicing records of loans sold to non-agencies. Additionally, repurchase losses depend upon economic factors and other external conditions that may change over the life of the underlying loans, adding difficulty to the estimation process and 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.

Goodwill and Other Intangible Assets

During the first quarter of 2010, we determined that an impairment test on our remaining goodwill was required because of the uncertainty regarding our ability to continue as a going concern at that time combined with the fact that our market capitalization remained depressed. As a result of that impairment test, we determined that the remaining goodwill associated with our Hawaii Market reporting unit was impaired and we recorded a non-cash impairment charge of $102.7 million. Since that time, we had no goodwill remaining on our consolidated balance sheet.

Prior to the first quarter of 2010, we reviewed the carrying amount of goodwill for impairment on an annual basis and performed additional assessments on a quarterly basis whenever indicators of impairment were evident. Goodwill attributable to each of our reporting units was tested for impairment by comparing their respective fair values to their carrying values. When determining fair value, we utilized a discounted cash flow methodology for our Commercial Real Estate reporting unit and versions of the guideline company, guideline transaction and discounted cash flow methodologies for our Hawaii Market reporting unit. Absent any impairment indicators, we performed our annual goodwill impairment tests during the fourth quarter of each fiscal year.
 
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Similar to our process for evaluating our goodwill for impairment, we also 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 assessment of goodwill and other intangible assets 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, including assumptions about the future growth and potential volatility in revenues and costs, capital expenditures, industry economic factors and future business strategy. The variability of the factors we use to perform the goodwill impairment test depends on a number of conditions, including 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. If we had used other assumptions and estimates or if different conditions occur in future periods, including, but not limited to, changes in other reporting units or operating segments, future operating results could be materially impacted.

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 2009, we established a valuation allowance against our net DTAs. See “— Results of Operations — Income Taxes” below.

We have established income tax contingency reserves 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.

Defined Benefit Retirement Plan

Defined benefit plan obligations and related assets of our defined benefit retirement plan are presented in Note 14 to the consolidated financial statements. In 2002, the defined benefit retirement plan was curtailed and all plan benefits were fixed as of that date. Plan assets, which consist primarily of marketable equity and debt securities, are typically valued using market quotations. Plan obligations and the annual pension expense are determined by independent actuaries through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate, we utilize a yield that reflects the top 50% of the universe of bonds, ranked in the order of the highest yield. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plans.

At December 31, 2010, we used a weighted-average discount rate of 5.1% and an expected long-term rate of return on plan assets of 8.0%, which affected the amount of pension liability recorded as of year-end 2010 and the amount of pension expense to be recorded in 2011. For both the discount rate and the asset return rate, a range of estimates could reasonably have been used which would affect the amount of pension expense and pension liability recorded.

An increase in the discount rate or asset return rate would reduce pension expense in 2011, while a decrease in the discount rate or asset return rate would have the opposite effect. A 0.25% change in the discount rate assumption would impact 2011 pension expense by less than $0.1 million and year-end 2010 pension liability by $0.9 million, while a 0.25% change in the asset return rate would impact 2011 pension expense by less than $0.1 million.

Impact of Recently Issued Accounting Pronouncements on Future Filings

In January 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, which temporarily delays the effective date for public entities of the disclosures about troubled debt restructurings (“TDRs”) in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The deferral will allow the FASB to complete its deliberations on what constitutes a TDR, and to coordinate the effective dates of the new disclosures about TDRs for public entities in ASU 2010-20 and the guidance for determining what constitutes a TDR. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
 
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In April 2011, the FASB issued ASU 2011-02, A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring. This ASU provides additional guidance related to determining whether a creditor has granted a concession, includes factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibits creditors from using the borrower's effective rate test to evaluate whether a concession has been granted to the borrower, and adds factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision in ASU 2011-02 also ends the FASB’s deferral of the additional disclosures about TDRs as required by ASU 2010-20. This ASU is effective for the Company's reporting period ending September 30, 2011. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In April 2011, the FASB issued ASU 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The amendments in this ASU also eliminate the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. This ASU is effective prospectively for transactions, or modifications of existing transactions, that occur on or after January 1, 2012. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards (“IFRS”). This ASU is effective for the Company’s reporting period beginning on January 1, 2012. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Amendments to Topic 220, Comprehensive Income.” Under the amendments in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This ASU is effective for the Company’s reporting period beginning on January 1, 2012, with retrospective application required. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

Financial Summary

During the second quarter of 2011, we reported net income of $8.2 million, or $0.20 per diluted share, compared to a net loss of $16.1 million, or $12.01 per diluted share, reported in the second quarter of 2010. Net income for the first half of 2011 was $12.9 million, or $3.15 per diluted share, compared to a net loss of $176.3 million, or $119.18 per diluted share for the first half of 2010. Our net income per diluted share for the first half of 2011 of $3.15 includes the impact of a one-time accounting adjustment totaling $85.1 million related to the previously mentioned TARP Exchange. Excluding this one-time adjustment, which did not impact our reported net income of $12.9 million, our net income per diluted share for the first half of 2011 was $0.38. See Note 11 to the consolidated financial statements for more information. The net loss in the first half of 2010 included a non-cash goodwill impairment charge of $102.7 million.

Our net income in the first and second quarters of 2011 was driven by continued improvement in our asset quality, which resulted in a significant reduction in our total credit costs. Total credit costs, which includes the Provision, write-downs of loans classified as held for sale, write-downs of foreclosed property and the change in the reserve for unfunded commitments, were reduced from a charge of $21.8 million and $88.3 million in the three and six months ended June 30, 2010, respectively, to credits of $6.4 million and $4.5 million in the three and six months ended June 30, 2011, respectively.

 
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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 includes goodwill, core deposit premium, customer relationships and non-compete agreements. Average intangible assets were $20.9 million and $21.3 million for the three and six months ended June 30, 2011, respectively, and $23.8 million and $74.6 million for the comparable prior year periods.
 
 
Three Months Ended
   
Six Months Ended
 
June 30,
   
June 30,
 
2011
   
2010
   
2011
   
2010
                             
Return (loss) on average assets
  0.81  %       (1.50 ) %       0.64  %       (7.73 ) %
Return (loss) on average shareholders' equity
  8.08         (41.67 )       8.48         (146.95 )
Return (loss) on average tangible equity
  8.52         (49.25 )       9.12         (213.29 )
Basic earnings (loss) per common share
$ 0.20       $ (12.01 )     $ 3.22  *     $ (119.18 )
Diluted earnings (loss) per common share
  0.20         (12.01 )       3.15  *       (119.18 )
                                     
* Includes the impact of a one-time accounting adjustment totaling $85.1 million related to the TARP Exchange. Excluding this one-time adjustment, our basic and diluted earnings per share was $0.39 and $0.38 for the six months ended June 30, 2011, respectively.
 
Material Trends

The global and U.S. economies continue to stabilize following the economic downturn caused by disruptions in the financial system in 2008. Signs of stabilization of the financial markets and growth in the U.S. economy were partly attributable to various initiatives of the U.S. government. Initiatives such as the Emergency Economic Stabilization Act (“EESA”) and the American Recovery and Reinvestment Act (“ARRA”) have thus far helped the financial markets and U.S. economy. Additionally, the Federal Reserve System (“FRB”) implemented a number of initiatives to provide stability and additional liquidity to the financial markets in 2008. These initiatives included providing additional liquidity to the asset-backed commercial paper and money markets and planned purchases of short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The FRB lowered the federal funds benchmark rate to a range of zero to 0.25% and the discount rate to 0.50% in December 2008 and kept these rates at those levels until increasing the discount rate to 0.75% in February 2010. In November 2010, the FRB announced an initiative, known as QE2, to purchase an additional $600 billion in assets.

Despite recent signs of stabilization, concerns about the global and U.S. economies still remain, including weak consumer confidence and increased volatility in both energy prices and the capital markets. In addition, growing government indebtedness, a large budget deficit, and recent concerns over the federal debt ceiling have exacerbated the uncertainty surrounding a sustained economic recovery. On August 2, 2011, legislation was enacted to increase the federal debt ceiling and to reduce future spending levels by as much as $2.4 trillion over the next 10 years. Notwithstanding the passage of this legislation, a risk remains that major rating agencies could reduce the ratings of U.S. Treasury securities if the legislation is not deemed sufficient to address the country’s growing debt burden. While the potential effects of a U.S. downgrade are not yet well understood, it could raise borrowing costs and adversely impact the mortgage and housing markets.

The majority of our operations are concentrated in the state of Hawaii, and to a lesser extent, in California and a few western states. Our business performance is significantly influenced by conditions in the banking industry, macro economic conditions and the real estate markets in Hawaii and California. 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 declining gross state product, high unemployment and declining personal income.

Hawaii’s economy continues to show signs of recovery and is expected to see modest improvement during the remainder of 2011 and stronger growth in 2012, according to the Hawaii State Department of Business, Economic Development & Tourism (“DBEDT”). Tourism remains Hawaii’s most significant economic driver and according to the Hawaii Tourism Authority (“HTA”), total visitor arrivals and visitor expenditures increased by 4.7% and 18.4%, respectively, for the first half of 2011 compared to the same period in 2010. The Department of Labor and Industrial Relations reported that Hawaii’s seasonally adjusted unemployment rate declined from 6.3% in December 2010 to 6.0% in June 2011 and Hawaii’s unemployment rate remained below the national seasonally adjusted unemployment rate of 9.2%. DBEDT projects real personal income and real gross state product to grow by a modest 1.0% and 1.6%, respectively, in 2011.
 
39

 
On March 11, 2011, a massive earthquake triggered a giant tsunami that devastated northeastern Japan. According to the HTA, visitor arrivals and expenditures from Japan accounted for approximately 17.4% and 16.9%, respectively of the total visitor arrivals and expenditures in 2010. Japanese visitor arrivals and expenditures in the second quarter of 2011 were down 20.1% and 5.3%, respectively, compared to the same period in 2010, due to flight suspensions and trip cancellations following the earthquake and tsunami. Despite the negative impact of the earthquake and tsunami on Japanese travel to Hawaii, DBEDT projects that overall visitor arrivals will increase by 3.8% for 2011, a rate similar to its previous forecast conducted before the Japan earthquake. This forecast reflects the decline of Japanese arrivals, tempered by an increase in arrivals from the U.S. mainland and other international markets, especially visitors from Canada.

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 decreased 7.0% for single-family homes and 2.6% for condominiums for the six months ended June 2011 compared to the six months ended June 2010. The median sales price for single-family homes on Oahu for the six months ended June 2011 was $570,000, representing a decrease of 2.6% from the prior year. The median sales price for condominiums on Oahu for the six months ended June 2011 was $304,500, representing a decrease of 0.2% from the prior year. Expectations from local real estate experts and economists are for the Hawaii real estate market to show improvement in the second half of 2011, however, there is no assurance that this will occur. As part of our plans to reduce our credit risk exposure, we have taken and will continue to take, steps to reduce certain aspects of our commercial real estate and construction loan portfolios.

Potential impediments to recovery in the Hawaii economy include projected budget shortfalls for the Hawaii state government in 2011. To address these shortfalls, the Hawaii state government may initiate additional layoffs, furloughs and program cuts, as they have in the past.

California, along with the rest of the nation, appears to be in the midst of a modest, drawn-out recovery. After ending 2010 with some momentum, positive economic signs continued during the early months of 2011. However, during the second quarter of 2011, weak real estate market conditions, depressed construction activity, and public sector fiscal problems continued to dampen economic growth. In addition, unrest in oil producing nations and the earthquake and tsunami that struck Japan resulted in more uncertainty for California’s outlook. The California Association of Realtors (“CAR”) reported that June 2011 unit home sales were down 3.6% from the same period a year ago, while the median sales price decreased by 5.9% from year ago levels to $295,300. CAR anticipates 2011 to be a transition year, moving further toward stabilization, and forecasts California’s annual sales and median sales price to increase 2% to 502,000 units and $312,500, respectively. Labor markets within the state remained weak through the first half of 2011 as California’s seasonally adjusted unemployment rate increased to 11.8% at June 2011 and continues to be well above the national unemployment rate of 9.2%. California state government’s budget crisis is more severe than Hawaii’s. Having already issued IOUs once before to preserve cash, California’s government faces a $25.4 billion shortfall and is looking at further cuts in wages, furloughs and government programs. Although we are not making new loans in California, our existing loan portfolio continues to have significant exposure to its markets.

As we have seen over the past few years, our operating results are significantly impacted by the economy in Hawaii and California and the higher risk nature of our loan portfolio. Loan demand, deposit growth, provision for loan and lease losses, 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 do not improve or continue to deteriorate, our results of operations would be negatively impacted.
 
 
 
40

 
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 six months ended June 30, 2011 and 2010 is set forth below.
 
 
Three Months Ended
   
Three Months Ended
 
June 30, 2011
   
June 30, 2010
 
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
$ 471,173     0.26 %
 
  $ 300     $ 738,766     0.25 %
 
  $ 467
  Taxable investment securities (1)
  1,205,762     2.40         7,241       419,827     3.48         3,655
  Tax-exempt investment securities (1)
  12,480     8.92         276       14,459     8.05         292
  Loans and leases, net of unearned income (2)
  2,094,555     5.06         26,464       2,822,967     5.08         35,788
  Federal Home Loan Bank stock
  48,797     -         -       48,797     -         -
    Total interest earning assets
  3,832,767     3.58         34,281       4,044,816     3.98         40,202
Nonearning assets
  214,354                       247,518                
    Total assets
$ 4,047,121                     $ 4,292,334                
                                             
Liabilities and Equity
                                           
Interest-bearing liabilities:
                                           
  Interest-bearing demand deposits
$ 535,057     0.12 %
 
  $ 161     $ 604,983     0.17 %
 
  $ 250
  Savings and money market deposits
  1,113,800     0.18         500       1,075,028     0.55         1,487
  Time deposits under $100,000
  402,721     1.03         1,037       535,227     1.61         2,149
  Time deposits $100,000 and over
  438,971     0.79         865       425,938     1.56         1,659
  Short-term borrowings
  1,730     -         -       202,191     0.61         306
  Long-term debt
  409,152     2.59         2,642       649,910     3.12         5,053
    Total interest-bearing liabilities
  2,901,431     0.72         5,205       3,493,277     1.25         10,904
Noninterest-bearing deposits
  663,119                       568,140                
Other liabilities
  66,195                       66,308                
    Total liabilities
  3,630,745                       4,127,725                
Shareholders' equity
  406,381                       154,592                
Non-controlling interests
  9,995                       10,017                
  Total equity
  416,376                       164,609                
    Total liabilities and equity
$ 4,047,121                     $ 4,292,334                
                                             
Net interest income
                $ 29,076                     $ 29,298
                                             
Net interest margin
        3.04 %                     2.90 %        

 
41

 
 
Six Months Ended
   
Six Months Ended
 
June 30, 2011
   
June 30, 2010
 
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
$ 544,153     0.26 %
 
  $ 689     $ 621,935     0.26 %
 
  $ 797
  Taxable investment securities (1)
  1,049,131     2.38         12,465       612,880     3.84         11,759
  Tax-exempt investment securities (1)
  12,728     8.79         559       30,255     7.17         1,085
  Loans and leases, net of unearned income (2)
  2,141,816     5.17         55,030       2,934,483     5.01         73,100
  Federal Home Loan Bank stock
  48,797     -         -       48,797     -         -
    Total interest earning assets
  3,796,625     3.64         68,743       4,248,350     4.11         86,741
Nonearning assets
  212,298                       315,313                
    Total assets
$ 4,008,923                     $ 4,563,663                
                                             
Liabilities and Equity
                                           
Interest-bearing liabilities:
                                           
  Interest-bearing demand deposits
$ 532,246     0.11 %
 
  $ 293     $ 608,072     0.17 %
 
  $ 508
  Savings and money market deposits
  1,110,691     0.22         1,232       1,110,717     0.57         3,136
  Time deposits under $100,000
  421,984     1.15         2,403       533,425     1.64         4,334
  Time deposits $100,000 and over
  386,860     0.98         1,876       525,676     1.33         3,455
  Short-term borrowings
  70,338     0.59         204       237,974     0.42         495
  Long-term debt
  424,537     2.55         5,359       653,767     3.14         10,168
    Total interest-bearing liabilities
  2,946,656     0.78         11,367       3,669,631     1.21         22,096
Noninterest-bearing deposits
  670,949                       580,062                
Other liabilities
  78,242                       63,976                
    Total liabilities
  3,695,847                       4,313,669                
Shareholders' equity
  303,078                       239,973                
Non-controlling interests
  9,998                       10,021                
  Total equity
  313,076                       249,994                
    Total liabilities and equity
$ 4,008,923                     $ 4,563,663                
                                             
Net interest income
                $ 57,376                     $ 64,645
                                             
Net interest margin
        3.04 %                     3.06 %        
                                             
(1)  At amortized cost.
                                           
(2)  Includes nonaccrual loans.
                                           
 
Net interest income expressed on a taxable-equivalent basis of $29.1 million for the second quarter of 2011, decreased by $0.2 million, or 0.8%, from the second quarter of 2010, while taxable-equivalent net interest income for the first half of 2011 decreased by $7.3 million, or 11.2%, to $57.4 million from the comparable prior year period. The decrease in net interest income for the current quarter and first half of 2011 was primarily attributable to a significant reduction in average loans and leases as we continued our efforts to improve our credit risk profile by reducing our exposure to certain sectors of the construction and commercial real estate sectors. Partially offsetting this reduction was an increase in average taxable investment securities and a decrease in average interest-bearing liabilities as we continue to redeploy a portion of our excess liquidity into higher yielding investment securities and reduce our overall funding costs. The decrease in net interest income for the current quarter also reflects a 40 basis point (“bp”) decline in average yields earned on interest earning assets over the comparable prior year period and a 53 bp decline in average rates paid on our interest-bearing liabilities. The decrease in net interest income for the first half of 2011 reflects a 47 bp decline in average yields earned on interest earning assets over the comparable prior year period, which exceeded the 43 bp decline in average rates paid on our interest-bearing liabilities. The decrease in average yields earned on our interest earning assets was directly attributable to the depressed interest rate environment, reductions in our higher yielding commercial real estate loan portfolios and the corresponding increase in our lower yielding investment securities portfolio.

 
42

 
Interest Income

Taxable-equivalent interest income of $34.3 million for the second quarter of 2011 decreased by $5.9 million, or 14.7%, from the second quarter of 2010. The current quarter decrease was primarily attributable to a significant decline in average loans and leases, partially offset by an increase in average taxable investment securities as described above. Average loans and leases decreased by $728.4 million in the current quarter compared to the second quarter of 2010, contributing to approximately $9.3 million of the current quarter interest income decline, while average taxable investment securities increased by $785.9 million in the current quarter compared to the second quarter of 2010, offsetting the decline of interest income by approximately $6.8 million. Average yields earned on taxable investment securities decreased by 108 bp in the current quarter, contributing to approximately $1.1 million of the current quarter interest income decline.

Consistent with the above, the year-to-date decrease in taxable-equivalent interest income was primarily attributable to a significant decline in average loans and leases, partially offset by an increase in average taxable investment securities. During the first half of 2011, average loans and leases decreased by $792.7 million from the first half of 2010, reducing interest income by approximately $19.9 million during the period, while average taxable investment securities increased by $436.3 million, offsetting the decline of interest income by approximately $8.4 million. Average yields earned on taxable investment securities for the first half of 2011 decreased by 146 bp, resulting in a reduction in interest income of approximately $4.5 million, while average yields on loans and leases increased by 16 bp, offsetting the decline in interest income by approximately $2.3 million.

Interest Expense

Interest expense of $5.2 million for the second quarter of 2011 decreased by $5.7 million, or 52.3%, from the comparable prior year quarter. The decrease in interest expense during the current quarter was attributable to the overall decline in both average balances and rates paid on interest-bearing liabilities. The 37 bp decline in average rates on savings and money market deposits contributed to $1.0 million of the current quarter decrease in interest expense, the 58 bp decline in average rates on time deposits under $100,000 contributed to $0.8 million of the current quarter decrease, the 77 bp decline in average rates on time deposits $100,000 and over contributed to $0.8 million of the current quarter decrease, the 61 bp decline on average rates on short-term borrowings contributed to $0.3 million of the current quarter decrease and the 53 bp decline on average rates on long-term debt contributed to $0.9 million of the current quarter decrease. Additionally, the current quarter decrease in average balances of all time deposits, short-term borrowings and long-term debt also resulted in lower interest expense of $0.5 million, $0.3 million and $1.9 million, respectively.

For the first half of 2011, interest expense decreased by $10.7 million, or 48.6%, from the first half of 2010. The 35 bp decline in average rates on savings and money market deposits contributed to $1.9 million of the decrease in interest expense, declines of 49 bp and 35 bp in average rates on time deposits under $100,000 and time deposits $100,000 and over contributed to $1.3 million and $0.9 million, respectively, of the decrease in interest expense, and the 59 bp decline on average rates on long-term debt contributed to $1.9 million of the decrease in interest expense from the comparable prior year period. Additionally, the overall decrease in average balances of all time deposits, short-term borrowings and long-term debt also resulted in a decrease in interest expense of $1.8 million, $0.4 million and $3.6 million, respectively, compared to the first half of 2010.

Net Interest Margin

Our net interest margin was 3.04% for the second quarter of 2011, compared to 2.90% in the comparable year-ago quarter. As described above, the increase was primarily attributable to the redeployment of a portion of our excess liquidity into higher yielding investment securities and an overall reduction in our funding costs.

Our net interest margin for the first half of 2011 was 3.04% compared to 3.06% in the comparable year-ago period.  The year-over-year compression was primarily due to lower yields on our interest earning assets as we continued our efforts to reduce our higher yielding commercial real estate loan portfolio to improve our credit risk profile and our efforts to maximize balance sheet liquidity by maintaining elevated levels of lower yielding cash and cash equivalent accounts through the first quarter of 2011. Additionally, as part of our recovery plan, we sold available for sale securities for gross proceeds of $439.4 million during the latter part of March 2010. A significant amount of these proceeds were held as cash and cash equivalents until the first quarter of 2011.

 
43

 
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.
 
 
June 30,
   
December 31,
 
 
2011
   
2010
 
 
(Dollars in thousands)
 
Nonperforming Assets
         
Nonaccrual loans (including loans held for sale):
         
  Commercial, financial and agricultural
$ 578     $ 982  
  Real estate:
             
    Construction
  129,275       182,073  
    Mortgage-residential
  58,204       47,560  
    Mortgage-commercial
  18,428       14,464  
  Consumer
  -       225  
      Total nonaccrual loans
  206,485       245,304  
Other real estate
  42,863       57,507  
      Total nonperforming assets
  249,348       302,811  
               
Accruing loans delinquent for 90 days or more:
             
  Real estate:
             
    Construction
  -       6,550  
    Mortgage-residential
  -       1,800  
  Consumer
  4       181  
      Total accruing loans delinquent for 90 days or more
  4       8,531  
               
Restructured loans still accruing interest:
             
  Real estate:
             
    Mortgage-residential
  1,813       13,401  
      Total restructured loans still accruing interest
  1,813       13,401  
               
Total nonperforming assets, accruing loans delinquent for 90
             
  days or more and restructured loans still accruing interest
$ 251,165     $ 324,743  
               
Total nonperforming assets as a percentage of loans and leases,
             
  loans held for sale and other real estate
  11.81 %     13.18 %
               
Total nonperforming assets and accruing loans delinquent for 90
             
  days or more as a percentage of loans and leases, loans held for sale
             
  and other real estate
  11.81 %     13.56 %
               
Total nonperforming assets, accruing loans delinquent for 90 days or more
             
  and restructured loans still accruing interest as a percentage of loans
             
  and leases, loans held for sale and other real estate
  11.89 %     14.14 %
 
Nonperforming assets, which includes nonaccrual loans and leases, nonperforming loans classified as held for sale and foreclosed real estate, totaled $249.3 million at June 30, 2011, compared to $302.8 million at December 31, 2010. The decrease from fiscal 2010 was primarily attributable to sales of nonperforming loans classified as held for sale and foreclosed properties of $27.6 million and $24.7 million, respectively, paydowns of $46.5 million and charge-offs and write-downs of $17.0 million. Offsetting these decreases were the following significant additions to nonperforming assets: Hawaii residential mortgage loans and foreclosed properties of $27.6 million, Hawaii construction and development loans totaling $18.9 million, Mainland commercial mortgage loans totaling $6.8 million, Hawaii commercial mortgage loans totaling $3.5 million and Mainland construction and development loans totaling $2.6 million.

 
44

 
Restructured loans included in nonperforming assets at June 30, 2011 consisted of 116 Hawaii residential mortgage loans with a combined principal balance of $47.6 million, seven Hawaii construction and development loans with a combined principal balance of $37.2 million, and one Hawaii commercial loan with a principal balance of $0.4 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 restructured loans matured and/or were in default at the time of restructuring and we have no commitments to lend additional funds to any of these borrowers. There were $1.8 million of restructured loans still accruing interest at June 30, 2011, none of which were more than 90 days delinquent.

Provision and 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
   
Six Months Ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Dollars in thousands)
 
Allowance for loan and lease losses:
                     
   Balance at beginning of period
$ 178,010     $ 211,646     $ 192,854     $ 205,279  
                               
   Provision (credit) for loan and lease losses
  (8,784 )     20,412       (10,359 )     79,249  
                               
   Charge-offs:
                             
   Commercial, financial and agricultural
  455       3,823       1,861       5,981  
   Real estate:
                             
      Construction
  3,000       20,800       16,858       48,774  
      Mortgage-residential
  1,263       4,059       3,299       15,223  
      Mortgage-commercial
  879       1,462       1,105       19,192  
   Consumer
  597       598       1,202       1,539  
   Leases
  -       -       -       1  
      Total charge-offs
  6,194       30,742       24,325       90,710  
                               
   Recoveries:
                             
   Commercial, financial and agricultural
  854       179       1,286       1,740  
   Real estate:
                             
      Construction
  2,549       107       5,915       5,608  
      Mortgage-residential
  231       48       931       75  
      Mortgage-commercial
  3       12       42       14  
   Consumer
  265       297       590       663  
   Leases
  -       -       -       41  
      Total recoveries
  3,902       643       8,764       8,141  
                               
   Net charge-offs
  2,292       30,099       15,561       82,569  
                               
   Balance at end of period
$ 166,934     $ 201,959     $ 166,934     $ 201,959  
                               
Annualized ratio of net charge-offs to average loans
  0.44 %     4.26 %     1.45 %     5.63 %
 
Our Allowance at June 30, 2011 totaled $166.9 million, a decrease of $25.9 million, or 13.4%, from year-end 2010. The decrease in our Allowance was a direct result of $15.6 million in net loan charge-offs and a credit to the Provision of $10.4 million.

Our Provision was a credit of $8.8 million during the second quarter of 2011, compared to a charge of $20.4 million in the second quarter of 2010. The decrease was due to continued improvement in our credit risk profile as evidenced by further declines in nonperforming assets and net charge-offs during the second quarter of 2011, compared to the comparable prior year quarter.

Our Allowance as a percentage of our total loan portfolio decreased from 8.89% at December 31, 2010 to 8.16% at June 30, 2011. Our Allowance as a percentage of our nonperforming assets increased from 63.69% at December 31, 2010 to 66.95% at June 30, 2011.

 
45

 
The decrease in the Allowance is consistent with the sequential quarter decrease in our nonperforming assets, lower net loan charge-off activity, and is consistent with our belief that we have begun to see signs of stabilization in certain sectors of our loan portfolio, the overall economy and the commercial real estate markets both in Hawaii and on the Mainland.

Depending on the overall performance of the local and national economies, the strength of the Hawaii and California commercial real estate markets and the accuracy of our assumptions and judgments concerning our loan portfolio, further adverse credit migration is possible 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 preliminary signs of stabilization, we cannot determine when, or if, the challenging economic conditions that we experienced over the past three years will improve and whether or not 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.

Other Operating Income

Total other operating income of $10.9 million for the second quarter of 2011 decreased by $1.8 million, or 14.1%, from the comparable prior year period. The decrease was primarily due to lower unrealized gains on outstanding interest rate locks of $1.0 million and lower income from bank-owned life insurance of $0.9 million.

For the six months ended June 30, 2011, total other operating income of $23.4 million decreased by $2.1 million, or 8.1%, over the comparable prior year period. The decrease was primarily due to lower service charges on deposit accounts of $1.1 million, lower unrealized gains on outstanding interest rate locks of $0.9 million, lower income from bank-owned life insurance of $0.9 million and lower gains on trading securities of $0.7 million. These decreases were partially offset by higher other service charges and fees of $1.2 million and a non-cash gain on the change in fair value of a derivative liability of $1.0 million.

Other Operating Expense

Total other operating expense for the second quarter of 2011 was $40.5 million, compared to $37.6 million in the comparable prior year period. The increase was primarily attributable to a higher provision for repurchased residential mortgage loans of $2.1 million, higher credit-related charges (which include write-downs of loans held for sale, foreclosed asset expense, and changes in the reserve for unfunded commitments) of $1.2 million and higher salaries and employee benefits of $1.0 million. These increases were partially offset by lower legal and professional services of $1.8 million.

For the six months ended June 30, 2011, other operating expense of $78.1 million decreased by $108.7 million, or 58.2%, from the comparable prior year period. The decrease was primarily attributable to the $102.7 million non-cash goodwill impairment charge recorded in the first quarter of 2010, lower legal and professional services of $5.0 million and lower credit-related charges (which include write-downs of loans held for sale, foreclosed asset expense, and changes in the reserve for unfunded commitments) of $3.0 million. These decreases were partially offset by a higher provision for repurchased residential mortgage loans of $2.7 million and higher salaries and employee benefits of $1.2 million.

Income Taxes

We did not recognize any income tax expense in the first half of 2011 or 2010, as we continue to recognize a full valuation allowance against our net DTAs, which was first established in the third quarter of 2009. The establishment of the valuation allowance was primarily based upon our recent net operating losses and the existence of a three-year cumulative loss, which led to our conclusion that it was more likely than not that our DTAs would not be fully realized. In determining the extent of the valuation allowance, management also considered, among other things, carryback/carryforward periods available to us and trends in our historical and projected earnings.

In the second quarter of 2011, we decreased our valuation allowance against our net DTAs by $6.4 million to $172.4 million at June 30, 2011 from $178.8 million at December 31, 2010. Of the total decrease to the valuation allowance, $2.2 million was recognized as a non-cash credit to income tax expense, while the remaining $4.2 million was credited against accumulated other comprehensive loss (“AOCL”).
 
 
 
46

 
Financial Condition

Total assets at June 30, 2011 were $4.1 billion, compared to $3.9 billion at December 31, 2010.

Loans and Leases

Loans and leases, net of unearned income, of $2.0 billion at June 30, 2011, decreased by $122.7 million, or 5.7%, from December 31, 2010. The decrease was primarily due to net reductions in the construction and development, commercial mortgage and commercial loan portfolios totaling $72.3 million, $47.4 million and $9.9 million, respectively, partially offset by a net increase in the residential mortgage portfolio of $14.5 million. The net decreases in these portfolios reflect transfers to other real estate totaling $8.5 million, net charge-offs of $15.6 million and paydowns.

Construction and Development Loans

At June 30, 2011, the construction and development loan portfolio (excluding owner-occupied loans) totaled $226.5 million, or 11.1% of the total loan portfolio. Of this amount, $140.1 million were located in Hawaii and $86.4 million were located on the Mainland. This portfolio decreased by $73.5 million from December 31, 2010.

The allowance for loan and lease losses allocated for these loans was $41.6 million at June 30, 2011, or 18.4% of the total outstanding balance. Of this amount, $31.1 million related to construction and development loans in Hawaii and $10.5 million related to construction and development loans on the Mainland.

Nonperforming construction and development assets in Hawaii totaled $107.7 million at June 30, 2011, or 2.6% of total assets. At June 30, 2011, this balance was comprised of portfolio loans totaling $93.0 million and foreclosed properties totaling $14.7 million. Nonperforming assets related to this sector totaled $159.3 million at December 31, 2010.

Nonperforming construction and development assets on the Mainland totaled $57.4 million at June 30, 2011, or 1.4% of total assets. At June 30, 2011, this balance was comprised of portfolio loans totaling $33.6 million and foreclosed properties totaling $23.8 million. Nonperforming assets related to this sector totaled $72.1 million at December 31, 2010.

Deposits

Total deposits of $3.2 billion at June 30, 2011 reflected an increase of $97.4 million, or 3.1%, from December 31, 2010. The increase was primarily attributable to increases in non-interest bearing demand deposits, savings and money market deposits and time deposits of $75.7 million, $25.5 million and $114.6 million, respectively. These increases were partially offset by a decrease in interest-bearing demand deposits of $118.5 million. The decrease in our interest-bearing demand deposits was primarily due to the expiration of the Transaction Account Guarantee Program on December 31, 2010, which resulted in some of our customers transferring balances from interest-bearing demand deposits to non-interest bearing demand deposits to remain fully insured by the FDIC. Also contributing to the decrease in interest-bearing demand deposits was a transfer of approximately $35.0 million in government deposits from interest-bearing demand deposits to time deposits in March 2011.

Core deposits, which we define as demand deposits, savings and money market deposits, and time deposits less than $100,000, totaled $2.7 billion at June 30, 2011 and decreased by $82.7 million from December 31, 2010. The decrease was primarily due to the aforementioned expiration of the Transaction Account Guarantee Program and transfer of government deposits.

Capital Resources

Common Stock

Shareholders’ equity totaled $423.8 million at June 30, 2011, compared to $66.1 million at December 31, 2010. The increase in total shareholders’ equity was a direct result of the completion of the aforementioned Private Placement, TARP Exchange and Rights Offering.
 
 
 
47

 
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. During the deferral period, which currently stands at eight consecutive quarters, the respective trusts are likewise suspending 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 will continue to accrue, and reflect in our consolidated financial statements, the deferred interest payments on our junior subordinated debentures. At June 30, 2011, accrued interest on our outstanding junior subordinated debentures relating to our trust preferred securities was $6.7 million. With the recent completion of our recapitalization, we may seek regulatory approval to pay all deferred payments under our trust preferred securities.

The FRB has determined that certain cumulative preferred securities having the characteristics of trust preferred securities to qualify as non-controlling interest, and are included in CPF’s Tier 1 capital.

Holding Company Capital Resources

CPF is required to act as a source of strength to the bank under the Bank Holding Company Act. The majority of the funds that we received upon completion of the Private Placement were contributed by CPF to the bank as capital. CPF is obligated to pay its expenses, including payments on its outstanding trust preferred securities. In the past, CPF has primarily relied upon dividends from the bank for its cash flow needs. However, as a Hawaii state-chartered bank, it is prohibited from declaring or paying dividends greater than its retained earnings. As of June 30, 2011, the bank had an accumulated deficit of $468.0 million. The bank will need to eliminate the deficit and generate positive retained earnings before it can pay any dividends.  As a result, we do not anticipate receiving dividends from the bank in the foreseeable future. On a stand alone basis, as of June 30, 2011, CPF had approximately $46.4 million of cash available to meet its ongoing obligations.

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 rated 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.

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 June 30, 2011 were above the levels required for a “well capitalized” regulatory designation and the bank is currently in compliance with the Bank MOU which requires that it maintain a leverage capital ratio of at least 8%.

 
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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
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
       
Company
                                       
At June 30, 2011:
                                       
   Leverage capital
  $ 528,096     13.1 %
 
  $ 160,909     4.0 %
 
  $ 201,136     5.0 %
   Tier 1 risk-based capital
    528,096     22.5         93,982     4.0         140,973     6.0  
   Total risk-based capital
    559,240     23.8         187,964     8.0         234,955     10.0  
                                               
At December 31, 2010:
                                             
   Leverage capital
  $ 180,626     4.4 %
 
  $ 163,454     4.0 %
 
  $ 204,318     5.0 %
   Tier 1 risk-based capital
    180,626     7.6         94,544     4.0         141,815     6.0  
   Total risk-based capital
    212,259     9.0         189,087     8.0         236,359     10.0  
                                               
Central Pacific Bank
                                             
At June 30, 2011:
                                             
   Leverage capital
  $ 496,556     12.3 %
 
  $ 160,966     4.0 %
 
  $ 201,208     5.0 %
   Tier 1 risk-based capital
    496,556     21.1         94,052     4.0         141,078     6.0  
   Total risk-based capital
    527,712     22.4         188,103     8.0         235,129     10.0  
                                               
At December 31, 2010:
                                             
   Leverage capital
  $ 197,626     4.8 %
 
  $ 163,500     4.0 %
 
  $ 204,376     5.0 %
   Tier 1 risk-based capital
    197,626     8.4         94,592     4.0         141,888     6.0  
   Total risk-based capital
    229,271     9.7         189,183     8.0         236,479     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.

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 $646.7 million line of credit with the FHLB as of June 30, 2011. At June 30, 2011, we did not have any short-term borrowings outstanding under this arrangement and our long-term borrowings totaled $300.8 million. At December 31, 2010, we had $200.0 million of short-term borrowings outstanding and our long-term borrowings totaled $351.3 million. In March 2011, the $200.0 million in short-term borrowings matured and were paid off. As of June 30, 2011, approximately $345.9 million was undrawn under this arrangement. The FHLB has no obligation to make future advances to the bank.

In accordance with the collateral provisions of the Advances, Security and Deposit Agreement with the FHLB, as of June 30, 2011, all outstanding FHLB advances were secured by investment securities with a fair value of $320.6 million and certain real estate loans totaling $576.3 million.
 
 
 
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Besides its line of credit with the FHLB, the bank also maintained a $30.9 million line of credit with the Federal Reserve discount window. There were no borrowings under this arrangement at June 30, 2011 and December 31, 2010. Advances under this arrangement would have been secured by certain commercial real estate loans with a carrying value of $123.8 million at June 30, 2011.

As of June 30, 2011, the entire $30.9 million line amount was available to the bank for future borrowings; however, the Federal Reserve has the right to decline to make advances under this line of credit. Since September 2009, the bank was no longer eligible to access the Federal Reserve’s primary credit facility but maintained access to its secondary facility. There was no change in the level of credit available to the bank. However, future advances will have higher borrowing costs under the secondary facility. Furthermore, all terms and maturities of advances under this arrangement are at the discretion of the Federal Reserve and are generally limited to overnight borrowings.

Our ability to maintain adequate levels of liquidity is dependent on us continuing to execute our recovery plan, and more specifically, our ability to continue to improve our credit risk profile, maintain our capital base, and comply with the provisions of our agreements with 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, 2010. There have been no material changes in our contractual obligations since December 31, 2010.
 
 
 
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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 June 30, 2011 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 upon that evaluation, the Company's Chief Executive Officer and Principal Financial and Accounting Officer concluded, as of the end of the period covered by this report, that the Company's disclosure controls and procedures were effective in recording, processing, summarizing and reporting information required to be disclosed by the Company, within the time periods specified in the Securities and Exchange Commission's rules and forms.

Changes in Internal Controls

As of the end of the period covered by this report, there have been no changes in the Company's internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter to which this report relates that have materially affected or is reasonably likely to materially affect, the internal control over financial reporting.
 
 
51

 
PART II.   OTHER INFORMATION

Item 1. Legal Proceedings

Overdraft Litigation

In March 2011, the Company and the bank were named as defendants in a putative class action captioned as Gregory and Camila Peterson, individually and on behalf of all others similarly situated, Plaintiffs, v. Central Pacific Bank, Central Pacific Financial Corp. and Doe Defendants 1-50, Defendants, Case No. 11-1-0457-03 VLC, in the First Circuit Court of Hawaii in Honolulu. The complaint asserts claims for unconscionability, conversion, unjust enrichment, and violations of Hawaii’s Uniform Deceptive Trade Practice Act, relating to the bank’s overdraft practices and fees. Plaintiffs seek declaratory relief, restitution, disgorgement, damages, interest, costs and attorneys’ fees. As of the date of this filing, we are in discussions with the plaintiffs to resolve the matter and the parties have agreed to perform additional diligence in an attempt to reach an acceptable outcome. Because this diligence is ongoing, at this time, we are not able to estimate the amount of costs or a reasonable range of potential costs that the Company may need to incur to resolve this matter.

Item 1A. Risk Factors

The following risk factors have been updated from the risk factor previously disclosed in our Annual Report on Form 10-K for the period ended December 31, 2010, filed with the SEC.

We are subject to a number of requirements and prohibitions under regulatory actions and we cannot assure you whether or when such requirements and prohibitions will be terminated.

In May 2011, the members of the Board of Directors of the bank entered into the Bank MOU with the FDIC and DFI, which replaced the Consent Order. The Bank MOU continues a number of the same requirements previously required by the Consent Order, including the maintenance of an adequate allowance for loan and lease losses, improvement of our asset quality, limitations on credit extensions, maintenance of qualified management and the prohibition on cash dividends to CPF, among other matters. In addition, the Bank MOU requires the bank to further reduce classified assets below the level previously required by the Consent Order. The Bank MOU lowers the minimum leverage capital ratio that the bank is required to maintain from 10% in the Consent Order to 8% and does not mandate a minimum total risk-based capital ratio.

In addition, the Company continues to be subject to the Agreement with the FRBSF and DFI dated July 2, 2010, which superseded in its entirety the Memorandum of Understanding that the Company entered into on April 1, 2009 with the FRBSF and DFI. Among other matters, the Agreement provides that unless we receive the consent of the FRBSF and DFI, we cannot: (i) pay dividends; (ii) receive dividends or payments representing a reduction in capital from the bank; (iii) directly or through our non-bank subsidiaries make any payments on subordinated debentures or trust preferred securities; (iv) directly or through any non-bank subsidiaries incur, increase or guarantee any debt; or (v) purchase or redeem any shares of our stock. The Agreement requires that the Board of Directors fully utilize the Company’s financial and managerial resources to ensure that the bank complies with the Bank MOU and any other supervisory action. We were also required to submit to the FRBSF an acceptable capital plan and cash flow projection.

Besides the Bank MOU and the Agreement, we are also subject to the BSA MOU.

Even though the Consent Order has been replaced by the Bank MOU, the bank remains subject to a number of requirements as described above. We cannot assure you whether or when the Company and the bank will be in full compliance with the agreements with the regulators or whether or when the Bank MOU, the Agreement and the BSA MOU will be terminated. Even if terminated, we may still be subject to other agreements with regulators that restrict our activities and may also continue to impose capital ratios requirements. The requirements and restrictions of the Bank MOU , the Agreement and the BSA 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 a new consent order; the imposition of civil monetary penalties; the termination of insurance of deposits; the issuance of removal and prohibition orders against institution-affiliated parties; the appointment of a conservator or receiver for the bank; the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party, if we again fall below the capital ratio requirements; and the enforcement of such actions through injunctions or restraining orders.

 
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Despite recent signs of stabilization, uncertainty about the global and U.S. economies could have an adverse effect on us.

Although general economic trends and market conditions have shown initial signs of stabilization, concerns about the global and U.S. economies still remain, including weak consumer confidence and increased volatility in both energy prices and the capital markets. In addition, growing government indebtedness, a large budget deficit, and recent concerns over the federal debt ceiling have exacerbated the uncertainty surrounding a sustained economic recovery. On August 2, 2011, legislation was enacted to increase the federal debt ceiling and to reduce future spending levels by as much as $2.4 trillion over the next 10 years. Notwithstanding the passage of this legislation, a risk remains that major rating agencies could reduce the ratings of U.S. Treasury securities if the legislation is not deemed sufficient to address the country’s growing debt burden. While the potential effects of a U.S. downgrade are not yet well understood, it could raise borrowing costs and adversely impact the mortgage and housing markets, any of which could have one or more of the following adverse impacts on us: (i) loan delinquencies may increase; (ii) problem assets and foreclosures may increase leading to higher loan charge-offs; (iii) demand for our products and services may decline; (iv) low cost or non-interest bearing deposits may decrease; and (v) collateral for loans made by us, especially involving real estate, may decline in value, in turn reducing customers’ borrowing power and reducing the value of assets and collateral associated with our existing loans.

Our business could be adversely affected by unfavorable actions from rating agencies.

Ratings assigned by ratings agencies to us, our affiliates or our securities may impact the decision of certain customers, in particular, institutions, to do business with us. A rating downgrade or a negative rating could adversely affect our deposits and our business relationships. On February 23, 2011, Fitch Ratings upgraded the long-term Issuer Default Rating of the Company and the bank from CC to B- and removed the Company and the bank from Rating Watch Evolving. On May 20, 2011, Fitch Ratings upgraded the long-term Issuer Default Rating of the Company and the bank to B+ from B- and assigned a Positive Rating Outlook. However, our ratings may not improve further and may be downgraded in the future if there are adverse developments concerning our business.

The transferability of our common shares is limited as a result of the Tax Benefits Preservation Plan and the Protective Charter Amendment.

We have generated significant net operating losses (“NOLs”) as a result of our recent losses. In order to reduce the likelihood that future transactions in our common shares will result in an ownership change, on November 23, 2010, we adopted a Tax Benefits Preservation Plan, which provides an economic disincentive for any person or group to become an owner, for relevant tax purposes, of 4.99% or more of our common shares. To further protect our NOLs, we filed the Protective Charter Amendment on May 2, 2011 to restrict transfers of our stock if the effect of an attempted transfer would cause the transferee to become a Threshold Holder or cause the beneficial ownership of a Threshold Holder to increase. The Protective Charter Amendment expires on the earliest of (i) May 2, 2014, (ii) such time as the Board of Directors determines the Protective Charter Amendment is no longer necessary for the preservation of our tax benefits and (iii) the date the Board of Directors determines that the Protective Charter Amendment is no longer in our and our shareholders' best interest.

The Tax Benefits Preservation Plan and the Protective Charter Amendment have the effect of limiting transferability of our common shares because they may make it more difficult and more expensive to acquire our common shares under the circumstances described above and, in the case of the Protective Charter Amendment, prohibit certain acquisitions of our common shares as described above. A shareholder's ability to dispose of our common shares is therefore limited by reducing the class of potential acquirers for such common shares.
 
53

 
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 **

*   Filed herewith.

** Furnished herewith.
 
 
 
54

 
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:  August 8, 2011
/s/ John C. Dean
 
John C. Dean
 
President and Chief Executive Officer
   
Date:  August 8, 2011
/s/ Lawrence D. Rodriguez
 
Lawrence D. Rodriguez
 
Executive Vice President and Chief Financial Officer
   
 
 
 
 
 
55

 
Central Pacific Financial Corp.
Exhibit Index
 
Exhibit No.
 
Description
     
31.1
 
Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
31.2
 
Certification of the Principal Financial and Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
32.1
 
Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
     
32.2
 
Certification of the Principal Financial and Accounting Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 

 
 
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