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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark  One)**                                                                                                                                                                                                                                               |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                                                                         | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                    | ** ** |
| **For the quarterly period ended September 30, 2008**                                                                                                                                                                                                    |
| ** **                                                                                                                                                                                                                                                    | ** ** |
| **OR**                                                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                    | ** ** |
| **o**                                                                                                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                    |
| **For the transition period  from                  to                  ** |
|                                                                                                                                                                                                                                                               |  |  |

 

**Commissionfile number: 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **02-0426634**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **6 Executive Circle, Suite 250  Irvine, California**      | ** ** | **92614**                            |
| (Address of principal executive offices)                        |       | (Zip Code)                           |

 

Registrant’s telephonenumber, including area code: **(949) 250-7700**

 

Securities registeredpursuant to Section 12(b) of the Act:

 
| **Title of Each Class**                | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------|
| Common Stock, par value $.05 per share |       | NASDAQ Global Market                          |

 

Securities registeredpursuant to Section 12(g) of the Act:

**None**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. YES o  NO x

 

Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. YES o  NO x

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. YES x NO o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o                     |   | Accelerated filer x         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). YES o NO x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

As of November 10,2008 there were 10,870,902 shares of Common Stock, par value $.05 outstanding.

 

 

 

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**CALIFORNIA COASTAL COMMUNITIES,INC.**

 

**FORM 10-Q**

 

**FOR THE QUARTER ENDED SEPTEMBER30, 2008**

 

**INDEX**

** **
| Cautionary  Statement About Forward-Looking Statements |   | 3                      |
|--------------------------------------------------------|--------|------------------------|
|                                                   |   |                   |
| Part I -                                          |   | Financial Information: |   | 5 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 1.                |   | Consolidated Financial Statements |   | 5 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   |                   |   | Consolidated  Balance Sheets — September 30, 2008 (unaudited) and December 31,  2007 |   | 5 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   |                   |   | Consolidated  Statements of Operations — Three and Nine Months Ended September 30,  2008 and 2007 (unaudited) |   | 6 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   |                   |   | Consolidated Statements of Cash Flows - Nine Months  Ended September 30, 2008 and 2007 (unaudited) |   | 7 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   |                   |   | Notes to Consolidated Financial Statements |   | 8 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 2.                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 21 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 3.                |   | Quantitative  and Qualitative Disclosures About Market Risk |   | 39 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 4.                |   | Evaluation of  Disclosure Controls and Procedures |   | 39 |
|                                                   |   |                   |   |   |   |   |
| Part II -                                         |   | Other Information:     |   | 40 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 1.                |   | Legal Proceedings |   | 40 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 1A.               |   | Risk Factors |   | 40 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 2.                |   | Not Applicable |   |   |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 3.                |   | Defaults Upon  Senior Securities |   | 42 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 4.                |   | Not Applicable |   |   |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 5.                |   | Other Information |   | 42 |
|                                                   |   |                   |   |   |   |   |
|                                                   |   | Item 6.                |   | Exhibits |   | 43 |
|                                                   |   |                   |   |   |   |   |
| Signature                                              |   |                   |   |   |   | 44 |

 

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**CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS**

 

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Exchange Act of 1933 and Section 21E of the Securities ExchangeAct of 1934 that relate to future events or our future financial performance.In addition, other statements we may make from time to time, such as pressreleases, oral statements made by our officials and other reports that we filewith the Securities and Exchange Commission may also contain suchforward-looking statements. Undue reliance should not be placed on thesestatements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to be materiallydifferent from any future results, performances or achievements expressed orimplied by the forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,”or the negative of such terms or other comparable terminology.

 

These forward-looking statements include, butare not limited to:

 

·                  statements aboutour strategies, plans, objectives, goals, expectations and intentions;

 

·                  informationrelating to anticipated operating results, financial resources, changes inrevenues, changes in profitability, interest expense, growth and expansion, anticipatedincome to be realized from our investments in unconsolidated entities;

 

·                  the impact ofdemographic trends and supply constraints on the demand for and supply ofhousing;

 

·                  housing marketconditions in the geographic markets in which we operate;

 

·                  the number andtypes of homes and number of acres of land that we may develop and sell;

 

·                  the ability todeliver homes from backlog;

 

·                  the timing andoutcomes of regulatory approval processes or administrative proceedings, whichmay result in delays in the land entitlement, development, construction, or theopening of new communities (including, but not limited to ongoingadministrative proceedings related to our joint venture near Oxnard,California);

 

·                  the ability tosecure materials and subcontractors;

 

·                  the ability toproduce the liquidity and capital necessary to expand and take advantage ofopportunities in the future;

 

·                  our ability torealize the value of our net operating loss carry forwards;

 

·                  our ability tocontinue relationships with current or future partners;

 

·                  theeffectiveness and adequacy of our disclosure and internal controls;

 

·                  the impact ofrecent accounting pronouncements; and

 

·                  stock marketvaluations.

 

Any or all of the forward-looking statementsincluded in this report and in any other reports or public statements made byus may turn out to be inaccurate. This can occur as a result of incorrectassumptions or as a consequence of known or unknown risks and uncertainties.These risks and uncertainties include the competitive environment in which weoperate; local, regional and national economic conditions; the effects of thecurrent national credit market crisis; inflation or a recession; the demand forhomes; adverse market conditions that could result in additional inventoryimpairments, including an oversupply of unsold homes and declining home prices,among other things; declines in consumer confidence; increases in competition;fluctuations in interest rates and the availability of mortgage financing;mortgage foreclosure rates; the availability and cost of land for futuregrowth; the availability of capital; uncertainties and fluctuations in capitaland securities markets; changes in tax laws and their interpretation; legalproceedings; the ability of customers to finance the purchase of homes or sellexisting homes; the availability and cost of labor and materials; the amount ofour debt and the impact of restrictive covenants in our loan agreements;adverse weather conditions; domestic and international political events;geopolitical risks and the uncertainties created by terrorist attacks; theeffects of governmental 

 

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regulation, including regulations concerning development of land, thehome building industry, sales and customer financing processes, and theenvironment; and other risks discussed in our filings with the Securities andExchange Commission. Many factors mentioned in this report or in other reportsor public statements made by us, such as government regulation and thecompetitive environment, will be important in determining our futureperformance. Consequently, actual results may differ materially from those thatmight be anticipated from our forward-looking statements. You should not placeundue reliance on any of these forward-looking statements because they arebased on current expectations or beliefs regarding future events orcircumstances, which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by these forward-looking statements.

 

Although we believe that our strategies, plans,objectives, goals, expectations and intentions reflected in, or suggested bythese forward-looking statements are reasonable given current informationavailable to us, we can give no assurance that any of them will be achieved.Forward-looking statements speak only as of the date they are made. Weundertake no obligation to publicly update any forward-looking statements,whether as a result of new information, future events or otherwise. However,any further disclosures made on related subjects in our subsequent reports onForms 10-K, 10-Q and 8-K should be consulted.

 

These forward-looking statements should beconsidered in light of the information included in this report and our otherfilings with the Securities and Exchange Commission, including, withoutlimitation, the “Risk Factors” set forth in this Form 10-Q, as well as thedescription of trends and other factors in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” set forth in this Form 10-Qand in our Form 10-K for the year ended December 31, 2007. You shouldalso read the following “Consolidated Financial Statements” and the relatednotes.

 

We assume no, and hereby disclaim any, obligation toupdate any of the foregoing or any other forward-looking statements, whether asa result of new information, future events, changed circumstances or any otherreason after the date of this Form 10-Q. We nonetheless reserve the rightto make such updates from time to time by press release, periodic report orother method of public disclosure without the need for specific reference tothis Form 10-Q or any other report filed by us. No such update shall bedeemed to indicate that other statements not addressed by such update remain corrector create an obligation to provide any other updates.

 

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**PART I — FINANCIALINFORMATION**

 

**Item 1.  Financial Statements.**

 

CALIFORNIA COASTALCOMMUNITIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                   | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                    |       | $                            | 7.0        |                        | $          | 24.3 |   |
| Restricted cash                                                                                                                              |       | 5.9                          |       | 6.0                         |       |
| Real estate inventories                                                                                                                      |       | 262.3                        |       | 286.4                       |       |
| Deferred tax assets                                                                                                                          |       | 53.8                         |       | 44.4                        |       |
| Other assets, net                                                                                                                            |       | 10.0                         |       | 6.5                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 339.0      |                        | $          | 367.6 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                 |       |                         |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                     |       | $                            | 5.3        |                        | $          | 12.5 |   |
| Senior secured project revolver                                                                                                              |       | 93.9                         |       | 76.0                        |       |
| Senior secured term loan                                                                                                                     |       | 116.0                        |       | 121.8                       |       |
| Other project debt                                                                                                                           |       | 40.9                         |       | 48.8                        |       |
| Other liabilities                                                                                                                            |       | 6.3                          |       | 7.0                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Total liabilities                                                                                                                            |       | 262.4                        |       | 266.1                       |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Commitments and contingencies                                                                                                                |       |                         |       |                        |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                   |       |                         |       |                        |       |
| Common Stock—$.05 par value; 13,500,000  shares authorized; 10,871,780 and 10,852,708 shares issued and  outstanding, respectively |       | .5                           |       | .5                          |       |
| Excess Stock—$.05 par value; 13,500,000  shares authorized; no shares outstanding                                                       |       | —                       |       | —                      |       |
| Additional paid-in capital                                                                                                                   |       | 59.3                         |       | 59.3                        |       |
| Retained earnings                                                                                                                            |       | 18.2                         |       | 43.1                        |       |
| Accumulated other comprehensive loss                                                                                                         |       | (1.4                         | )          | (1.4                        | )          |
| Total stockholders’ equity                                                                                                              |       | 76.6                         |       | 101.5                       |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 339.0      |                        | $          | 367.6 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OFOPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                     | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | $                                                    | 13.9       |                                                | $          | 5.2 |   | $ | 29.3 |   | $ | 21.6 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Costs of sales:                                |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | 10.6                                                 |       | 5.0                                                 |       | 22.7 |   | 20.3 |   |
| Loss on impairment of real estate  inventories |       | 29.1                                                 |       | 28.0                                                |       | 34.1 |   | 32.0 |   |
|                                           |       | 39.7                                                 |       | 33.0                                                |       | 56.8 |   | 52.3 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Gross operating loss                           |       | (25.8                                                | )          | (27.8                                               | )          | (27.5 | ) | (30.7 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative  expenses  |       | 1.5                                                  |       | 1.7                                                 |       | 5.0 |   | 4.8 |   |
| Interest expense                               |       | .6                                                   |       | .1                                                  |       | .6 |   | .1 |   |
| Income from unconsolidated joint ventures      |       | (.1                                                  | )          | (.1                                                 | )          | (.2 | ) | (.5 | ) |
| Other expense, net                             |       | .3                                                   |       | —                                              |       | 1.5 |   | .1 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Loss before income taxes                       |       | (28.1                                                | )          | (29.5                                               | )          | (34.4 | ) | (35.2 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Benefit from income taxes                      |       | (7.0                                                 | )          | (12.0                                               | )          | (9.5 | ) | (14.3 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                       |       | $                                                    | (21.1      | )                                                   | $          | (17.5 | ) | $ | (24.9 | ) | $ | (20.9 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss per common share:                     |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                          |       | $                                                    | (1.94      | )                                                   | $          | (1.61 | ) | $ | (2.28 | ) | $ | (1.92 | ) |
| Diluted                                        |       | $                                                    | (1.94      | )                                                   | $          | (1.61 | ) | $ | (2.28 | ) | $ | (1.92 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Common equivalent shares:                      |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                          |       | 10.9                                                 |       | 10.9                                                |       | 10.9 |   | 10.9 |   |
| Diluted                                        |       | 10.9                                                 |       | 10.9                                                |       | 10.9 |   | 10.9 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OFCASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                                                             |       |                                                |       |   |   |
| Cash flows from operating activities:                                            |       |                                                |       |   |   |
| Net loss                                                                         |       | $                                                   | (24.9      | ) | $ | (20.9 | ) |
| Adjustments to reconcile net loss to cash  used in operating activities:         |       |                                                |       |   |   |
| Stock-based compensation expense                                                 |       | .1                                                  |       | .1 |   |
| Distributions from unconsolidated joint  ventures                                |       | .1                                                  |       | .1 |   |
| Equity in earnings of unconsolidated joint  ventures                             |       | (.2                                                 | )          | (.5 | ) |
| Model homes depreciation                                                         |       | .6                                                  |       | — |   |
| Gain on change in fair value of derivative  instrument                           |       | (.2                                                 | )          | — |   |
| Deferred taxes                                                                   |       | (14.0                                               | )          | (14.3 | ) |
| Deferred tax asset valuation allowance                                           |       | 4.5                                                 |       | — |   |
| Gains on sales of real estate inventories                                        |       | (6.6                                                | )          | (1.3 | ) |
| Loss on impairment of real estate  inventories                                   |       | 34.1                                                |       | 32.0 |   |
| Proceeds from sale of real estate  inventories, net                              |       | 28.4                                                |       | 20.7 |   |
| Investments in real estate inventories                                           |       | (31.7                                               | )          | (70.6 | ) |
| Changes in assets and liabilities:                                               |       |                                                |       |   |   |
| (Increase) decrease in other assets                                              |       | (.3                                                 | )          | .8 |   |
| Decrease in accounts payable, accrued and  other liabilities                     |       | (7.7                                                | )          | (1.3 | ) |
|                                                                             |       |                                                |       |   |   |
| Cash used in operating activities                                                |       | (17.8                                               | )          | (55.2 | ) |
|                                                                             |       |                                                |       |   |   |
| Cash flows from investing activities:                                            |       |                                                |       |   |   |
| Sales of short-term investments                                                  |       | —                                              |       | .5 |   |
| Investments in unconsolidated joint  ventures                                    |       | (.4                                                 | )          | (.3 | ) |
| Change in restricted cash                                                        |       | .1                                                  |       | 1.0 |   |
|                                                                             |       |                                                |       |   |   |
| Cash (used in) provided by investing  activities:                                |       | (.3                                                 | )          | 1.2 |   |
|                                                                             |       |                                                |       |   |   |
| Cash flows from financing activities:                                            |       |                                                |       |   |   |
| Borrowings of senior secured project  revolver                                   |       | 40.7                                                |       | 43.4 |   |
| Repayments of senior secured project  revolver                                   |       | (22.8                                               | )          | — |   |
| Repayments of senior secured term loan                                           |       | (5.8                                                | )          | — |   |
| Borrowings of other project debt                                                 |       | 1.1                                                 |       | 16.4 |   |
| Repayments of other project debt                                                 |       | (9.0                                                | )          | (11.2 | ) |
| Deferred financing costs                                                         |       | (3.4                                                | )          | — |   |
|                                                                             |       |                                                |       |   |   |
| Cash provided by financing activities                                            |       | .8                                                  |       | 48.6 |   |
|                                                                             |       |                                                |       |   |   |
| Net decrease in cash and cash equivalents                                        |       | (17.3                                               | )          | (5.4 | ) |
|                                                                             |       |                                                |       |   |   |
| Cash and cash equivalents - beginning of  period                                 |       | 24.3                                                |       | 10.6 |   |
|                                                                             |       |                                                |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                                   | 7.0        |   | $ | 5.2 |   |
|                                                                             |       |                                                |       |   |   |
| Supplemental disclosures of cash flow  information:                              |       |                                                |       |   |   |
| Cash paid during the period for income  taxes, net of refunds received           |       | $                                                   | —     |   | $ | .2 |   |
| Supplemental disclosures of non-cash  investing and financing activities:        |       |                                                |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories |       | $                                                   | .9         |   | $ | — |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 - Basis of Presentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidatedsubsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes thatthese unaudited consolidated financial statements reflect all materialadjustments (consisting only of normal recurring adjustments) and disclosuresnecessary for the fair presentation of the results of operations and statementsof financial position when read in conjunction with the Consolidated FinancialStatements and Notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2007 and the current year’s previouslyissued Quarterly Reports on Form 10-Q. Intercompany accounts andtransactions have been eliminated.

 

The results for interim periods are not necessarilyindicative of the results to be expected for the full year. This reportcontains forward-looking statements. Readers are cautioned that any suchforward-looking statements are not guarantees of future performance and involverisks and uncertainties that actual events or results may differ materiallyfrom those described herein as a result of various factors, including withoutlimitation, the factors discussed generally in this report.

 

**Note 2 - Significant Accounting Policies**

 

*Basis of Consolidation*

 

Certain of the Company’s wholly-owned subsidiariesare members in joint ventures involved in the development and sale ofresidential projects and residential loan production. The Company’sconsolidated financial statements include the Company’s accounts and all of itsmajority-owned and controlled subsidiaries and joint ventures. The financialstatements of joint ventures in which the Company has a controlling or majorityeconomic interest (and thus are controlled by the Company) are consolidatedwith the Company’s financial statements. The Company’s investments inunconsolidated joint ventures are accounted for using the equity method whenthe Company does not have voting or economic control of the venture operations,as further discussed in Note 4 to the consolidated financial statementsincluded in the Company’s Annual Report on Form 10-K for the year ended December 31,2007.

 

*Cash Flows and Debt Compliance*

 

Negative conditions in the current housing andcredit markets give rise to uncertainty as to the Company’s present and futureability to meet its projected home sale closings and whether new or modifiedfinancings can be obtained, if needed. The Company, like many other homebuilders,is constantly evaluating potential alternatives regarding its capital structureincluding, but not limited to, various strategies for restructuring its debtand raising additional capital. There can be no assurance that the Company willbe successful in any of these endeavors. The current national credit marketcrisis presents uncertainty as to the ability of the Company to secureadditional financing, if needed, and the terms of such financing if it isavailable, and as to the ability of the Company to achieve positive cash flowfrom operations required to satisfy its obligations. See Notes 4, 5 and 6 for further discussion.

 

*Real Estate*

 

Real estate inventories primarily consist of completedhomes available for sale, homes under construction and lots under developmentand are carried at the lower of cost or fair value less costs to sell. Theestimation process involved in the determination of fair value is inherentlyuncertain because it requires estimates as to future events and market conditions.Such estimation process assumes the Company’s ability to complete developmentand dispose of its real estate properties in the ordinary course of businessbased on management’s present plans and intentions. Economic, market, andenvironmental conditions will affect management’s development and marketingplans. In addition, the implementation of such development and marketing planscould be affected by the availability of future financing for development andconstruction activities. Accordingly, the ultimate values of the Company’s realestate properties depend upon future economic and market conditions, and theavailability of financing.

 

The cost of sales of multi-unit projects is computedusing the relative sales value method. Interest and other carrying costs arecapitalized to real estate projects during their development and constructionperiod.

 

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*Impairment of Long-Lived Assets*

 

The Company recorded impairment charges of$29.1 million and $34.1 million, respectively, during the three and nine monthsended September 30, 2008, compared with impairment charges of $28.0million and $32.0 million, respectively, during the comparable periods of 2007.The impairment charges recorded during the three and nine months ended September 30,2008 and 2007 are as follows (in millions):

 
| ** **        | ** ** | ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------|------------|----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Project**       | ** ** | **Location**                     | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Inland Empire:    |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Hearthside Lane   |       | Corona                           |       | $                                                    | 24.1       |                                                | $          | 16.5 |   | $ | 24.1 |   | $ | 16.5 |   |
| Woodhaven         |       | Beaumont                         |       | 3.4                                                  |       | 3.9                                                 |       | 3.4 |   | 7.9 |   |
| Alisal at Ontario |       | Ontario                          |       | —                                               |       | 1.8                                                 |       | .6 |   | 1.8 |   |
| Chandler Ranch    |       | North Corona                     |       | .1                                                   |       | .4                                                  |       | .1 |   | .4 |   |
| * *          |       | *Subtotal –  Inland Empire* |       | 27.6                                                 |       | 22.6                                                |       | 28.2 |   | 26.6 |   |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Lancaster:        |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Las Colinas       |       | Lancaster                        |       | 1.5                                                  |       | 5.4                                                 |       | 5.9 |   | 5.4 |   |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| * *          |       | *Total –  All Projects*     |       | $                                                    | 29.1       |                                                | $          | 28.0 |   | $ | 34.1 |   | $ | 32.0 |   |

 

The impairment charges recorded during thethird quarter of 2008 primarily reflect a $24.1 million fair value write-downfor the Hearthside Lane project in Corona. The subsidiary which owns theproperty ceased making the required interest payments in October 2008 andis in default on the Hearthside Lane loan facility (also referred to as the “HellmanLoan” in Note 6) which has an outstanding balance of $29.7 million as of September 30,2008. The loan is non-recourse to California Coastal Communities, Inc.,however, the subsidiary’s parent, Hearthside Homes, Inc., guaranteedpayment of the debt. Hearthside Homes’ subsidiary is attempting to negotiate aconsensual resolution of the loan with the lender, IndyMac Federal Bank, whichis likely to involve turnover of the property securing the loan to the lender.In accordance with EITF Issue No. 91-2, “*Debtor’sAccounting for Forfeiture of Real Estate Subject to a Nonrecourse Mortgage*”(“EITF 91-2”), and a FASB staff interpretation thereof, the Company reduced thecarrying value of the Hearthside Lane real estate project to its estimated fairvalue during the third quarter of 2008. If the Hearthside Lane property istransferred to IndyMac Federal Bank in full settlement of the loan withoutfurther recourse or obligation, the Company will recognize a gain as a resultof debt cancellation. However, there can be no assurance that IndyMac FederalBank will agree to a consensual resolution.

 

During 2007 and 2008, the Company recordedimpairment charges aggregating $66.1 million related to five of its inlandprojects. The impairment charges were calculated based on market conditions andassumptions made by management that reflected current conditions at the timesuch impairment charges were determined, which may differ materially fromactual results if market conditions change. As required by SFAS 144,should market conditions deteriorate in the future or other events occur thatindicate the carrying amount of the Company’s real estate inventories may notbe recoverable, the Company will reevaluate the expected cash flows from eachproject to determine whether any additional impairment exists at any point intime.

 

The Company assesses the impairment of realestate inventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets”* (“SFAS 144”), which requires that long-livedassets be reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Asprovided by SFAS 144, impairment is evaluated by comparing an asset’scarrying value to the undiscounted estimated cash flows expected from the asset’soperations and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset for purposes of SFAS 144 is deemed to be theamount a willing buyer would pay a willing seller for such asset in a currenttransaction. Additionally, as appropriate, the Company identifies alternativecourses of action to recover the carrying value of its long-lived assets andevaluates all likely alternatives under a probability-weighted approach asdescribed in SFAS 144.

 

In accordance with SFAS 144, indeveloping estimated future cash flows for impairment testing for its realestate inventories, the Company has incorporated its own market assumptionsincluding those regarding home prices, sales pace, sales and marketing costs,infrastructure and home-building costs and financing costs regarding realestate inventories. The Company’s assumptions are based, in part, on generaleconomic conditions, the current state of the homebuilding industry,expectations about the short- and long-term outlook for the housing market, andcompetition from other homebuilders in the areas in which the Company buildsand sells homes. These assumptions can significantly affect the Company’sestimates of future cash flows. For those communities deemed to be impaired,the Company determined fair value based on discounted estimated future cashflows using estimated absorption rates for each community.

 

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The estimation process involved in thedetermination of value is inherently uncertain since it requires estimates asto future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and disposition of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic and market conditions may affect management’sdevelopment and marketing plans. In addition, the implementation of suchdevelopment and marketing plans could be affected by the availability of futurefinancing for development and construction activities. Accordingly, the amountultimately realized from such project may differ materially from currentestimates and the project’s carrying value.

 

The Company believes that accounting for theimpairment of long-lived assets is a critical accounting policy because thevaluation analysis involves a number of assumptions that may differ from actualresults and the impact of recognizing impairment losses has been material tothe Company’s consolidated financial statements. The critical assumptions inthe Company’s evaluation of real estate inventories impairment includedprojected sales prices, anticipated sales pace within each community, andapplicable discount rates, any of which could change materially as economicconditions change.

 

*Earnings Per Common Share*

 

Earnings per common share is accounted for inaccordance with SFAS No. 128, *“Earnings Per Share.”*Basic earnings per common share is computed using the weighted-average numberof common shares outstanding for the period. Diluted earnings per common shareis computed using the weighted-average number of common shares outstanding andthe dilutive effect of potential common shares outstanding.

 

*Recent Accounting Pronouncements*

 

In May 2008, the FASB issued SFAS No. 162,*“The Hierarchy of Generally AcceptedAccounting Principles”* (“SFAS 162”), which identifies thesources of accounting principles and the framework for selecting the principlesto be used in the preparation of financial statements of nongovernmentalentities that are presented in conformity with generally accepted accountingprinciples in the United States. The FASB has not determined an adoption datefor SFAS 162. The Company does not expect the adoption of SFAS 162 to havea material effect on the Company’s consolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161,“*Disclosures About Derivative Instruments andHedging Activities — an amendment of FASB Statement No. 133”* (“SFAS 161”), which expandsthe disclosure requirements for derivative instruments and hedging activitiesrequired by Statement No. 133. SFAS 161 is effective for financialstatements issued for fiscal periods beginning after November 15, 2008(the Company’s fiscal year beginning January 1, 2009). The Company iscurrently evaluating the impact of adopting SFAS 161 on its consolidatedfinancial statements.

 

In December 2007, the FASB issued SFAS No. 160,*“Noncontrolling Interests in ConsolidatedFinancial Statements—an amendment of ARB No. 51”* (“SFAS 160”),which clarifies and expands the accounting and reporting standards for thenoncontrolling interest in a subsidiary. SFAS 160 requires that net incomeattributable to the parent and the noncontrolling interest be reported on theface of the consolidated statement of income and that a noncontrolling interestbe presented in the consolidated statement of financial position within equity.SFAS 160 is effective for financial statements issued for fiscal periodsbeginning after December 15, 2008 (the Company’s fiscal year beginning January 1,2009). The Company is currently evaluating the impact of adopting SFAS 160on its consolidated financial statements.

 

In February 2007,the FASB issued SFAS No. 159, *“The Fair Value Option forFinancial Assets and Financial Liabilities”* (“SFAS 159”), whichexpands the standards under SFAS 157 and provides entities a one-time electionto measure financial instruments and certain other items at fair value. TheCompany adopted SFAS 159 on January 1, 2008. The adoption of SFAS 159 didnot have a material effect on the Company’s consolidated financial statements.

 

In September 2006, theFASB issued SFAS No. 157, *“Fair Value Measurements”*(“SFAS 157”), which defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. In February 2008, the FASB issued FASBStaff Position No. 157-2, “*Effective Date of FASBStatement No. 157*,” which delayed for one year theapplicability of SFAS 157’s fair value measurements to certain nonfinancialassets and liabilities. The Company adopted SFAS 157 as it applies to financialassets and liabilities on January 1, 2008. The adoption of SFAS 157 didnot have a material effect on the Company’s consolidated financial statements.The Company is currently evaluating the impact of adopting SFAS 157 on itsconsolidated financial statements as it applies to nonfinancial assets andliabilities.

 

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**Note 3 — Real Estate Inventories**

 

Real estate inventories primarily consist ofhomes under construction and lots under development at Brightwater in coastalOrange County and three inland communities in Riverside and Los Angelescounties. At September 30, 2008, real estate inventories aggregated 680lots and homes, including 12 standing inventory homes completed and unsold,eight homes completed and in escrow, and 12 homes under construction and inescrow. Real estate inventories at September 30, 2008 included$236.9 million recorded for 331 lots and homes under development at theBrightwater community which is located on a 105-acre parcel on a mesa north ofthe Bolsa Chica wetlands in Huntington Beach, California and $25.4 millionrecorded for 349 lots and homes at its subsidiaries’ various inland projects.During the three and nine months ended September 30, 2008, the Companyrecorded additional impairment charges aggregating $29.1 million and $34.1million, respectively, related to inland projects. See additional discussion inNote 2. The Company capitalizes carrying costs including interest and propertytaxes, as well as direct construction costs, to real estate inventories duringthe development and construction period.

 

The Brightwater planned community offers abroad mix of home choices, averaging 2,860 square feet and ranging in size from1,710 square feet to 4,339 square feet. The community also has 37 acres of openspace and conservation area. With 349 homes permitted on 68 acres, theresulting low-density plan equates to approximately five homes per acre,consistent and compatible with the neighboring Huntington Beach communities. Inaddition, the Company owns land adjacent to the Brightwater development, onwhich it intends to process permits to build seven additional homes which willbe included in the Brightwater community.

 

The Company began selling homes at The Trailsand The Sands in August 2007 and began delivering homes for these productsduring December 2007. Construction of models for the larger two products,The Cliffs and The Breakers, was completed in January 2008. In February 2008,the Company began selling homes to homebuyers who had previously registered onthe Brightwater priority list. The Company held a grand opening for theseproducts on March 15, 2008 and delivered the first five homes at TheCliffs and The Breakers neighborhoods during the third quarter of 2008.

 

Capitalized interest is allocated to real estateinventories when incurred and charged to cost of sales when the relatedproperty is delivered. Changes in capitalized interest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Capitalized interest, beginning of period |       | $                                                    | 32.3       |                                                | $          | 17.8 |   | $ | 26.2 |   | $ | 10.2 |   |
| Interest incurred and capitalized         |       | 3.2                                                  |       | 5.1                                                 |       | 10.7 |   | 13.5 |   |
| Charged to cost of sales                  |       | (1.2                                                 | )          | (.3                                                 | )          | (2.6 | ) | (1.1 | ) |
| Capitalized interest, end of period       |       | $                                                    | 34.3       |                                                | $          | 22.6 |   | $ | 34.3 |   | $ | 22.6 |   |

 

As of September 30, 2008, real estateinventories include $2.6 million of model home furnishings, net of relateddepreciation. Model home furnishings are depreciated using the straight-linemethod over three to five years.

 

**Note 4 —Senior Secured Project Revolver**

 

On September 30, 2008, the Companyentered into the third amendment (“Third Revolving Amendment”) to the $100Million Senior Secured Revolving Credit Agreement with KeyBank NationalAssociation, as a lender and as agent for the other loan syndicate members (the“Revolving Loan”). The Revolving Loan is secured by a first trust deed on theBrightwater project, and stock pledges of the Company’s material subsidiaries.

 

In exchange for the Third RevolvingAmendment, the Company paid a modification and extension fee of 37.5 basispoints to each lender, along with legal fees and fees to the Company’sfinancial advisor. As of September 30, 2008 and December 31, 2007,approximately $1.7 million and $600,000, respectively, of deferred loan feesand closing costs related to the Revolving Loan are included in other assetsand amortized over the life of the loan. Amortization of these costs isincluded in the capitalization of interest allocated to real estate inventoriesand charged to cost of sales when the related homes are delivered. The mostsignificant provisions of the Third Revolving Amendment are discussed below.

 

·                  The Companyreceived an option to extend the Revolving Loan maturity date from September 2009to June 2010, subject to compliance with all covenants for the periodending December 31, 2008

 

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·                  Debt repaymentsthat were previously due by December 31, 2008 totaling $20.0 million,along with previously scheduled repayments for the first three quarters of2009, were deferred to future periods as follows:

 
| ** **              | ** ** | **Without Extension** | ** ** | **With Extension (1)** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------------|------------|
| **Date**                | ** ** | **Commitment  Reduction**  | ** ** | **Commitment**                   | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
| December 31, 2008  |       | $                          | 5.0        |                             | $          | 95.0 |   | $ | 5.0 |   | $ | 95.0 |   |
| June 30, 2009      |       | $                          | 5.0        |                             | $          | 90.0 |   | $ | 5.0 |   | $ | 90.0 |   |
| September 30, 2009 |       | $                          | 90.0       |                             | $          | — |   | $ | 10.0 |   | $ | 80.0 |   |
| December 31, 2009  |       | n/a                        |       | n/a                              |       | $ | 10.0 |   | $ | 70.0 |   |
| March 31, 2010     |       | n/a                        |       | n/a                              |       | $ | 10.0 |   | $ | 60.0 |   |
| June 30, 2010      |       | n/a                        |       | n/a                              |       | $ | 60.0 |   | $ | — |   |

 

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(1) Presuming the Company is incompliance with its covenants at December 31, 2008, which would enable itto exercise its option to extend the current maturity date from September 2009to June 2010. However, given the current national economic recession anddifficult housing market, there can be no assurance that the Company will beable to meet the December 31, 2008 covenants.

 

·                  The leveragecovenant, which prohibits the Company’s ratio of consolidated total liabilitiesto consolidated tangible net worth from exceeding a maximum ratio, wasadjusted. The calculation of the covenant was also modified to excludeimpairment charges related to the Hearthside Lane project in Corona and the LasColinas project in Lancaster and valuation reserves on deferred tax assets:

 
| **Reporting Period**                       | ** ** | **Maximum  Leverage Ratio** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| June 30, 2008 through March 30,  2009 |       | 2.75 to 1.0                      |       |
| March 31, 2009 and thereafter              |       | 2.50 to 1.0                      |       |

 

·                  Theloan-to-value ratio, which prohibits the Company’s ratio of Revolver Loan debtoutstanding to borrowing base value from exceeding a maximum ratio was adjustedto the following:

 
| **Reporting Period**                                | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------|------------|
| June 30, 2008 through September 29,  2009      |       | 40                                | %          |
| September 30, 2009 through  March 30, 2010 (1) |       | 35                                | %          |
| March 31, 2010 and thereafter (1)                   |       | 30                                | %          |

 

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(1) Presuming the Company is incompliance with its covenants at December 31, 2008, which would enable itto exercise its option to extend the current maturity date from September 2009to June 2010. However, given the current national economic recession anddifficult housing market, there can be no assurance that the Company will beable to meet the December 31, 2008 covenants.

 

In addition to the modified covenants above,the Company is subject to a minimum consolidated tangible net worth covenant of$80 million, excluding non-cash impairment charges for the Hearthside Laneand Las Colinas projects and valuation reserves on deferred tax assets. As of September 30,2008, the Company’s consolidated total liabilities are $262.4 million,tangible net worth after excluding the recent Hearthside Lane and Las Colinasimpairment charges and valuation reserves on deferred tax assets is$96.3 million and the leverage ratio is 2.72. The loan-to-value ratio is30% and the Company is in compliance with the covenants of the Revolving Loanas of September 30, 2008.

 

The Revolving Loan is also subject tomandatory repayments and commitment reductions based on 40% of the $600,000release price on the first 70 units closed at the Brightwater project, and 40%of the $1 million release price per unit thereafter. These mandatoryrepayments are applicable to the commitment reductions set forth above. Duringthe three and nine months ended September 30, 2008, the Company deliveredseven and 16 homes, respectively, at Brightwater and made mandatory repaymentson the Revolving Loan of $1.7 million and $3.8 million, respectively. As of September 30,2008, the Company has delivered 25 homes at Brightwater and made cumulativemandatory repayments for the Revolving Loan of $240,000 per home, or $6.0million. Availability under the $100.0 million Revolving Loan has been reducedto $94.0 million after subtracting the $6.0 million cumulative mandatoryrepayments.

 

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As of September 30, 2008 and December 31,2007, $93.9 million and $76.0 million, respectively, was outstandingunder the Revolving Loan at weighted average rates of 4.91% and 6.90%,respectively, based upon the Company’s elected rates. As of September 30,2008, the undrawn availability was $60,000. Outstanding advances currently bearinterest based on the following loan-to-value grid:

 
| **Loan-to-Value**                              | ** ** | **LIBOR Margin** | ** ** | **Prime Margin** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| Greater than or equal to 30% to less than  40% |       | 350                   |       | 200                   |       |
| Greater than or equal to 20% to less than  30% |       | 325                   |       | 175                   |       |
| Less than 20%                                  |       | 300                   |       | 150                   |       |

 

Interest on the facility is calculated on theaverage, outstanding daily balance and is paid monthly. Interest incurred onthe Revolving Loan for the three and nine months ended September 30, 2008was $1.1 million and $3.1 million, respectively, at weighted-average interestrates of 4.49% and 4.90%, respectively. Interest incurred on the Revolving Loanfor the three and nine months ended September 30, 2007 was $900,000 and$2.1 million, respectively, at weighted-average interest rates of 7.31% and7.32%, respectively. As of November 7, 2008, the Revolving Loan interestrate is 5.21%. Given the recently elevated levels of LIBOR rates, the Companyutilized the Prime rate-based option from September 2008 to November 6,2008.

 

The Company, like many other homebuilders, isconstantly evaluating potential alternatives regarding its capital structureincluding, but not limited to, various strategies for restructuring its debtand raising additional capital. There can be no assurance that the Company willbe successful in any of these endeavors. The current national crisis in thecredit markets present significant uncertainty as to the ability of the Companyto secure additional financing, if needed, and the terms of such financing ifit is available, and as to the ability of the Company to achieve positive cashflow from operations required to satisfy its obligations.

 

**Note 5 — Senior Secured Term Loan**

 

On September 15, 2006, the Companyentered into a five-year, $125 Million Senior Secured Term Loan Agreementwith KeyBank National Association, as a lender and as agent for the other loansyndicate members (the “Term Loan”), and on September 15, 2006, theCompany borrowed the maximum loan amount of $125 million. The proceedswere used to fund a “special dividend” of $12.50 per share, totaling$135.7 million, to common stockholders paid on September 28, 2006.The Term Loan is secured by a second trust deed on the Brightwater project, anda general pledge and assignment of the Company’s ownership interests in allmaterial subsidiaries. All existing material subsidiaries of the Company haveprovided full unconditional guarantees. The Term Loan includes financialcovenants which may limit the amount that may be outstanding.

 

On September 30, 2008, the Companyentered into the third amendment (“Third Term Amendment”) to the Term Loan. Inexchange for the Third Term Amendment, the Company paid a modification andextension fee of 37.5 basis points to each lender, along with legal fees andfees to the Company’s financial advisor. As of September 30, 2008 and December 31,2007, approximately $3.6 million and $1.9 million, respectively, of deferredloan fees and closing costs related to the Term Loan are included in otherassets and amortized over the life of the loan. Amortization of these costs isincluded in the capitalization of interest allocated to real estateinventories, and charged to cost of sales when the related homes are delivered.The most significant provisions of the Third Term Amendment are discussedbelow.

 

·                  Debt repaymentsthat were previously due by December 31, 2008 totaling $5.0 million, alongwith previously scheduled repayments for future quarters, were deferred tofuture periods as follows:

 

| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|----------------|------------|
| December 31, 2008  |       | $                         | 10.0       |           | $          | 115.0 |   |
| June 30, 2009      |       | $                         | 5.0        |           | $          | 110.0 |   |
| September 30, 2009 |       | $                         | 5.0        |           | $          | 105.0 |   |
| December 31, 2009  |       | $                         | 15.0       |           | $          | 90.0 |   |
| March 31, 2010     |       | $                         | 15.0       |           | $          | 75.0 |   |
| June 30, 2010      |       | $                         | 10.0       |           | $          | 65.0 |   |
| September 30, 2010 |       | $                         | 15.0       |           | $          | 50.0 |   |
| December 31, 2010  |       | $                         | 12.5       |           | $          | 37.5 |   |
| March 31, 2011     |       | $                         | 12.5       |           | $          | 25.0 |   |
| June 30, 2011      |       | $                         | 12.5       |           | $          | 12.5 |   |

 

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·                  The leveragecovenant, which prohibits the Company’s ratio of consolidated total liabilitiesto consolidated tangible net worth from exceeding a maximum ratio, wasadjusted. The calculation of the covenant was also modified to excludeimpairment charges related to the Hearthside Lane project in Corona and the LasColinas project in Lancaster and valuation reserves on deferred tax assets:

 
| **Reporting Period**                       | ** ** | **Maximum  Leverage Ratio** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| June 30, 2008 through March 30,  2009 |       | 2.75 to 1.0                      |       |
| March 31, 2009 and thereafter              |       | 2.50 to 1.0                      |       |

 

·                  Theloan-to-value ratio, which prohibits the Company’s ratio of Term Loan debtoutstanding to borrowing base value from exceeding a maximum ratio was adjustedto the following:

 
| **Reporting Period**                            | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| June 30, 2008 through  December 30, 2009   |       | 70                                | %          |
| December 31, 2009 through  March 30, 2010  |       | 65                                | %          |
| March 31, 2010 through  September 29, 2010 |       | 60                                | %          |
| September 30, 2010 and thereafter               |       | 45                                | %          |

 

·                  The interestcoverage covenant which prohibits the Company’s ratio of EBITDA to interestincurred was modified to reflect the following:

 
| **Period**                                              | ** ** | **Minimum  Coverage Ratio** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| September 30, 2008 through  March 30, 2009    |       | .25 to 1.0                       |       |
| March 31, 2009 through June 29,  2009         |       | 1.00 to 1.0                      |       |
| June 30, 2009 through  September 29, 2009     |       | 1.25 to 1.0                      |       |
| September 30, 2009 through  December 30, 2009 |       | 1.50 to 1.0                      |       |
| December 31, 2009 and thereafter                   |       | 2.00 to 1.0                      |       |

 

In addition to the modified covenants above,the Company is subject to a minimum consolidated tangible net worth covenant of$80 million, excluding non-cash impairment charges for the Hearthside Laneand Las Colinas projects and valuation reserves on deferred tax assets. As of September 30,2008, the Company’s consolidated total liabilities are $262.4 million,tangible net worth after excluding the recent Hearthside Lane and Las Colinasimpairment charges and valuation reserves on deferred tax assets is$96.3 million and the leverage ratio is 2.72. The loan-to-value ratio is68% and the Company is in compliance with covenants of the Term Loan as of September 30,2008.

 

The Term Loan is also subject to mandatoryrepayments and commitment reductions based on 60% of the $600,000 release priceon the first 70 units closed at the Brightwater project, and 60% of the$1 million release price per unit thereafter. These mandatory repaymentsare applicable to the commitment reductions set forth above. During the threeand nine months ended September 30, 2008, the Company delivered seven and16 homes, respectively, at Brightwater and made mandatory repayments of $2.5million and $5.8 million, respectively. As of September 30, 2008, theCompany has delivered 25 homes at Brightwater and made cumulative mandatoryrepayments for the Term Loan of $360,000 per home, or $9.0 million.Availability under the $125.0 million Term Loan has been reduced to $116.0million after subtracting the $9.0 million cumulative mandatory repayments.

 

As of September 30, 2008 and December 31,2007, $116.0 million and $121.8 million, respectively, wasoutstanding under the Term Loan at rates of 5.25% and 7.5%, respectively, basedupon the Company’s elected rates. The outstanding balance currently bearinterest based on the following loan-to-value grid:

 
| **Loan-to-Value**                              | ** ** | **LIBOR Margin** | ** ** | **Prime Margin** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| Greater than or equal to 65% to less than  70% |       | 450                   |       | 300                   |       |
| Greater than or equal to 50% to less than  65% |       | 400                   |       | 250                   |       |
| Less than 50%                                  |       | 350                   |       | 200                   |       |

 

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Interest on the facility is calculated on theaverage, outstanding daily balance and is paid monthly. Interest incurred onthe Term Loan for the three and nine months ended September 30, 2008 was$1.7 million and $5.5 million, respectively, at weighted-average interest ratesof 5.23% and 5.68%, respectively. Interest incurred on the Term Loan for thethree and nine months ended September 30, 2007 was $2.7 million and $7.9million, respectively, at weighted-average interest rates of 8.10% and 8.08%,respectively. As of November 7, 2008, the Term Loan interest rate is6.46%. Given the recently elevated levels of LIBOR rates, the Company utilizedthe Prime rate-based option from September 2008 to November 6, 2008.

 

Under the Term Loan agreement, the Companywas required to enter into a swap agreement to hedge against risks associatedwith fluctuating interest rates related to $62.5 million of floating ratedebt. On September 15, 2006 the Company entered into an interest rate swaptransaction to effectively fix the interest rate on $62.5 million infloating rate debt at 8.015% per annum. The swap transaction terminated September 15,2008. The swap did not qualify for hedge accounting under SFAS No. 133, *“Accounting for Derivative Instruments and HedgingActivities.”* The fair value of the interest rate swap agreementrepresents the spread between the interest rate the Company would pay and theinterest rate the Company would receive over the remaining life of theagreement which are considered level 2 inputs under SFAS 157. The non-cashchange in fair value of the interest rate swap agreement during the three andnine months ended September 30, 2008 was an approximately $400,000 and$200,000 increase, respectively, and was included in other expense, net. Inaddition, the Company recorded $400,000 and $1.0 million of expense for cashpayments made under the terms of the interest rate swap agreement during thethree and nine months ended September 30, 2008, respectively, due todeclining interest rates during the periods. The counterparties to the interestrate swap agreement are financial institutions.

 

The Company, like many other homebuilders, isconstantly evaluating potential alternatives regarding its capital structureincluding, but not limited to, various strategies for restructuring its debtand raising additional capital. There can be no assurance that the Company willbe successful in any of these endeavors. Current credit market conditionspresent uncertainty as to the ability of the Company to secure additionalfinancing, if needed, and the terms of such financing if it is available, andas to the ability of the Company to achieve positive cash flow from operationsrequired to satisfy its obligations.

 

**Note 6 — Other Project Debt**

 

In conjunction with the acquisition ofsingle-family residential lots, the Company’s homebuilding subsidiary,Hearthside Homes, Inc. and its subsidiaries, entered into constructionloan agreements with commercial banks. These loan facilities finance a portionof land acquisitions and the majority of the construction of infrastructure andhomes. Each loan facility requires a guaranty of project completion and paymentand an environmental indemnity by Hearthside Homes, Inc., but these loansare nonrecourse to California Coastal Communities, Inc. The loans aresecured by first trust deeds and bear an interest rate of prime plus one-fourthor prime plus one-half percent (5.25% to 5.5% at September 30, 2008). TheLancaster and Hellman loan facilities have minimum interest rates of 7.5% and7.25%, respectively. During the nine months ended September 30, 2008,Hearthside Homes, Inc. and its subsidiaries did not enter into any newloan facilities.

 

The following amounts were available andoutstanding under these loan facilities as of September 30, 2008 and December 31,2007 ($ in millions):

 
| ** **     | ** ** | ** **                   | ** ** | ** **            | ** **     | ** **               | ** ** | ** **         | ** ** | **Outstanding at**      | ** ** |
|----------------|------------|------------------------------|------------|-----------------------|----------------|--------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Lender**            | ** **     | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|           |       |                         |       |                  |           |                     |       |               |       |                         |       |   |   |
| Ontario        |       | $                            | —     |                  | Comerica  Bank |                     | —     |               | n/a        |                         | $          | — |   | $ | 2.6 |   |
| Lancaster      |       | 14.0                         | (1)        | IndyMac  Federal Bank |           | 60                       |       | 9/30/08            |       | 3.9                          |       | 4.2 |   |
| Corona-Hellman |       | 54.5                         | (1)        | IndyMac  Federal Bank |           | 142                      |       | 1/7/09             |       | 29.7                         |       | 32.1 |   |
| Beaumont       |       | 17.9                         |       | Comerica  Bank        |           | 72                       |       | 9/17/09            |       | 7.3                          |       | 9.9 |   |
|           |       |                         |       |                  |           |                     |       |               |       |                         |       |   |   |
|           |       |                         |       |                  |           |                     |       |               |       | $                            | 40.9       |   | $ | 48.8 |   |
|                |            |                              |            |                       |                |                          |            |                    |            |                              |            |  |  |  |  |  |

 

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(1)  The Lancaster and Corona-Hellman loan facilities arecurrently in default as discussed below. A subsidiary of Hearthside Homesreceived a notice of event of default from IndyMac Bank in October 2008relating to the Corona-Hellman loan informing the subsidiary that it intends toaccelerate the loan, which it declared immediately due and payable.

 

During July 2008, a subsidiary ofHearthside Homes repaid the Ontario loan in full.

 

A subsidiary of Hearthside Homes has extendedthe Beaumont loan from September 17, 2008 to September 17, 2009. Theoutstanding balance on the Beaumont loan as of September 30, 2008 reflectsthe prepayment of $750,000 of principal, which was required in connection withextending the maturity of the loan.

 

Subsidiaries of Hearthside Homes are currently in default on theCorona-Hellman loan facility for development of the Hearthside Lane project (“HellmanLoan”) as a result of not making its required interest payment in October 2008and on the Lancaster loan facility for development of the Las Colinas projectwhich matured on September 30, 2008. These subsidiaries made all 

 

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required interest payments required to be made through September 30,2008 and ceased making payments beginning in October. The loans are nonrecourseto California Coastal Communities, Inc.; however, the subsidiaries’parent, Hearthside Homes, Inc., guaranteed payment of the debt. HearthsideHomes’ subsidiaries are attempting to negotiate a consensual resolution of theloans with the lender, IndyMac Federal Bank, which is likely to involveturnover of the properties securing these loans to the lender. As a result,during the third quarter of 2008 in accordance with EITF 91-2 and a FASB staffinterpretation thereof, the Company reduced the carrying value of theHearthside Lane and Las Colinas real estate projects to their estimated fairvalues (see Note 2). If the Hearthside Lane property is transferred to IndyMacFederal Bank in full settlement of the loan without further recourse orobligation, the Company will recognize a gain as a result of debt cancellation.However, there can be no assurance that IndyMac Federal Bank will agree to aconsensual resolution of these loans.

 

**Note 7 - Other Liabilities**

 

Other liabilities were comprised of the following(in millions):

 
| ** **                                          | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                       |       | $                            | 3.5        |                        | $          | 3.8 |   |
| Home warranty reserves                              |       | 2.0                          |       | 2.3                         |       |
| Contingent indemnity and environmental  obligations |       | 1.1                          |       | 1.3                         |       |
| Unamortized discount                                |       | (.3                          | )          | (.4                         | )          |
|                                                |       | $                            | 6.3        |                        | $          | 7.0 |   |

 

Contingent indemnity and environmental obligationspartially reflect reserves before related discount (recorded pursuant toFresh-Start Reporting in 1997) for contingent indemnity obligations forbusinesses disposed of by former affiliates and unrelated to the Company’scurrent operations.

 

*Home Warranty Reserve*

 

The Company provides a home warranty reserve toreflect its contingent obligation for product liability. The Company generallyrecords a provision as homes are delivered, based upon historical and industryexperience, for the items listed in the homeowner warranty manual, which doesnot include items that are covered by manufacturers’ warranties or items thatare not installed by the Company’s employees or contractors. The home warrantyreserve activity is presented below (in millions):

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Balance at beginning of period       |       | $                                                    | 2.0        |                                                | $          | 2.4 |   | $ | 2.3 |   | $ | 2.4 |   |
| Provision                            |       | .1                                                   |       | .1                                                  |       | .1 |   | .3 |   |
| Adjustment due to change in estimate |       | —                                               |       | —                                              |       | (.1 | ) | — |   |
| Payments                             |       | (.1                                                  | )          | (.3                                                 | )          | (.3 | ) | (.5 | ) |
| Balance at end of period             |       | $                                                    | 2.0        |                                                | $          | 2.2 |   | $ | 2.0 |   | $ | 2.2 |   |

 

**Note 8 - Income Taxes**

 

The following is a summary of thetax benefit:

 
| ** **                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Current taxes             |       | $                                                    | —     |                                                | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes            |       | (7.0                                                 | )          | (12.0                                               | )          | (9.5 | ) | (14.3 | ) |
| Benefit from income taxes |       | $                                                    | (7.0       | )                                                   | $          | (12.0 | ) | $ | (9.5 | ) | $ | (14.3 | ) |

 

The net deferred tax balance at September 30,2008 and December 31, 2007 is primarily composed of federal net operatinglosses (“NOLs”). During the third quarter of 2008, the Company concluded it wasnot “more likely than not” that the Company would be able to generatesufficient taxable income in 2008 and 2009 to realize certain expiring federalNOLs and recorded a valuation allowance of $4.5 million. The Company monitorsthe availability of real estate for development at economically viable prices,market conditions and other economic factors affecting the Company’soperations, as well as other positive and negative factors that may arise inthe future, as it assesses the need for additional valuation allowances againstits deferred tax assets. The most critical uncertainties are whether theCompany will be able to continue selling homes at its Brightwater project usingcurrently projected sales prices and absorption rates in light of thecontinuing deterioration in the housing and credit markets and the timing ofrecognition of losses on inland properties.

 

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The federal NOLs available as of September 30,2008 were approximately $137 million. The amount of federal NOLs which expireif not utilized is $3 million for 2008, $11 million, $49 million, $42 million,zero, and $32 million for 2009, 2010, 2011, 2012 and thereafter, respectively.

 

The Internal Revenue Code (the “Code”) generallylimits the availability of NOLs if an ownership change occurs within any three-yearperiod under Section 382. If the Company were to experience an ownership changeof more than 50%, the use of all remaining NOLs would generally be subject toan annual limitation equal to the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate (4.94% as of November 2008)plus (ii) recognized built-in-gains, defined as those gains recognizedwithin five years of the ownership change subject to an overall limitation ofthe net unrealized built-in gains existing as of the ownership change date. TheCompany estimates that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the Company, it hasexperienced a three-year cumulative ownership shift of approximately 23% as of November 3,2008, as computed in accordance with Section 382. In the event of anownership change, the Company’s use of its NOLs may be limited and the deferredtax assets recorded at September 30, 2008 may not be fully realizable.

 

On September 18, 2006, the Company’s Board ofDirectors suspended enforcement of the Company’s charter documents thatrestrict stockholders from acquiring more than 5% of the outstanding shares ofCommon Stock. The Board determined that such restrictions were not currentlyrequired to preserve the tax benefits of the Company’s $137 million of NOLs.While the Company remains subject to Code section 382, which limits theavailability of NOLs in the event of an ownership change, the Company wouldhave five years from the date of any such ownership change to recognize itsbuilt in gains and utilize its NOLs. However, the Board may reinstitute the 5%ownership limitation if required by currently unanticipated events.

 

Pursuant to SFAS 123(R), the Company has elected torecognize stock option deductions on the tax law ordering method, whichmaximizes the realization of the stock option deductions in the current year.While the Company realized the majority of its 2006 stock option deductions,approximately $400,000 of unrealized tax benefits related to stock optiondeductions are not reflected in the consolidated financial statements. Uponrealization of the tax benefits, the Company would increase its additionalpaid-in capital.

 

*Uncertain Tax Positions*

 

The Company adopted the provisions of FASBInterpretation No. 48, *“Accounting forUncertainty in Income Taxes”* (“FIN 48”), on January 1,2007. As a result of the implementation of FIN 48, during the first quarter of2007, the Company recorded a $5.1 million decrease in deferred tax assetsfor unrecognized tax benefits, which was offset by an increase in deferred taxassets of $1.8 million for assets re-evaluated as recognizable. The net changein deferred tax assets of $3.3 million was recorded as a cumulative effect of achange in accounting principle and resulted in a decrease to the January 1,2007 retained earnings balance of $200,000 and a decrease to the additionalpaid in capital balance of $3.1 million related to fresh-start accountingpursuant to a 1997 pre-packaged bankruptcy. During the three and nine monthsended September 30, 2008, the Company recorded a $50,000 decrease indeferred tax assets, due to the impact of potential expiration of NOLs onuncertain tax positions. Of the Company’s unrecognized tax benefits of $5.1million at September 30, 2008, $100,000 would decrease the Company’seffective tax rate if recognized. The Company does not expect that itsunrecognized tax benefits will significantly fluctuate or change within twelvemonths of the reporting date.

 

The Company recognizes interest expense andpenalties related to uncertain tax positions as interest or other expense. Asof September 30, 2008, the Company has not recorded any interest orpenalties related to unrecognized tax benefits, due to the substantial NOLsavailable.

 

Certain tax year filings remain open toFederal and California examination, which are the Company’s primary taxjurisdictions. The years 2005 through 2007 and the years 2004 through 2007remain open for Federal and California purposes, respectively, for which theCompany utilized NOLs generated between 1990 and 1993 to offset taxable income.Except as reserved, the Company expects to utilize Federal NOLs generatedbetween 1993 and 1997 and in 1999, 2006 and 2007 in future years. In addition,the Company expects to utilize California NOL generated in 2007 in futureyears.

 

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**Note 9 - Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company is subject to the usualobligations associated with entering into contracts for the purchase of landand improved home sites. The purchase of properties under these contracts isgenerally contingent upon satisfaction of certain requirements by the sellers,including obtaining applicable property entitlements. The Company also utilizesoption contracts with third-party land sellers and financial entities as amethod of acquiring land in staged takedowns and minimizing the use of fundsfrom other corporate financing sources. These option contracts also help tomanage the financial and market risk associated with land holdings. Optioncontracts generally require the payment of a non-refundable cash deposit of 5%to 15% of the purchase price for the right to acquire lots over a specifiedperiod of time (usually one to two years) at predetermined prices. The Companyhas the right at its discretion to terminate its obligations under these landpurchase and option agreements by forfeiting the cash deposit with no furtherfinancial responsibility. As of September 30, 2008, the Company has noconsolidated land option deposits.

 

The Company has outstanding performance andsurety bonds, for the benefit of city and county jurisdictions, relatedprincipally to its obligations for site improvements and fees at variousprojects at September 30, 2008. The Company does not believe that drawsupon these bonds, if any, will have a material effect on the Company’sfinancial position, results of operations or cash flows.

 

*Oxnard Land Development Joint Venture*

 

In February 2003, the Company, throughits Hearthside Homes, Inc. homebuilding subsidiary, entered into twooption contracts to acquire land adjacent to the City of Oxnard in VenturaCounty, California aggregating approximately 168 acres. The option contractsallow the Oxnard joint venture to complete entitlement activities beforepurchasing the land. The option contracts currently expire in February 2009,and there are three additional extensions available for each contract that, ifexercised, would extend the outside closing date to December 31, 2011. TheCompany is developing a land plan for the area, which also includes anadditional 149 acres owned by other landowners, with the intention of entitlingthe property for residential development and annexing it into Oxnard. During October 2003,the Company entered into a limited liability company joint venture agreementwith a major financial partner to pursue the Oxnard development opportunity.Hearthside Homes, Inc. assigned the land purchase option contracts to theOxnard LLC. Hearthside Homes, Inc. is the managing member of theOxnard LLC.

 

As of September 30, 2008, the Company’saggregate capital contributions were $2.5 million and its total investmentin the Oxnard LLC was $3.2 million. In addition, as of September 30,2008, the Company has incurred capitalized overhead costs of approximately$700,000 for the project which are unreimbursed by the venture, bringing theCompany’s total investment in the project to $3.9 million. As of September 30,2008, the non-managing member’s aggregate capital contributions to theOxnard LLC were $6.5 million. The members are currently fundingcapital requirements on a 50/50 basis. The Company expects to make additionalaggregate capital contributions of approximately $100,000 to theOxnard LLC during the remaining three months of 2008, bringing the Company’stotal expected investment to $3.3 million and the Company’s totalinvestment in the project to $4.0 million.

 

While the Company exerts a large degree ofinfluence over the joint venture, the Company’s partner does have varioussubstantive participating rights such as approval rights with regard to themajority of business decisions, including approval of project budgets.

 

*Legal Proceedings*

 

There are various lawsuits and claims pending againstthe Company and certain subsidiaries. In the opinion of the Company’smanagement, ultimate liability, if any, will not have a material adverse effecton the Company’s financial condition or results of operations.

 

*California Department of Toxic Substances Control*

 

In October 2006, the CaliforniaDepartment of Toxic Substances Control (“DTSC”) filed a civil complaint againstthe Company’s Hearthside Residential Corp. subsidiary (“HRC”) in the FederalDistrict Court for the Southern Division of the Central District of California.A trial on this matter is currently scheduled to begin on December 2, 2008and discovery in the case is completed. The DTSC’s complaint requests that HRCpay for approximately $1.0 million of costs incurred by the DTSC, togetherwith interest on that amount, primarily in connection with the oversight andremediation of PCB contamination found on residential properties adjacent to a43-acre site where HRC completed the removal of PCB contaminated soil during September 2005.HRC’s remediation process was approved by the DTSC in December 2005 whenit issued a final acceptance of the remediation work. The complaint also seeksan order for HRC to pay any future costs which may be incurred in connectionwith further remediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has receivedinvoices from DTSC seeking reimbursement for these costs; however, HRCcontends, based upon advice of counsel, that it is not responsible for suchcosts because neither HRC nor any affiliate ever developed or built theneighboring residential properties, neither HRC nor any affiliate generated thecontamination, the contamination did not emanate from the 43-acre site that HRCremediated, and, even if the contamination did emanate from the 43-acre site,it did not do so while HRC owned the site. Furthermore, HRC has also disputedsuch charges due to the fact that DTSC improperly submitted its bill. TheCompany’s subsidiary is vigorously defending itself in this matter. Therefore,the Company has not accrued for any of DTSC’s approximately $1.0 millionof claims related to these residential properties.

 

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See Note 7 for a discussion of other contingencies.

 

*Corporate Indemnification Matters*

 

The Company and its former affiliates have, through avariety of transactions effected since 1986, disposed of several assets andbusinesses, many of which are unrelated to the Company’s current operations. Byoperation of law or contractual indemnity provisions, the Company may haveretained liabilities relating to certain of these assets and businesses. Thereis generally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities is supported by insurance or byindemnities from certain of the Company’s previously affiliated companies. TheCompany believes its consolidated balance sheet reflects adequate reserves forthese matters.

 

**Note 10 — Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

The 1993 Stock Option/Stock Issuance Plan (“1993Plan”) was approved at the 1994 Annual Meeting of Stockholders, reserving7.5 million shares each of Series A Preferred Stock and Class ACommon Stock for issuance to officers, key employees and consultants of theCompany and its subsidiaries and the non-employee members of the Board ofDirectors (the “Board”). On April 28, 1997, in connection with theRecapitalization, a new class of Common Stock replaced the Series APreferred Stock and Class A Common Stock, and the Compensation Committeeof the Board authorized the grant of stock options for 759,984 shares,equivalent at that time to 6% of the Company’s fully diluted equity, forcertain directors and officers. At the May 2004 and June 2006stockholder meetings, the stockholders of the Company authorized an additional150,000 and 250,000 stock options, respectively, for the 1993 Plan, resultingin total authorized grants of 1,159,984.

 

In January 2008, the Company issued atotal of 15,817 shares of its common stock to four independent directors underthe Director Fee Program, which is a component of the 1993 Plan. These sharesvest at the rate of 25% per quarter during 2008. On October 16, 2008, oneof the Company’s independent directors resigned from the Board and forfeited878 unvested shares.

 

The Company did not grant any options duringthe nine months ended September 30, 2008 and 2007. Pursuant toSFAS 123(R), the Company recorded $78,000 and $98,000 of compensationexpense during the nine months ended September 30, 2008 and 2007,respectively, which is reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993plan for the nine months ended September 30, 2008 follows:

 
| ** **                                         | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|----------------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                        |       | 17,500                      |       | $                                     | 21.58      | (a)                              |       |   |
| Granted                                            |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                          |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, September 30                     |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 7.35 years |   |
|                                               |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at  September 30 |       | 16,250                      |       | $                                     | 18.44      | (a)                                   | 7.29 years |   |
| Available for future grants at  September 30  |       | 345,916                     |       |                                  |       |                                  |       |

 

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(a)           Adjustedfor special dividend of $12.50.

 

As of September 30, 2008, there were17,500 options outstanding with a weighted-average exercise price of $21.58(ranging from $13.35 to $25.99) and a weighted-average remaining life of7.35 years. All outstanding unvested stock options are expected to vest.The aggregate intrinsic value of all outstanding, fully-vested and exercisablestock options at September 30, 2008 was zero.

 

The Company adopted SFAS 123(R) inthe first quarter of 2006 using the modified prospective method. Similar toSFAS 123, which the Company adopted in 2003, SFAS 123(R) requiresthe cost of all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalues measured at the grant date, or the date of later modification, over therequisite service period. For tax purposes, the Company expects to be entitledto a tax 

 

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deduction, subject to certain limitations, based on the fair value ofcertain equity awards when stock options are exercised. The cumulativecompensation cost recognized for equity awards pursuant to SFAS 123(R) andamounts that ultimately will be deductible for tax purposes are temporarydifferences as prescribed by SFAS 109, ***“****Accountingfor Income Taxes.”* The tax effect of compensation deductions for taxpurposes in excess of compensation cost recognized in the financial statements,if any, will be recorded as an increase to additional paid-in capital whenrealized. A deferred tax asset recorded for compensation cost recognized in thefinancial statements that exceeds the amount that is ultimately realized on thetax return, if any, will be charged to income tax expense when the restrictionslapse or stock options are exercised or expire unless the Company has anavailable additional paid-in capital pool (“APIC Pool”), as defined pursuant toSFAS 123(R). The Company is required to assess whether there is anavailable APIC Pool when the stock options are exercised or expire.

 

SFAS 123(R) also amendsSFAS 95, *“Statement of Cash Flows,”*to require companies to change the classification in the statement of cashflows of any tax benefits realized upon the exercise of stock options orissuance of nonvested share unit awards in excess of that which is associatedwith the expense recognized for financial reporting purposes. These amounts arerequired to be reported as a financing cash inflow rather than as a reductionof income taxes paid in operating cash flows.

 

In addition, SFAS 123(R) requires acalculation to establish the beginning pool of excess tax benefits, or theadditional paid-in capital pool (“APIC pool”), available to absorb any taxdeficiencies recognized after the adoption of SFAS 123(R). The Company haselected the alternative transition method, which includes a simplifiedcalculation method, set forth in FASB Staff Position No. FAS 123(R)-3,*“Transition Election Related to Accountingfor the Tax Effects of Share-Based Payment Awards”* to calculate itsbeginning APIC pool.

 

The Company estimates the fair value of itsstock options using the Black-Scholes option pricing model (the “Option Model”).The Option Model requires the use of subjective and complex assumptions,including the option’s expected term and the estimated future price volatilityof the underlying stock, which determine the fair value of the share-basedawards. The Company’s estimate of expected term is determined based on theweighted-average period of time that options granted are expected to beoutstanding considering current vesting schedules and the historical exercisepatterns of the existing option plan. The expected volatility assumption usedin the Option Model is based on historical volatility on traded options on theCompany’s stock in accordance with guidance provided in SFAS 123(R) andSAB 107. The risk-free interest rate used in the Option Model is based onthe yield of U.S. Treasuries with a maturity closest to the expected term ofthe Company’s stock options.

 

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

 

Thisitem contains forward-looking statements that involve risks and uncertaintiesas set forth in “Cautionary Statements About Forward-Looking Statements” at thebeginning of this Quarterly Report on Form 10-Q. Actual results may differmaterially from those indicated in the forward-looking statements set forthbelow. Factors that may cause such a difference include, but are not limitedto, those discussed in “Item 1A. Risk Factors” of both our Annual Report on Form 10-Kfor the year ended December 31, 2007, and below in this Form 10-Q.

 

**Overview of California Coastal Communities, Inc.**

 

We are a residential land development andhomebuilding company with properties owned or controlled primarily in OrangeCounty, California, and also in three other Southern California counties (LosAngeles, Riverside and Ventura). Our principal activities include:

 

·                  obtainingzoning and other entitlements for land we own or control through purchaseoptions or joint ventures;

 

·                  improvingthe land for residential development; and

 

·                  designing,constructing and selling single-family homes in Southern California.

 

Once our residential land is entitled, we may buildhomes, sell unimproved land to other developers or homebuilders, sell improvedland to homebuilders, or participate in joint ventures with other developers,investors or homebuilders to finance and construct infrastructure and homes.The majority of our homes are designed to appeal to move-up homebuyers and aregenerally offered for sale in advance of their construction.

 

During the remaining three months of 2008, ourprimary goals will be to:

 

·                  continueevaluating potential alternatives regarding our capital structure including,but not limited to, various strategies for raising additional capital such as asale-leaseback financing of our 17 model homes at Brightwater;

 

·                  continue sellingand delivering homes at Brightwater; and

 

·                  continuereducing standing inventories and therefore maximize deliveries and revenues atour other homebuilding projects in Los Angeles and Riverside counties.

 

There can be no assurance that we will accomplish,in whole or in part, all or any of these strategic goals or any other strategicgoals or opportunities that we may pursue.

 

Our total revenues for the three months ended September 30,2008 and 2007 were $13.9 million and $5.2 million, respectively, and $29.3million and $21.6 million for the nine months ended September 30, 2008 and2007, respectively. For the three months ended September 30, 2008 and2007, we delivered 17 and 12 homes, respectively, and for the nine months endedSeptember 30, 2008 and 2007, we delivered 40 and 36 homes, respectively.Our total assets as of September 30, 2008 and December 31, 2007 were$339.0 million and $367.6 million, respectively, with Brightwater constituting$236.9 million (70% of total assets) and $219.9 million (60% of total assets),respectively. Our homebuilding subsidiary, Hearthside Homes, Inc., hasdelivered over 2,100 homes to families throughout Southern California since itsformation in 1994.

 

Prior to obtaining the Coastal Development Permitfor our Brightwater project in December 2005, we historically maintained aminimal amount of leverage. In September 2006, we obtained $225 million ofdebt financing as described in Notes 4 and 5 to the consolidated financialstatements in this Form 10-Q, which provided $100 million for Brightwaterconstruction and $125 million to fund the $12.50 special dividend to ourstockholders in September 2006, as described in Note 12 to theconsolidated financial statements in our Annual Report on Form 10-K forthe year ended December 31, 2007. As of September 30, 2008, we had$250.8 million of debt against $76.6 million of book equity.

 

We were formed in 1988 and our executive offices arelocated at 6 Executive Circle, Suite 250, Irvine, California 92614. Ourwebsite address is http://www.californiacoastalcommunities.com and ourtelephone number is (949) 250-7700. Through our website we make available ourannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to these reports filed or furnishedpursuant to Section 13(d) or 15(d) of the Securities ExchangeAct of 1934 as soon as reasonably practicable after they are filed with, orfurnished to, the Securities and Exchange Commission. Copies of our annualreport on Form 10-K, quarterly reports on Form 10-Q, current reportson Form 8-K, and amendments to these reports are available free of chargeupon request. In addition, at our website we post current versions of our codeof ethics, audit committee charter and nominating committee charter.

 

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**Outlook and Operating Strategy**

 

During the third quarter of 2008, thehomebuilding industry continued to experience challenging business conditionscreated by a supply-demand imbalance which substantially worsened during thequarter. On the supply side, several factors persisted, including an oversupplyof new and existing homes; increased foreclosures; and intense competition forsales. On the demand side, we saw further deterioration in consumer confidencedue in part to a general downturn in economic activity and job creation;ongoing turmoil in consumer mortgage lending and other credit markets resultingin limited availability of mortgage financing; the inability of potentialhomebuyers to sell existing homes at a perceived fair price or at a price thatcovers their existing mortgage; expectations that home prices will continue tofall. This protracted supply/demand imbalance intensified competition for salesthroughout the period and produced continued downward pressures on prices.These adverse conditions have now persisted to varying degrees since thebeginning of 2006 and their impact is reflected in our results for the three-and nine-month reporting periods ended September 30, 2008, and we reportednet losses for both periods.

 

Additionally, during 2008 we have witnessedthe national credit market crisis which has resulted in the significant erosionof Wall Street and other capital markets, giving rise to concerns about theaffects of a global recession in the mortgage financing and banking industrieswith the issues faced by Federal National Mortgage Association (Fannie Mae),Federal Home Loan Mortgage Corporation (Freddie Mac) and IndyMac Federal Bank.This financial crisis has further affected the banking system and financialmarkets with failure, takeover or bailout of certain corporations, such asLehman Brothers Holdings, Inc., American International Group, Inc.and Merrill Lynch & Co., Inc. While the United States governmentrecently has taken steps in an attempt to stabilize the banking system andfinancial markets through, among other things, the Emergency EconomicStabilization Act of 2008, the future impact of this or other existing orproposed legislation on the financial markets, and an eventual turnaround inthe homebuilding industry remains unclear.

 

The weakness in the housing marketaccelerated during the third quarter as a result of weakened consumerconfidence, increased foreclosures and tightened mortgage lending standards.With declining consumer confidence and significantly greater expectations of arecession, the prospect of further deterioration in the homebuilding industrywill likely become reality absent further Federal government action. If thereis further deterioration in market conditions, this may lead to a furtherincrease in the supply of new and existing homes that are for sale as a resultof decreased absorption levels and increased foreclosures.

 

We are also concerned about the dislocationin the secondary mortgage market. We maintain relationships with a diversifiedgroup of mortgage providers and, with few exceptions, the mortgage providersthat furnish our customers with mortgages continue to issue new commitments.Our buyers generally have been able to obtain adequate financing. Nevertheless,tightening credit standards have shrunk the pool of potential home buyers.Mortgage market liquidity issues and higher borrowing rates may impede some ofour home buyers from closing, while others may find it more difficult to selltheir existing homes as their buyers face the problem of obtaining a mortgage.We believe that our home buyers generally should be able to continue to securemortgages, due to their typically lower loan-to-value ratios and attractivecredit profiles, as compared to the average home buyer; however there can be noassurance in that regard. Because we cannot predict the short-and long-termliquidity of the credit markets, we continue to caution that, with theuncertainties in these markets, the pace of home sales could slow further untilthese markets settle down.

 

As a result, we believe that home buyers willremain reluctant to purchase homes until they are comfortable that the economyis stabilizing, home price declines are near bottom and they are able to securemortgage financing at affordable rates. The results of these adverse conditions include weakened demand for newhomes, slower sales, higher than normal cancellation rates, and increased pricediscounts in our inland markets and other sales incentives to attracthomebuyers. Additionally, the availability of certain mortgage financingproducts continues to be constrained due to increased scrutiny of oncecommonly-used mortgage products such as sub-prime, Alt-A, and other non-primemortgage products.  The interest rates onjumbo mortgages continue to be significantly greater than interest rates onconforming mortgages, with spreads greater than 1% compared with historicalspreads in the range of only .25% to .35%.

 

The continued downward turn in the economyhas negatively impacted our results for the first nine months of 2008,particularly in our inland markets. While standing inventory in our inlandmarkets has been reduced from 33 homes at the end of 2007 to seven homes as of September 30,2008, the price reductions and additional incentives have resulted insignificantly reduced gross profits and resulted in additional impairmentcharges. In response to the ongoing crisis in the housing market and nationalcredit markets, during the third quarter we have:

 

·                  furtherreduced headcount and project overhead;

 

·                  re-evaluatedour sales efforts in our inland markets;

 

·                  determinedto sell the existing models at our Las Colinas project;

 

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·                  postponedfurther inland market construction activity until that market improves;

 

·                  reducedsales prices and offered incentives for all of our inland homes in order toreduce our standing inventory;

 

·                  completedamendments to our $210 million aggregate revolving and term loans that willpreserve an additional $100.0 million of borrowing capacity until September 2009and defer loan amortization and commitment reductions; and

 

·                  commencednegotiations with IndyMac Federal Bank in an attempt to reach a consensualresolution of our subsidiaries’ loans on the Hearthside Lane and Las Colinasproperties.

 

We expect these changes to produce tangiblebenefits, in the form of selling, general and administrative expensereductions, in future quarters, and we will continue to reduce these costs. Weexpect to continue to operate with fewer active communities until we seereasonable signs of a housing market recovery. If market conditions declinefurther, we may need to take additional charges for inventory impairments infuture quarters. In addition, our fourth quarter and 2009 results could beadversely affected if general economic conditions continue to deteriorate, ifconsumer confidence remains weak or declines further, if job losses accelerate,if foreclosures increase, or if consumer mortgage lending becomes lessavailable or more expensive, any or all of which would further diminish theprospects for a recovery in housing markets.

 

In light of the current crisis in the national financial markets,conditions in the housing market and the overall economy are likely todeteriorate further before they improve. We believe that stability in thecredit and capital markets and an eventual renewal of confidence in thenational economy will play a major role in any turnaround in the homebuildingand mortgage lending industries.

We also believe that a meaningful improvement in housing marketconditions will require the restoration of consumer and credit marketconfidence that will support a decision to buy a home, which will in turnrequire a sustained decrease in inventory levels, price stabilization andreduced foreclosure rates. With the passage of the Housing and EconomicRecovery Act of 2008, Congress and the White House have offered a lifeline tomany homeowners facing foreclosure, which should help keep many distressedproperties from coming on the market. In addition, this legislation hasprovided an incentive for people to become first-time home buyers in a marketthat we believe offers prices that are in their favor. This may help to restoreconfidence in the market and help address the issue of oversupply.

 

While it is difficult to predict when theseevents will occur, we believe we have responded with the right strategies tothe current and expected near-term housing market environment. Longer term, webelieve favorable demographics and population growth in California and acontinuing desire for home ownership will drive demand for new homes in ourmarkets, which will allow us to capitalize on the recovery in those marketswhen it comes.

 

Despite the challenges of the currentnational homebuilding market and our inland market, we believe the potentialfor our Brightwater project remains high. Brightwater has not been immune tothe effects of the unstable mortgage and housing markets; however, that impactappears less severe than the weakness we are seeing in our inland markets. Webelieve that the reduced impact is a result of Brightwater’s superior coastallocation, the extremely limited supply of new homes on the coast of SouthernCalifornia and the absence of significant competition from other homebuildersin the Huntington Beach market due to the lack of available land for thedevelopment of new single family detached homes. We believe that Brightwater isin a location that is difficult to replace and in a market where approvals areincreasingly difficult to achieve. We also believe that Brightwater hassubstantial embedded value that will be realizable in the future and that thisvalue should not be sacrificed under current depressed market conditions.Finally, we believe that Brightwater’s demographics remain strong due to thecontinuing regulation-induced constraints on lot supplies and the growingnumber of affluent households along the coast of Southern California.Therefore, we remain optimistic about continuing sales at Brightwater.

 

We recently completed the successfulnegotiation of the amendments to our revolving and term loans which, in view ofthe national credit market crisis, we believe further indicates Brightwater’sunique characteristics and substantial value. The amendments will enable us tofinance construction and repay the loans on a schedule that better reflects ourcurrent expectations about home sales at Brightwater in this challenginghousing market. During the first nine months of 2008, we delivered 16 homes atBrightwater and, as of November 3, 2008, 12 additional homes are in escrow(discussed further below under “Our Current and Future Homesites—Brightwater atBolsa Chica”).

 

We currently believe that market conditionswill continue to be challenging for the remainder of 2008 and 2009,particularly in our inland markets where foreclosure activity continues torise, consumer mortgage lending and other credit markets continue to beunsettled and consumer confidence continues to decline. Although substantiallyreduced home prices and relatively low consumer mortgage interest rates forconforming loans have improved housing affordability, many potential homebuyersremain reluctant to purchase homes. This demand-side dynamic, in conjunctionwith rising foreclosures, is sustaining the oversupply of unsold new andexisting homes and competitive pricing pressures that have generated theextremely challenging conditions our industry has experienced since thebeginning of 2006. We remain hopeful that the federal government’s recent initiativesto stabilize the credit markets and restore confidence in the financial systemand economy will be effective; however, we have not yet been positivelyimpacted by any of these developments.

 

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In view of the continuing significanteconomic downturn in the housing market, we currently expect that during theremainder of 2008 and continuing into 2009 our new home construction will belimited to our 356-home Brightwater project located on the Bolsa Chica mesa inHuntington Beach, California. We expect that continuing operations in ourinland markets will focus on the sale of standing inventory, with limited, ifany, construction starts. In some inland markets, we may determine to sellexisting model homes and re-open the projects when the market demonstratesimproved sales activity. Our management has concluded that under the prevailingmarket conditions, this strategy for our inland markets is necessary for us tobe able to market the inland properties at some future time when marketconditions may have improved. In addition, we are attempting to negotiate a consensualresolution with IndyMac Federal Bank with respect to our subsidiaries’Hearthside Lane and Las Colinas properties. However, there can be no assurancethat these strategies or any alternatives will prove successful. Finally, weintend to continue with our entitlement efforts for our joint venture projectnear Oxnard.

 

As the housing market downturn continues tounfold, we continue to adjust and reevaluate our operating strategy in aneffort to reduce standing inventories while monitoring our margins andliquidity. Recognizing the challenges presented by the downturn in thehomebuilding market, our current operating strategy includes:

 

·                  adjusting ourcost structure to today’s market conditions by reducing our headcount andoverhead and rebidding subcontracts and materials in line with reduced demand;

 

·                  offering moreincentives and price reductions at our inland projects to reduce standinginventories and achieve acceptable levels of sales volume and cash flow;

 

·                  temporarilyceasing construction and sales efforts at certain inland projects where we areunable to generate acceptable levels of sales volume and cash flow until thehousing market improves;

 

·                  limitingconstruction starts to better align product available for sale with salesactivity; and

 

·                  seeking tobalance our short-term goal of selling homes in a depressed market and ourlong-term goal of maximizing the value of our communities.

 

In the ordinary course of doing business, we must make estimates andjudgments that affect decisions on how we operate and on the reported amountsof assets, liabilities, revenues and expenses. These estimates include, but arenot limited to, those related to impairment of assets; capitalization of coststo inventory; cost of sales including estimates for financing, warranty, andother costs; and income taxes. We base our estimates on historical experienceand on various other assumptions that are believed to be reasonable under thecircumstances. On an ongoing basis, we evaluate and adjust our estimates basedon the information then currently available. Actual results may differ fromthese estimates, assumptions and conditions.

 

Finally, our operating results during the remainder of 2008 andthroughout 2009 could be adversely affected if housing, credit market, orgeneral economic conditions continue to deteriorate, if job losses accelerate,if consumer mortgage lending becomes less available or more expensive, or ifconsumer confidence continues to fall, any or all of which would furtherdiminish the prospects for a recovery in the housing market. We believe thatthere will not be a meaningful improvement in the housing market until there isa sustained decrease in inventory levels, price stabilization, reducedforeclosure rates, available financing, and the restoration of consumerconfidence that can support a decision to buy a home. While it is difficult topredict when any of these events will occur, we believe we have responded withan appropriate strategy to address the dramatic reversal in the housing marketsthat has been occurring since the beginning of 2006.

 

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**Our Current and Future Homesites**

 

We currently have on-going SouthernCalifornia homebuilding projects in:

 

·                  Orange County inthe Huntington Beach area;

 

·                  Riverside Countyin the City of Corona and in the City of Beaumont; and

 

·                  Northern LosAngeles County in the City of Lancaster.

 

The following chart describes our current projects, their location andour lot and standing home inventories as of September 30, 2008:

 
| **Project**                              | ** ** | **Location**     | ** ** | **Models** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** |
|------------------------------------------|------------|------------------|------------|------------|------------|-------------|------------|-------------------------|------------|---------------------|------------|-------------------------------|
| Brightwater in Orange County:            |       |             |       |       |       |        |       |                    |       |                |       |                          |
| The Trails                               |       | Huntington Beach |       | 4          |       | —      |       | 2                       |       | 45                  |       | 51                            |
| The Sands                                |       | Huntington Beach |       | 4          |       | 2           |       | 1                       |       | 62                  |       | 69                            |
| The Cliffs                               |       | Huntington Beach |       | 4          |       | 2           |       | 2                       |       | 95                  |       | 103                           |
| The Breakers                             |       | Huntington Beach |       | 5          |       | 8           |       | —                  |       | 95                  |       | 108                           |
|                                     |       |             |       |       |       |        |       |                    |       |                |       |                          |
| *Subtotal—Orange  County*           |       |             |       | 17         |       | 12          |       | 5                       |       | 297                 |       | 331                           |
| * *                                 | * *   | * *         | * *   | * *   | * *   | * *    | * *   | * *                | * *   | * *            | * *   | * *                      |
| Inland Empire/Lancaster:                 |       |             |       |       |       |        |       |                    |       |                |       |                          |
| Hearthside Lane                          |       | Corona           |       | 5          |       | 1           |       | 2                       |       | 134                 |       | 142                           |
| Woodhaven                                |       | Beaumont         |       | 4          |       | 3           |       | 3                       |       | 62                  |       | 72                            |
| Las Colinas                              |       | Lancaster        |       | 2          |       | 3           |       | 1                       |       | 54                  |       | 60                            |
| Other developments                       |       | Various          |       | —     |       | 1           |       | 1                       |       | —              |       | 2                             |
| Other unimproved lots                    |       | Lancaster        |       | —     |       | —      |       | —                  |       | 73                  |       | 73                            |
|                                     |       |             |       |       |       |        |       |                    |       |                |       |                          |
| *Subtotal—Inland  Empire/Lancaster* |       |             |       | 11         |       | 8           |       | 7                       |       | 323                 |       | 349                           |
| * *                                 | * *   | * *         | * *   | * *   | * *   | * *    | * *   | * *                | * *   | * *            | * *   | * *                      |
| *Total—All  Projects*               |       |             |       | 28         |       | 20          |       | 12                      |       | 620                 |       | 680                           |

 

These homebuilding projects are currentlyexpected to generate cash flows and gross operating margins through 2013. Up toapproximately 554 additional single-family lots could be available forhomebuilding operations if we obtain entitlements for our Oxnard joint ventureproject and decide to purchase the land; however, the exact number of homeswill depend on the final outcome of the entitlement process.

 

As of September 30, 2008, we hadstanding inventory of 12 homes, including five homes at Brightwater and sevenhomes at our inland projects. During the third quarter of 2008, net new ordersdecreased to 14 homes compared with 23 homes during the comparable period of2007, primarily due to reduced sales activity at our inland communities.Cancellations as a percentage of new orders were 25% during the nine monthsended September 30, 2008 (20% at Brightwater and 30% at our inlandprojects), compared with approximately 30% during the comparable period of2007. Backlog as of September 30, 2008 decreased to 20 homes compared with28 homes as of September 30, 2007 primarily due to decreased salesactivity at our inland projects.

 

*Brightwater at Bolsa Chica*

 

Brightwater is our coastal Orange Countyresidential community, located on the 110-acre Bolsa Chica upper mesa in theCity of Huntington Beach, approximately 35 miles south of downtown Los Angeles.Brightwater was recently annexed into the City of Huntington Beach. Brightwateroffers a broad mix of home choices averaging 2,860 square feet and ranging insize from 1,710 square feet to 4,339 square feet. Located near Pacific CoastHighway and overlooking the Pacific Ocean, Huntington Harbor and the recentlyrestored 1,300-acre Bolsa Chica Wetlands, 62 of the 356 homes at Brightwaterwill have unobstructed ocean and/or wetlands views. To date, over 3,800 peoplehave registered on our website requesting information about purchasing a homeat Brightwater; however, there can be no assurance that a significant number ofthese people will ultimately purchase a home.

 

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Brightwater is the largest property in ourportfolio, representing approximately 90% of our real estate inventories as of September 30,2008. This project is located on one of the last large undeveloped coastalproperties in Southern California. Brightwater is bordered on the north and eastby residential development in the City of Huntington Beach and HuntingtonHarbor, to the south by open space and the 1,300-acre Bolsa Chica wetlands, andto the west by 120 acres of publicly-owned conservation land and open space onthe lower bench of the Bolsa Chica mesa, Pacific Coast Highway, Bolsa ChicaState Beach, and the Pacific Ocean. Brightwater also has 37 acres of open spaceand conservation area. We recently submitted a proposed site plan to the Cityof Huntington Beach to extend the Brightwater development to include a 5-acreparcel on the eastern end of the mesa that is currently zoned agricultural.

 

We completed construction of eight modelhomes at The Trails and The Sands neighborhoods in July 2007 and held agrand opening in August 2007 and delivered the first nine homes in December 2007.We delivered two and 11 homes at The Trails and The Sands during the three andnine months ended September 30, 2008, respectively, and generated $1.8million and $11.2 million in revenue, respectively. We generated grossoperating margins of 25.6% and 29.0% for the three and nine months ended September 30,2008, respectively, due, in part, to our low cost basis in Brightwater. Homesat The Trails and The Sands are presently being offered at prices ranging from$900,000 to $1.2 million. As of November 3, 2008, we have threecompleted homes available for sale at The Trails and The Sands.

 

During January 2008, we completedconstruction of nine additional model homes for The Cliffs and The Breakers andin February 2008 began selling homes to buyers who previously registeredon our priority list. We held a grand opening for these neighborhoods on March 15,2008. These homes are larger than The Trails and The Sands, ranging from 2,724to 4,339 square feet. We delivered the first four homes at The Cliffs and thefirst home at The Breakers during the third quarter of 2008 and generated $6.1million and $1.8 million in revenue, respectively. We generated gross operatingmargins of 35% for The Cliffs and The Breakers for the three months ended September 30,2008. Homes at The Cliffs and The Breakers are presently being offered atprices ranging from $1.5 to $3.4 million for 2,724 to 4,339 square foothomes.

 

Key facts and assumptions regarding theBrightwater development project include the following:

 

·                  Brightwater isexpected to consist of 356 homes, including 109 homes at The Breakers, 107homes at The Cliffs, 78 homes at The Sands and 62 homes at The Trails.

 

·                  There are 62homes at Brightwater which will have unobstructed views of the Pacific Oceanand/or the Bolsa Chica wetlands, including 35 homes at The Breakers, 25 homesat The Cliffs and two homes at The Sands.

 

·                  Build-out ofproduction homes, which is subject to market conditions, is currently expectedto take approximately four years and be completed in 2012.

 

·                  Costs to improvethe lots from their raw condition to finished lots, including County permits,City annexation fees and school fees, approximate $200,000 per lot.

 

·                  The direct costs(excluding indirect costs such as supervision, overhead, sales and marketing,warranty, insurance, etc.) of building homes at Brightwater are currentlyexpected to range from approximately $130 to $150 per square foot.

 

·                  Indirect costsare expected to approximate 6% of sales revenues.

 

·                  Based on currentsales price and cost projections, the various Brightwater products arecurrently expected to generate gross margins of approximately 25% to 38% due toour low carrying value in Brightwater. Gross margins for the larger homes atThe Cliffs and The Breakers are currently expected to approximate 34% to 38%,while gross margins at The Trails and The Sands are currently expected toapproximate 25% to 27%.

 

The estimation process involved in thedetermination of value is inherently uncertain because it requires estimates asto future events and market conditions. This estimation process assumes ourability to complete development and disposition of our real estate inventoriesin the ordinary course of business based on management’s present plans andintentions. Economic, market, and environmental conditions may affect ourdevelopment and marketing plans. The development of Brightwater depends uponvarious factors. Accordingly, the amount ultimately realized from theBrightwater project may differ materially from our current estimates and theproject’s carrying value.

 

*Oxnard Land Development - UnconsolidatedJoint Venture*

 

In February 2003,our Hearthside Homes, Inc. homebuilding subsidiary entered into two optioncontracts to acquire approximately 168 acres of land adjacent to the City ofOxnard in Ventura County, California. The option contracts allow the Oxnardjoint venture to complete entitlement activities before purchasing the land.The option contracts currently expire in February 2009, and there arethree additional extensions available for each contract that, if exercised,would extend the outside closing date to 

 

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December 31, 2011. We are developing a land plan for the area,which also includes an additional 149 acres owned by other landowners, with theintention of entitling the property for residential development and annexing itinto Oxnard. During October 2003, we entered into a joint ventureagreement with a major financial partner to pursue the Oxnard developmentopportunity. Hearthside Homes, Inc. assigned the land purchase optioncontracts to the Oxnard joint venture. Hearthside Homes, Inc. is themanager of the Oxnard joint venture.

 

A draft environmental impact report (“EIR”)for the proposed Oxnard development was circulated for public comments duringthe summer of 2007. As a result of the public comments received, the City ofOxnard decided that the EIR needed to be amended to address availability ofwater for the development and the impact of such development on global warming.During July 2008, the City recirculated a revised EIR for additionalpublic comments which were due by September 9, 2008. The City is currentlyresponding to the comments received and a revised EIR is currently expected tobe presented to the Oxnard City Council in early 2009. The Oxnard joint ventureis attempting to obtain approval of its development plan from the Oxnard CityCouncil during the first half of 2009 and approval of annexation into the Cityof Oxnard from the Local Agency Formation Commission during the second half of2009; however, additional delays could be encountered. We do not expect toexercise our land purchase options until housing market conditions demonstratea clear and significant recovery. Following any land purchase, infrastructure construction is expected totake approximately one year, and build out of homes is expected to occur overthe course of five to six years, based on current expectations and assumptions.

 

We currently expect the residentialdevelopment plan to include approximately 760 single-family detached lots andapproximately 630 attached residential units (townhomes, condominiums andapartments); however, these numbers are subject to change during the course ofthe entitlement process. Approximately 554 of the single-family lots andapproximately 347 of the attached units would be developed on the 168 acres ofoptioned land that the Oxnard joint venture may purchase. The single-familydetached product is currently expected to range from approximately 1,700 squarefeet to 3,400 square feet and the attached units are currently expected torange from approximately 1,050 square feet to 1,575 square feet.

 

As of September 30, 2008, our aggregatecapital contributions were $2.5 million and our total investment in theOxnard joint venture was $3.2 million. In addition, as of September 30,2008, we have incurred capitalized overhead costs of approximately $700,000 forthe project which are unreimbursed by the venture, bringing our totalinvestment in the project to $3.9 million. As of September 30, 2008,the non-managing member’s aggregate capital contributions to the joint venturewere $6.5 million. The members are currently funding capital requirementson a 50/50 basis. We expect to make additional aggregate capital contributionsof approximately $100,000 to the joint venture during the remaining threemonths of 2008, bringing our total expected investment in the venture to$3.3 million and our total investment in the project to $4.0 million.

 

After payment of a preferred return of thegreater of 10% or prime plus 5% on invested capital to us and the non-managingmember, the first $8 million of profits are allocated 75% to thenon-managing member and 25% to us, and profits over $8 million and lossesover $5 million are generally allocated on a 50/50 basis in accordancewith the operating agreement. The first $5 million of losses are generallyallocated 80% to the non-managing member and 20% to us. While we are themanaging member and exert a large degree of influence over the joint venture,the non-managing member does have various substantive participating rights suchas approval rights with regard to the majority of business decisions, includingapproval of project budgets.

 

*Homebuilding*

 

Our homebuilding operations include activeprojects in the Huntington Beach, Inland Empire (Corona and Beaumont), andLancaster areas of Southern California. We delivered 17 homes during the thirdquarter of 2008, compared with 12 deliveries during the comparable period of2007. During the nine months ended September 30, 2008 and 2007, wedelivered 40 and 36 homes, respectively. We acquired no single-familyresidential lots during the three and nine months ended September 30, 2008and 2007 and we have no contracts to acquire land or lots except through ourOxnard joint venture.

 

During the third quarter of 2008, we sawcontinued price depreciation in some but not all areas and an excess supply ofhomes available for sale in the Inland Empire and Lancaster markets. Therefore,we have reduced sales prices and offered incentives for all of our homes inthese markets in order to reduce our standing inventory and remain competitiveduring this continuing significant economic downturn in the housing market. Theprice reductions and additional incentives have resulted in significantlyreduced gross profits for Inland Empire and Lancaster home sales. In addition,during the third quarter of 2008 we began selling the existing model homes atour Las Colinas project in Lancaster and will delay the remainder of theproject until sales activity in the area improves.

 

We recorded asset impairment charges of $34.1million during the first nine months of 2008, compared with $32.0 million ofasset impairment charges recorded during the first nine months of 2007. Theimpairment charges reflect our expectations about home prices, sales pace,sales and marketing costs, infrastructure and homebuilding costs and financingcosts for our inland projects. The 

 

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impairment charges were calculated based on market conditions andassumptions made by management that reflected current conditions at the timesuch impairment charges were determined, which may differ materially fromactual results if market conditions change. As required by Statement ofFinancial Accounting Standards No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” (“SFAS 144”),we will reevaluate the expected cash flows from our homebuilding projects todetermine whether any additional impairment exists should events orcircumstances change.

 

In view of the continuing downturn in thehousing market, we currently expect that, during the next 12 months, ournew home construction will primarily be at our 356-home Brightwater project inHuntington Beach; and that our operations in other markets will involve thesale of standing inventory, with limited or no new construction. In some inlandmarkets, we may determine to sell additional existing model homes and re-openthe projects when the market demonstrates improved sales levels. Our managementhas concluded that this strategy is necessary under the prevailing marketconditions and will allow us to market the inland properties at some futuretime when market conditions may have improved.

 

Our homebuilding projects are describedbelow:

 
| ** **                      | ** ** | ** **       | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Deliveries**         | ** ** |
|---------------------------------|------------|------------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------------------|------------|
| ** **                      | ** ** | ** **       | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Three  Months**      | ** ** | **Nine  Months** | ** ** |
| ** **                      | ** ** | ** **       | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Ended**              | ** ** | **Ended** | ** ** |
| ** **                      | ** ** | ** **       | ** ** | **Land**        | ** ** | **Commenced**    | ** ** | **Commenced** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                      | ** ** | **Location**     | ** ** | **Acquisition** | ** ** | **Construction** | ** ** | **Sales**     | ** ** | **2008**               | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                      | ** ** | ** **       | ** ** | ** **      | ** ** | ** **       | ** ** | **n/a**       | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater                     |       |             |       |            |       |             |       |          |       |                   |       |   |   |   |   |   |   |
| The Trails                      |       | Huntington Beach |       | 1970            |       | 2006             |       | 2007          | (a)        | 1                      |       | — |   | 6 |   | — |   |
| The Sands                       |       | Huntington Beach |       | 1970            |       | 2006             |       | 2007          | (a)        | 1                      |       | — |   | 5 |   | — |   |
| The Cliffs                      |       | Huntington Beach |       | 1970            |       | 2006             |       | 2008          | (b)        | 4                      |       | — |   | 4 |   | — |   |
| The Breakers                    |       | Huntington Beach |       | 1970            |       | 2006             |       | 2008          | (b)        | 1                      |       | — |   | 1 |   | — |   |
|                            |       |             |       |            |       |             |       |          |       |                   |       |   |   |   |   |   |   |
| *Total Brightwater*             |       | 7                |       | —          |       | 16               |       | —        |       |
| * *                        | * *   | * *         | * *   | * *        | * *   | * *         | * *   | * *      | * *   | * *               | * *   | * * | * * | * * | * * | * * | * * |
| Inland  Empire/Lancaster        |       |             |       |            |       |             |       |          |       |                   |       |   |   |   |   |   |   |
| Completed  Projects             |       | Various          |       | n/a             |       | n/a              |       | n/a           |       | —                 |       | — |   | — |   | 6 |   |
| Chandler Ranch                  |       | North Corona     |       | 2004            |       | 2005             |       | 2005          |       | 2                      |       | 5 |   | 3 |   | 12 |   |
| Alisal at Ontario               |       | Ontario          |       | 2005            |       | 2005             |       | 2006          |       | 4                      |       | — |   | 8 |   | 2 |   |
| Woodhaven                       |       | Beaumont         |       | 2005            |       | 2005             |       | 2006          |       | 2                      |       | 4 |   | 5 |   | 5 |   |
| Hearthside Lane                 |       | Corona           |       | 2005            |       | 2005             |       | 2007          |       | 1                      |       | — |   | 6 |   | — |   |
| Alisal at  Lancaster            |       | Lancaster        |       | 2004            |       | 2004             |       | 2005          |       | —                 |       | 1 |   | — |   | 6 |   |
| Las Colinas                     |       | Lancaster        |       | 2005            |       | 2006             |       | 2006          |       | 1                      |       | 2 |   | 2 |   | 5 |   |
| Future Community                |       | Lancaster        |       | 2005            |       | —           | (c)        | —        | (c)        | —                 |       | — |   | — |   | — |   |
|                            |       |             |       |            |       |             |       |          |       |                   |       |   |   |   |   |   |   |
| *Total Inland Empire/Lancaster* |       | 10               |       | 12              |       | 24               |       | 36            |       |
| * *                        | * *   | * *         | * *   | * *        | * *   | * *         | * *   | * *      | * *   | * *               | * *   | * * | * * | * * | * * | * * | * * |
| *Total Deliveries*              |       | 17               |       | 12              |       | 40               |       | 36            |       |
|                                 |            |                  |            |                 |            |                  |            |               |            |                        |            |  |  |  |  |  |  |  |  |

 

----

(a)                                  Commencedin August 2007.

 

(b)                                 Commencedin February 2008.

 

(c)                                  Tobe determined subject to market conditions.

 

*Huntington Beach.*  We completed construction of the first eightmodel homes for The Trails and The Sands products which range from 1,710 to2,160 square feet during July 2007 and opened for sales in August 2007.We completed construction of nine model homes for The Cliffs and The Breakersin January 2008 and began selling homes to homebuyers who previouslyregistered on our priority list in February 2008. We held a grand openingfor The Cliffs and The Breakers on March 15, 2008. We delivered nine homesat an average price of $1.2 million, or $609 per square foot during 2007and 16 homes during the nine months ended September 30, 2008, at anaverage price of $1.2 million, or approximately $543 per square foot. As of November 3,2008, 12 Brightwater homes are in escrow (including six homes with unobstructedocean views) at an average price of $2.4 million, or approximately $690per square foot, and 13 additional homes are completed or under constructionand have been released for sale.

 

*Corona.*  We acquired 83 lots in North Corona in May 2004.Following construction of infrastructure, during April 2005, we beganconstruction of homes averaging 3,160 square feet. We opened for sales duringthe third quarter of 2005 and delivered 58 homes during 2006 at an averageprice of $600,000. We delivered 21 homes during 2007 at an average price of$511,000 and three homes during the nine months ended September 30, 2008at an average price of $435,000. As of November 3, 2008, the final home isin escrow.

 

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During April 2005, we acquired 151additional lots in Corona known as Hearthside Lane. Following construction ofinfrastructure, construction of five model homes averaging 3,600 square feet onlots of approximately 7,200 square feet began during the fourth quarter of2006. These models were completed during April 2007, and we opened forsales during the second quarter of 2007. We delivered three homes at an averageprice of $545,000 during 2007 and six homes at an average price of $453,000during the first nine months of 2008. During October 2008, we deliveredone additional home at a price of $475,000. As of November 3, 2008, twohomes are completed and available for sale.

 

As of October 20, 2008, the subsidiarywhich owns the Hearthside Lane property is in default on the loan as a resultof not making its required interest payment in October. The loan isnon-recourse to California Coastal Communities, Inc.; however, thesubsidiary’s parent, Hearthside Homes, Inc. guaranteed payment of thedebt. Hearthside Homes’ subsidiary is attempting to negotiate a consensualresolution of the loan with the lender, IndyMac Federal Bank, which is likely toinvolve turnover of the property securing the loan to the lender. As a result,during the third quarter of 2008, we reduced the carrying value of theHearthside Lane real estate project to its estimated fair value. If theHearthside Lane property is transferred to IndyMac Federal Bank in fullsettlement of the loan, without further recourse or obligation, we willrecognize a substantial gain as a result of debt cancellation. However, therecan be no assurance that IndyMac Federal Bank will agree to a consensualresolution.

 

*Beaumont.*  We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. We delivered 15homes during 2006 at an average price of $387,000, 10 homes during 2007 at anaverage price of $304,000 and five homes during the first nine months of 2008at an average price of $269,000.  We deliveredone additional home during October 2008 at a price of $285,000. As of November 3,2008, one home is completed and in escrow and four additional homes arecompleted and available for sale.

 

*Lancaster.*  In April 2005, we acquired 73 unentitledlots in the City of Lancaster in northern Los Angeles County through asubsidiary of Hearthside Homes, Inc. We have deferred the constructionstart for the 73-unit project, which has no recorded loan, until sales activityin the market has improved. The tentative map for this project is prepared, butwe have delayed filing for approval in order to defer the entitlement feesrequired to be paid at the time of filing.

 

In December 2005, we acquired 77additional lots in an area known as Quartz Hill in the City of Lancaster. Thehomes in this community are on 10,000 square foot lots and average 3,640 squarefeet. Construction of models began in May 2006 and we opened for salesduring July 2006. We delivered three homes at an average price of $537,000during 2006 and 12 homes during 2007 at an average price of $427,000. Duringthe first nine months of 2008, we delivered two homes at an average price of$352,000. During October 2008, we delivered one additional home at a priceof $330,000. As of November 3, 2008, three homes are completed and inescrow at an average price of $347,000 and one additional completed home andthe final model are available for sale. A subsidiary of Hearthside Homes, Inc.is currently in default on the loan facility secured by this project and isattempting to negotiate a consensual resolution of the loan with the lender,IndyMac Federal Bank, which is likely to involve turnover of the propertysecuring the loan to the lender. As a result, during the third quarter of 2008we reduced the carrying value of the Las Colinas real estate project to itsestimated fair value. There can be no assurance that IndyMac Federal Bank willagree to a consensual resolution.

 

**Recent Accounting Pronouncements**

 

See Note 2 to our consolidated financialstatements for a discussion of new accounting pronouncements applicable to ourcompany.

 

**Critical Accounting Policies**

 

In the preparation of the ConsolidatedFinancial Statements, we applied accounting principles generally accepted inthe United States of America. The application of generally accepted accountingprinciples may require management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying results.Listed below are those policies and estimates that we believe are critical andrequire the use of complex judgment in their application. In particular, ourcritical accounting policies and estimates include the evaluation of theimpairment of long-lived assets and the evaluation of the probability of beingable to realize the benefits indicated by our significant federal tax netoperating losses, as discussed further in Note 8 to the consolidated financialstatements.

 

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*Basis of Consolidation*

 

Certain of our wholly-owned subsidiaries aremembers in joint ventures involved in the development and sale of residentialprojects and residential loan production. Our consolidated financial statementsinclude our accounts and all of our majority-owned and controlled subsidiariesand joint ventures. The financial statements of joint ventures in which wegenerally have a controlling or majority economic interest (and thus arecontrolled by us) are consolidated with our financial statements. Ourinvestments in unconsolidated joint ventures are accounted for using the equitymethod when we do not have voting or economic control of the ventureoperations, as further discussed in Note 9 to the consolidated financialstatements.

 

*Impairment of Long-Lived Assets*

 

We recorded impairment charges of $29.1million and $34.1 million, respectively, during the three and nine months endedSeptember 30, 2008, compared with impairment charges of $28.0 million and$32.0 million, respectively, during the comparable

periods of 2007. The impairment charges recorded during thethree and nine months ended September 30, 2008 and 2007 are as follows (inmillions):

 
| ** **        | ** ** | ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------|------------|----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Project**       | ** ** | **Location**                     | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Inland Empire:    |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Hearthside Lane   |       | Corona                           |       | $                                                    | 24.1       |                                                | $          | 16.5 |   | $ | 24.1 |   | $ | 16.5 |   |
| Woodhaven         |       | Beaumont                         |       | 3.4                                                  |       | 3.9                                                 |       | 3.4 |   | 7.9 |   |
| Alisal at Ontario |       | Ontario                          |       | —                                               |       | 1.8                                                 |       | .6 |   | 1.8 |   |
| Chandler Ranch    |       | North Corona                     |       | .1                                                   |       | .4                                                  |       | .1 |   | .4 |   |
| * *          |       | *Subtotal –  Inland Empire* |       | 27.6                                                 |       | 22.6                                                |       | 28.2 |   | 26.6 |   |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Lancaster:        |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| Las Colinas       |       | Lancaster                        |       | 1.5                                                  |       | 5.4                                                 |       | 5.9 |   | 5.4 |   |
|              |       |                             |       |                                                 |       |                                                |       |   |   |   |   |
| * *          |       | *Total –  All Projects*     |       | $                                                    | 29.1       |                                                | $          | 28.0 |   | $ | 34.1 |   | $ | 32.0 |   |

 

The impairment charges recorded during thethird quarter of 2008 primarily reflect a $24.1 million fair value write-downfor the Hearthside Lane project in Corona. The subsidiary which owns theproperty ceased making the required interest payments in October 2008 andis in default on the Hearthside Lane loan facility which has an outstandingbalance of $29.7 million as of September 30, 2008. The loan isnon-recourse to us; however, the parent of the borrower subsidiary is ourHearthside Homes, Inc. subsidiary, which has guaranteed payment of theborrower’s debt. The borrower subsidiary is attempting to negotiate aconsensual resolution of the loan with the lender, IndyMac Federal Bank, whichis likely to involve turnover of the property securing the loan to the lender.In accordance with EITF 91-2, and a FASB staff interpretation thereof, wereduced the carrying value of the Hearthside Lane and Las Colinas real estateprojects to their estimated fair values during the third quarter of 2008. Afterthese impairment charges, the related debt exceeds the carrying value of theseassets by approximately $18.5 million. If the Hearthside Lane property istransferred to IndyMac Federal Bank in full settlement of the loan without furtherrecourse or obligation, we will recognize a substantial gain as a result ofdebt cancellation. If the gain is equal to the amount that the recorded debtexceeds the carrying value of the assets, the $18.5 million pretax gain wouldresult in a gain of $10.9 million after tax, or $1.00 per share. However, therecan be no assurance that IndyMac Federal Bank will agree to a consensualresolution of these loans.

 

During 2007 and 2008, we recorded impairmentcharges aggregating $66.1 million related to five of our inland projects. Theimpairment charges were calculated based on market conditions and assumptionsmade by management that reflected current conditions at the time suchimpairment charges were determined, which may differ materially from actual resultsif market conditions change. As required by SFAS 144, should marketconditions deteriorate in the future or other events occur that indicate thecarrying amount of our real estate inventories may not be recoverable, we willreevaluate the expected cash flows from each project to determine whether anyadditional impairment exists at any point in time.

 

We assess the impairment of real estateinventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” (“SFAS 144”) which requiresthat long-lived assets be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not be recoverable.As provided by SFAS 144, impairment is evaluated by comparing an asset’scarrying value to the undiscounted estimated cash flows expected from the asset’soperation and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset for purposes of SFAS 144 is deemed to be theamount a willing buyer would pay a willing seller for such asset in a currenttransaction. Additionally, as appropriate, we identify alternative courses of actionto recover the carrying value of our long-lived assets and evaluate all likelyalternatives under a probability-weighted approach as described inSFAS 144.

 

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In accordance with SFAS No. 144, indeveloping estimated future cash flows for impairment testing for our realestate inventories, we incorporated our own market assumptions including thoseregarding home prices, sales pace, sales and marketing costs, infrastructure,home-building costs and financing costs regarding real estate inventories. Ourassumptions are based, in part, on general economic conditions, the currentstate of the homebuilding industry, expectations about the short- and long-termoutlook for the housing market, and competition from other homebuilders in theareas in which we build and sell homes. These assumptions can significantlyaffect our estimates of future cash flows. For those communities deemed to beimpaired, we determined fair value based on discounted estimated future cashflows using estimated absorption rates for each community.

 

We believe that the accounting for theimpairment of long-lived assets is a critical accounting policy because thevaluation analysis involves a number of assumptions that may differ from actualresults and the impact of recognizing impairment losses has been material toour consolidated financial statements. The critical assumptions in ourevaluation of real estate inventories impairment included projected salesprices, anticipated sales pace within each community, and applicable discountrates, any of which could change materially as economic conditions change.

 

*Income Taxe*s

 

We account for income taxes on the liabilitymethod. Deferred income taxes are determined based on the difference betweenthe financial statement and tax bases of assets and liabilities. The liabilitymethod requires an evaluation of the probability of being able to realize thebenefits indicated by deferred tax assets, such as tax net operating losses. Avaluation allowance related to the deferred tax asset is recorded when it ismore likely than not that some portion or all of the deferred tax asset willnot be realized. Given the significance of our historical federal tax netoperating losses, as discussed in Note 9 to the consolidated financialstatements, the application of our policy in evaluating the expected benefit ofnet operating losses is critical. In applying those policies, estimates andjudgments affect the amounts at which certain assets and liabilities are recorded.We apply our accounting policies on a consistent basis. As circumstanceschange, they are considered in our estimates and judgments, and future changesin circumstances could result in changes in the amounts at which assets andliabilities are recorded.

 

We remain subject to the general rules ofSection 382 of the Internal Revenue Code, which limit the availability ofnet operating losses if an ownership change occurs. If we were to experienceanother ownership change, the amount of net operating losses available wouldgenerally be limited to an annual amount equal to (i) the value of ourequity immediately before the ownership change, multiplied by the long-termtax-exempt rate (4.94% as of November 2008) plus (ii) recognizedbuilt-in-gains, defined as those gains recognized within five years of theownership change subject to an overall limitation of the net unrealizedbuilt-in gains existing as of the ownership change date. We estimate that as ofNovember 4, 2008, we have experienced a three-year cumulative ownershipshift of approximately 23%, as computed in accordance with Section 382.

 

*Homebuilding Revenues and Cost of Sales*

 

Our homebuilding operation generates revenuesfrom the sale of homes. The majority of these homes are designed to appeal tomove-up homebuyers and the homes are generally offered for sale in advance oftheir construction. Sales contracts are usually subject to certaincontingencies such as the buyer’s ability to qualify for financing. Revenuefrom the sale of homes is recognized at closing when title passes to the buyer,and the earnings process is complete. As a result, our revenue recognitionprocess does not involve significant judgments or estimates. However, we dorely on certain projections and estimates to determine the related constructioncosts and resulting gross margins associated with revenues recognized. The costof sales is recorded based upon total estimated costs within a subdivision andallocated using the relative sales value method. Our construction costs arecomprised of direct and allocated costs, including estimated costs for futurewarranties and indemnities. Our estimates are based on historical results,adjusted for current factors.

 

*Litigation Reserves*

 

We and certain of our subsidiaries have beennamed as defendants in various cases arising in the normal course of businessand regarding assets and businesses disposed of by us or our former affiliates.See Note 9 in our consolidated financial statements included in this quarterlyreport. We have reserved for costs expected to be incurred with respect tothese cases based upon information provided by our legal counsel. There can beno assurance that total litigation costs actually incurred will not exceed theamount of such reserve.

 

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**Results of Operations**

 

The following tables set forth key operating andfinancial data for our homebuilding operations for the three and nine monthsended September 30, 2008 and 2007.

 

**Backlog as of September 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                       | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 20                             |       | 28                                       |       | (28.5                                                           | )%         | $ | 31.0 |   | $ | 21.4 |   | 44.9 | % | $ | 1,549 |   | $ | 765 |   | 102.5 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Three Months Ended September 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                 | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 17                       |       | 12                                       |       | 41.7                                                            | %          | $ | 13.9 |   | $ | 5.2 |   | 167.3 | % | $ |  818 |   | $ | 433 |   | 88.9 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Nine Months Ended September 30**

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                 | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 40                       |       | 36                                       |       | 11.1                                                            | %          | $ | 29.3 |   | $ | 21.6 |   | 35.6 | % | $ | 733 |   | $ | 600 |   | 22.2 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

*Three Months Ended September 30, 2008 Comparedwith the Three Months Ended September 30, 2007*

 

We generated $25.8 million of gross operatingloss for the third quarter of 2008, reflecting $29.1 million of impairmentcharges partially offset by gross operating profit before impairment charges of$3.3 million. During the comparable period of the prior year, we generated$27.8 million of gross operating loss, reflecting impairment charges of $28.0million which were partially offset by gross operating profit before impairmentcharges of $200,000. We also reported revenues of $13.9 million for thethird quarter of 2008, compared with $5.2 million in revenues for thethird quarter of 2007. Revenues in the current period reflect deliveries of 17homes, including seven deliveries at Brightwater which generated revenues of$9.8 million and gross operating profit of $3.2 million, and 10 homes atour inland projects which generated revenues of $4.1 million and grossoperating profit of $100,000. The comparable period of the prior year reflectsdeliveries of 12 homes, including five homes at the Chandler Ranch project,four homes at our Woodhaven project in Beaumont, two homes at our Las Colinasproject in Lancaster, and one home at our Alisal project in Lancaster.

 

These impairment charges reflect our currentexpectations about selling prices, gross margins, and sales pace for theprojects. As required by SFAS 144, should market conditions furtherdeteriorate in the future or other events occur that indicate the carryingamount of our real estate inventories may not be recoverable, we willreevaluate our expected cash flows from each project to determine whether anyadditional impairment exists at any point in time.

 

Gross operating loss for the third quarter of2008 includes impairment charges of $29.1 million, primarily reflectingfair value write-downs for the Hearthside Lane project in Corona and LasColinas project in Lancaster (see Note 2 to the consolidated financialstatements) of $24.1 million and $1.5 million, respectively, and a $3.4 millioncharge related to our Woodhaven project in Beaumont.

 

Two subsidiaries of Hearthside Homes arecurrently in default on the loans secured by the Hearthside Lane and LasColinas projects and guaranteed by Hearthside Homes, as a result of theLancaster loan maturing on September 30, 2008 and not making requiredinterest payments in October. Hearthside Homes’ subsidiaries are attempting tonegotiate a consensual resolution of these loans with the lender, IndyMacFederal Bank, which is likely to involve turnover of the properties securingthe loans to the lender. As a result, during the third quarter of 2008 wereduced the carrying value of the Hearthside Lane and Las Colinas real estateprojects to their estimated fair values. After these impairment charges, therelated debt exceeds the carrying value of these assets by approximately $18.5million.  If the Hearthside Lane propertyis transferred to IndyMac Federal Bank in full settlement of the loan withoutfurther recourse or obligation, we will recognize a substantial gain as aresult of debt cancellation. If the gain is equal to the amount that therecorded debt exceeds the carrying value of the assets, the $18.5 millionpretax gain would result in a gain of $10.9 million after tax, or $1.00 pershare. However, there can be no assurance that IndyMac Federal Bank will agreeto a consensual resolution of these loans.

 

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We generated $3.1 million more in grossoperating profit before impairment charges from home sales during the thirdquarter of 2008 compared with the third quarter of 2007 primarily as a resultof delivering seven homes at Brightwater which generated a 32.8% gross marginand gross operating profit of $3.2 million. This profit margin percentage waspartially offset by 1.7% margins at our inland projects due to the prolongedreal estate slowdown which has resulted in lower selling prices and greaterincentives in order to remain competitive and move standing inventories in thisdifficult market. Homebuilding gross margin before impairment charges increasedto 23.7% for the third quarter of 2008 compared with 3.8% in the comparableperiod of 2007 due to the higher gross margin at Brightwater.

 

The $500,000 increase in interest expenseduring the third quarter of 2008 compared with the comparable period of 2007primarily reflects interest incurred on projects which are no longer underconstruction and, therefore, must be recorded as a period cost.

 

The $300,000 increase in other expense, netduring the third quarter of 2008 compared with the comparable period of 2007primarily reflects a $200,000 increase in real estate holding costs due to ourinability to capitalize property taxes for inland projects no longer underconstruction, and a $100,000 decrease in investment income for the thirdquarter of 2008.

 

*Nine Months Ended September 30, 2008 Comparedwith the Nine Months Ended September 30, 2007*

 

We reportedrevenues of $29.3 million and gross operating loss of $27.5 millionfor the nine months ended September 30, 2008, compared with$21.6 million in revenues and gross operating loss of $30.7 millionfor the comparable period of 2007. We generated $6.6 million of gross operatingprofit before impairment charges for the nine months ended September 30,2008, compared with $1.3 million of gross operating profit in the comparableperiod of 2007. Revenues in the current period reflect deliveries of 40 homes,including 16 deliveries at Brightwater which generated revenues of$19.2 million and gross operating profit of $6.0 million, and 24 homes atour inland projects which generated revenues of $10.1 million and grossoperating profit of $600,000. The comparable period of the prior year reflectsdeliveries of 36 homes, including 12 homes at our Chandler Ranch projectin North

Corona, the final six homesat our completed Rancho Santa Fe project, six homes at our Alisal project in Lancaster,five homes each at our Las Colinas project in Quartz Hill and our Woodhavenproject in Beaumont, and two homes at our Alisal project in Ontario.

 

Grossoperating loss for the nine months ended September 30, 2008 and 2007includes impairment charges of $34.1 million and $32.0 million,respectively. The impairment charges recorded during 2008 primarily reflectfair value write-downs for the Hearthside Lane project in Corona and LasColinas project in Lancaster (see above and Note 2 to the consolidatedfinancial statements) of $24.1 million and $5.9 million, respectively, a $3.4million charge related to our Woodhaven project in Beaumont and a $600,000impairment for our Alisal project in Ontario. The impairment charges recordedduring the first nine months of 2007 relate to the remaining homes at our ChandlerRanch, Alisal at Ontario, Woodhaven, Hearthside Lane and Las Colinas projects.These impairment charges reflect our expectations about selling prices, grossmargins, and sales pace for the projects. As required by SFAS 144, shouldmarket conditions further deteriorate in the future or other events occur thatindicate the carrying amount of our real estate inventories may not berecoverable, we will reevaluate our expected cash flows from each project todetermine whether any additional impairment exists at any point in time.

 

We generated $5.3 million more in grossoperating profit before impairment charges from home sales during the ninemonths ended September 30, 2008 compared with the comparable period of2007 primarily as a result of delivering 16 homes at Brightwater whichgenerated a 31.2% gross margin and gross operating profit of $6.0 million. TheBrightwater gross margin and gross operating profits were partially offset byreduced margins at our inland projects due to the prolonged real estateslowdown which has resulted in lower selling prices and greater incentives inorder to remain competitive and move standing inventories in this difficultmarket. Homebuilding gross margin before impairment charges increased to 22.5%for the nine months ended September 30, 2008 compared with 6.0% in thecomparable period of 2007 due to the higher gross margin at Brightwater.

 

The $500,000 increase in interest expenseduring the first nine months of 2008 compared with the comparable period of2007 primarily reflects interest incurred on projects which are no longer underconstruction and, therefore, must be recorded as a period cost.

 

The $1.4 million increase in other expense,net during the nine months ended September 30, 2008 compared with thecomparable period of 2007 primarily reflects an $800,000 loss on an interestrate swap agreement which included $1.0 million of cash payments made under theterms of the agreement partially offset by a $200,000 non-cash fair valueadjustment. The interest rate swap agreement was entered into in September 2006in connection with our Brightwater financing agreements and this swap agreementexpired in September 2008.  Theincrease in other expense, net also reflects a $200,000 decrease in investmentincome, a $500,000 increase in real estate holding costs due to our inabilityto capitalize property taxes for inland projects no longer under construction,as well as other items.

 

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*Payments Under Contractual Obligations*

 

We have entered into certain contractualobligations to make future payments for items such as loans, project debt, andlease agreements. A summary of the payments due under specified contractualobligations, aggregated by category of contractual obligation, for specifiedtime periods is presented below as of September 30, 2008 (in millions):

 
| ** **                                     | ** ** | **Payments due by period** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                     | ** ** | **Total**                                 | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More  than  5 years** | ** ** |
| Revolving loan(a)                              |       | $                                         | 99.3       |   | $ | 99.3 |   | $ | — |   | $ | — |   | $ | — |   |
| Term loan(a)                                   |       | 131.0                                     |       | 23.1 |   | 107.9 |   | — |   | — |   |
| Other project debt(a)                          |       | 41.3                                      |       | 41.3 |   | — |   | — |   | — |   |
| Defined benefit retirement plan  contributions |       | 1.4                                       |       | .3 |   | .4 |   | .4 |   | .3 |   |
| Operating leases                               |       | 1.1                                       |       | .3 |   | .7 |   | .1 |   | — |   |
| Total                                          |       | $                                         | 274.1      |   | $ | 164.3 |   | $ | 109.0 |   | $ | .5 |   | $ | .3 |   |

 

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(a)                                  Amountsinclude estimated interest expense which is calculated based on forecasted debtbalances and the applicable interest rate at September 30, 2008.

 

Our purchase contracts which are made in thenormal course of our homebuilding business for land acquisition andconstruction subcontracts are generally cancelable at will. Other contractualobligations including our tax liabilities, accrued benefit liability for afrozen retirement plan and other accrued pensions, home warranty reserves andcontingent indemnity and environmental obligations are estimated based onvarious factors. Payments are not due as of a given date, but rather aredependent upon the incurrence of professional services, the lives of annuitantsand other factors. The estimation process involved in the determination ofcarrying values of these obligations is inherently uncertain since it requiresestimates as to future events and contingencies. We have provided additionaldisclosure below in Part II Item 1. “Legal Proceedings” and inNote 9 to our consolidated financial statements above.

 

**Liquidity and Capital Resources**

 

Year-over-year changes in theprincipal components of our liquidity and capital resources are as follows (inmillions, except percentages):

 
| ** **                                       | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **September 30,**          | ** ** |
| ** **                                       | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| Cash and cash equivalents                        |       | $                               | 7.0        |   | $ | 5.2 |   |
| Cash used in operating activities                |       | (17.8                           | )          | (55.2 | ) |
| Cash (used in) provided by investing  activities |       | (.3                             | )          | 1.2 |   |
| Cash provided by financing activities            |       | .8                              |       | 48.6 |   |
|                                                  |            |                                 |            |  |  |  |  |

 

The principal assets in our portfolio areresidential land which must be held over an extended period of time in order tobe developed to a condition that, in management’s opinion, will ultimatelymaximize our return. Consequently, we require significant capital to financeour real estate development and homebuilding operations. Historically, sourcesof capital have included loan facilities secured by specific projects, assetsales and available internal funds. Our unrestricted cash and cash equivalentsas of September 30, 2008 aggregated $7.0 million.

 

On September 15, 2006 we entered intothe $100 million revolving loan and the $125 million term loan withKeyBank National Association, as a lender and agent for several other lenders.These loans are described in greater detail in Notes 4 and 5 to theconsolidated financial statements. On September 30, 2008, we amended therevolving and term loans to defer $25.0 million of principal payments that weredue at the end of 2008 and preserve an additional $75.0 million of borrowingcapacity until September 2009 by deferring loan amortization andcommitment reductions. These amendments provide greater flexibility to repaythe debt and finance construction based on current projections for home salesat Brightwater which better reflect current market

conditions and the ongoing economic downturn. In exchange for theseamendments we paid fees and related legal and financial

 

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advisor costs totaling $3.0 million, which are being amortized over thelife of the loans. The commitment reductions for the revolving and term loansare scheduled as follows:

 
| **Senior Secured Revolving Loan** | ** ** |
|--------------------------------------------------|------------|
| ** **                                       | ** ** | **Without Extension** | ** ** | **With Extension ****(1)** | ** ** |
| **Date**                                         | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
| December 31, 2008                           |       | $ | 5.0 |   | $ | 95.0 |   | $ | 5.0 |   | $ | 95.0 |   |
| June 30, 2009                               |       | $ | 5.0 |   | $ | 90.0 |   | $ | 5.0 |   | $ | 90.0 |   |
| September 30, 2009                          |       | $ | 90.0 |   | $ | — |   | $ | 10.0 |   | $ | 80.0 |   |
| December 31, 2009                           |       | n/a |   | n/a |   | $ | 10.0 |   | $ | 70.0 |   |
| March 31, 2010                              |       | n/a |   | n/a |   | $ | 10.0 |   | $ | 60.0 |   |
| June 30, 2010                               |       | n/a |   | n/a |   | $ | 60.0 |   | $ | — |   |

 

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(1)          Presuming the Company isin compliance with its covenants at December 31, 2008, which would enableit

to exercise its option to extend the currentmaturity date from September 2009 to June 2010. However, given thecurrent national economic recession and difficult housing market, there can beno assurance that we will be able to meet the December 31, 2008 covenants.

 
| **Senior Secured Term Loan** | ** ** |
|---------------------------------------------|------------|
| **Date**                                    | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
| December 31, 2008                      |       | $ | 10.0 |   | $ | 115.0 |   |
| June 30, 2009                          |       | $ | 5.0 |   | $ | 110.0 |   |
| September 30, 2009                     |       | $ | 5.0 |   | $ | 105.0 |   |
| December 31, 2009                      |       | $ | 15.0 |   | $ | 90.0 |   |
| March 31, 2010                         |       | $ | 15.0 |   | $ | 75.0 |   |
| June 30, 2010                          |       | $ | 10.0 |   | $ | 65.0 |   |
| September 30, 2010                     |       | $ | 15.0 |   | $ | 50.0 |   |
| December 31, 2010                      |       | $ | 12.5 |   | $ | 37.5 |   |
| March 31, 2011                         |       | $ | 12.5 |   | $ | 25.0 |   |
| June 30, 2011                          |       | $ | 12.5 |   | $ | 12.5 |   |

 

As of September 30, 2008, our revolvingloan is fully drawn except for $60,000. As of September 30, 2008 and December 31,2007, $93.9 million and $76.0 million, respectively, was outstandingunder the revolving loan. During the first nine months of 2008, we mademandatory repayments of $3.8 million and $5.8 million on the revolving and termloans, respectively, in connection with 16 home deliveries at Brightwaterduring the period. Outstanding advances on the revolving and term loans bearinterest based on the following loan-to-value grids:

 
| **Senior Secured Revolving Loan** | ** ** |
|--------------------------------------------------|------------|
| **Loan-to-Value**                                | ** ** | **LIBOR Margin** | ** ** | **Prime Margin** | ** ** |
| Greater than or equal to 30% to less than  40%   |       | 350 |   | 200 |   |
| Greater than or equal to 20% to less than  30%   |       | 325 |   | 175 |   |
| Less than 20%                                    |       | 300 |   | 150 |   |
|                                                  |            |  |  |  |  |  |

 
| **Senior Secured Term Loan**    | ** ** |
|------------------------------------------------|------------|
| **Loan-to-Value**                              | ** ** | **LIBOR Margin** | ** ** | **Prime Margin** | ** ** |
| Greater than or equal to 65% to less than  70% |       | 450 |   | 300 |   |
| Greater than or equal to 50% to less than  65% |       | 400 |   | 250 |   |
| Less than 50%                                  |       | 350 |   | 200 |   |
|                                                |            |  |  |  |  |  |

 

Two subsidiaries of Hearthside Homes arecurrently in default on the project debt loan facilities for the HearthsideLane project in Corona and the Las Colinas project in Lancaster, which loansare both held by IndyMac Federal Bank. The Lancaster loan matured September 30,2008 and the Corona loan has a current maturity date of January 7, 2009;however, the lender has accelerated this loan and declared it immediately dueand payable as a result of our default related to the interest payment due on October 1,2008. The only other project loan facility relates to the Woodhaven project inBeaumont which is held by Comerica Bank and currently matures in September 2009.

 

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The Corona and Las Colinas loans are nonrecourse to us; however, theyare guaranteed by Hearthside Homes. These subsidiaries are attempting tonegotiate a consensual resolution of these loans with the lender, IndyMacFederal Bank, which is likely to involve turnover of the properties securingthese loans to the lender. As a result, during the third quarter of 2008 wereduced the carrying value of the Hearthside Lane and Las Colinas real estateprojects to their estimated fair values (see Note 2 to the consolidatedfinancial statements). After these impairment charges, the related debt exceedsthe carrying value of these assets by approximately $18.5 million.  If the Corona property is transferred toIndyMac Federal Bank in full settlement of the Corona loan without furtherrecourse or obligation, we will recognize a substantial gain as a result ofdebt cancellation. If the gain is equal to the amount that the recorded debtexceeds the carrying value of the assets, the $18.5 million pretax gain wouldresult in a gain of $10.9 million after tax, or $1.00 per share. However, therecan be no assurance that IndyMac Federal Bank will agree to a consensualresolution of these loans.

 

DuringOctober 2008, one additional home closed at the Las Colinas project inLancaster resulting in an additional repayment of approximately $300,000. Threeadditional homes are currently in escrow and are expected to close during thefourth quarter of 2008, which would result in repayments of approximately$990,000 and reduce the loan balance to approximately $2.6 million. We arecontinuing our efforts to sell the two remaining completed homes.

 

We are utilizing internally generated cashand joint venture contributions to fund the Oxnard land development project.During the three months ended September 30, 2008, we made aggregateadditional capital contributions of approximately $100,000 to the Oxnard jointventure, bringing our total investment in the venture to $3.2 million (seeNote 9 to the consolidated financial statements). In addition, as of September 30,2008, we have incurred capitalized overhead costs of approximately $700,000 forthe project which are unreimbursed by the venture, bringing our totalinvestment in the project to $3.9 million. During the remaining threemonths of 2008, we expect to make additional aggregate capital contributions ofapproximately $100,000.

 

As with many other homebuilders, weconstantly evaluate potential alternatives regarding our capital structureincluding, but not limited to, various strategies for restructuring our debtand raising additional capital. There can be no assurance that we will besuccessful in any of these endeavors. The current national credit market crisispresents uncertainty as to our ability to secure additional financing, ifneeded, and the terms of such financing if it is available, and as to ourability to achieve positive cash flow from operations required to satisfy ourobligations.

 

As discussed above, we are pursuing andevaluating various financing alternatives. We believe that the funds availableto us under our revolving and term loans (as amended in September 2008),along with our option to extend the revolving loan maturity to June 2010which we currently expect to be able to exercise, together with our cash andcash equivalents and future real estate sales proceeds will be sufficient tomeet anticipated operating and capital investment requirements and projectdevelopment costs for Brightwater, the Oxnard land development project, andgeneral and administrative expenses, for at least the next 12 months.

 

We are subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhomesites. The purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers, includingobtaining applicable property entitlements. We also utilize option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Purchase and option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. We have the right atour discretion to terminate our obligations under these land purchase andoption agreements by forfeiting the cash deposit with no further financialresponsibility. As of September 30, 2008, we have no consolidated landoption deposits. However, our unconsolidated Oxnard joint venture does haveland deposits of $2.5 million.

 

We may enter into land development andhomebuilding joint ventures from time to time as a means of expanding ourmarket opportunities, establishing strategic alliances, managing our riskprofile and leveraging our capital base. These joint ventures may obtainsecured acquisition, development and construction financing, which minimize theuse of funds from other corporate financing sources.

 

*September 30, 2008 Compared with December 31, 2007*

 

Cash used in operating activities of$17.8 million for the first nine months of 2008 primarily reflectsinvestments in Brightwater of $29.2 million, which were partially offsetby net proceeds of $18.7 million generated by 16 deliveries at Brightwaterand $7.2 million of net cash flow generated by our inland projects($9.7 million generated from deliveries of 24 homes less $2.5 millionof project investments).

 

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Our primary sources of cash during the firstnine months of 2008 were $28.4 million of proceeds from sales of real estateinventories and $17.9 million of net borrowings from our revolving loan. Ourprimary uses of cash during the first nine months of 2008 include $29.2 millionof investments in Brightwater, $7.9 million of net repayments of otherproject debt and $5.8 million of net repayments of our term loan.

 

The $9.4 million increase in deferred taxassets primarily reflects deferred tax benefits for additional net operatinglosses generated during the first nine months of 2008, partially offset by avaluation reserve of $4.5 million recorded during the three months ended September 30,2008.

 

The $3.5 million increase in other assetsprimarily reflects deferred financing costs and related professional fees.

 

The $7.2 million decrease in accounts payableand accrued liabilities primarily reflects reductions in accounts payablerelated to payments of project construction costs due to the declining level ofconstruction activity at our inland projects and the substantial completion ofland development and model home construction at Brightwater.

 

**Off Balance Sheet Financing**

 

In the ordinary course of business, we enterinto land option contracts in order to procure land for the construction ofhomes. The use of such option agreements allows us to reduce the risksassociated with land ownership and development; reduce our financialcommitments, including interest and other carrying costs; and minimize landinventories. Under such land option contracts, we will fund a specified optiondeposit or earnest money deposit in consideration for the right to purchaseland in the future, usually at a predetermined price. Our liability isgenerally limited to forfeiture of the nonrefundable deposits, letters ofcredit and other nonrefundable amounts incurred. As of September 30, 2008,we have no consolidated land option deposits and no third party guarantees.

 

We also acquire land and conduct residentialconstruction activities through participation in joint ventures in which wehold less than a controlling interest. Through joint ventures, we reduce andshare our risk and also reduce the amount invested in land, while increasing ouraccess to potential future home sites. The use of joint ventures also, in someinstances, enables us to acquire land which we might not otherwise obtain oraccess on as favorable terms, without the participation of a strategic partner.While we view the use of unconsolidated joint ventures as beneficial to ourhomebuilding activities, we do not view them as essential to those activities.

 

Our investment in unconsolidated jointventures totaled $3.2 million and $2.7 million at September 30,2008 and December 31, 2007. These joint ventures had total assets of$9.1 million and $9.7 million as of September 30, 2008 and December 31,2007, respectively, which included land deposits of $2.5 million for bothperiods. In certain instances, we may provide varying levels of guarantees ondebt of unconsolidated joint ventures. As of September 30, 2008, weprovide no guarantees on debt of unconsolidated joint ventures.

 

Under the requirements of FASB InterpretationNo. 46(R), “*Consolidation of VariableInterest Entities*” (“FIN 46(R)”), certain of our land optioncontracts may create a variable interest for us, with the land seller beingidentified as a VIE. In compliance with FIN 46(R), we analyze our landoption contracts and other contractual arrangements and consider whether weshould consolidate the fair value of certain VIEs from which we are purchasingland under option contracts. As of September 30, 2008, we had noconsolidated deposits with VIEs.

 

**Impact of Inflation, Changing Prices and Economic Conditions**

 

Real estate and residential housing prices are affected by a number offactors, including but not limited to uncertainty by potential homebuyers inthe stability of the United States and global economy, inflation or deflation,interest rate changes, competition and the supply of new and existing homes tobe purchased. Uncertainty in the stability of the national economy andsignificant volatility in the banking system and financial markets can, andhas, caused potential homebuyers to refrain from committing to make significantpurchases, including the purchase of new homes. In the event the volatility inthe banking system and financial markets continues to remain high and thenational economy does not stabilize in the near term, our ability to sell newhomes to potential homebuyers can be impacted negatively.

 

The long-term impact of inflation may affectus through increased costs for land, land development, construction andoverhead, as well as in increased sales prices of our homes. Our landacquisition costs are generally fixed, therefore, increases or decreases in thesales prices of homes will affect our profits. The sales price of each of ourhomes is fixed at the time a buyer enters into a contract to acquire a home.Therefore, if we sell our homes before we begin construction, any inflation ofcosts in excess of those anticipated may result in lower gross margins, unlessthese increased costs are recovered through higher sales prices.

 

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Also, deflation can cause the market value ofour land and constructed homes to decline which could negatively impact ourresults of operations. If interest rates increase, construction and financingcosts, as well as the cost of borrowings, could also increase, which can resultin lower gross margins on home sales. Increases in home mortgage interest ratesmake it more difficult for our customers to qualify for home mortgage loans,potentially decreasing home sales revenue. Increases in interest rates also mayaffect adversely the volume of mortgage loan originations. Increases incompetition and the supply of unsold new and existing homes have had an adverseeffect on our ability to generate new home orders and maintain home orders inbacklog, and have had a significant negative impact on our results ofoperations and gross margins on home sales in our inland markets. Additionally,through September 30, 2008 we saw significant increases in energy costs,as well as other inflationary pressures, all contributing to an overall weakereconomic environment.

 

Interest rates, the length of time that landremains in inventory and the proportion of inventory that is financed affectour interest costs. If we are unable to raise sales prices enough to compensatefor higher costs, or if mortgage interest rates increase significantly,affecting prospective buyers’ ability to adequately finance home purchases, ourrevenues, gross margins and net income would be adversely affected. Increasesin sales prices, whether the result of inflation or demand, may affect theability of prospective buyers to afford new homes.

 

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**Item 3.  Quantitative andQualitative Disclosures About Market Risk.**

 

We utilize variable rate debt financing foracquisition, development and construction of homes. The interest rates on ourdebt approximate the current rates available for secured real estate financingwith similar terms and maturities, and as a result, their carrying amountsapproximate fair value. While changes in interest rates generally may notimpact the fair market value of the debt instrument, they do affect ourearnings and cash flows. Holding our variable rate debt balance constant as of September 30,2008, each one point percentage increase in interest rates would result in anincrease in variable rate interest incurred for the next 12 months ofapproximately $2.5 million.

 

We are exposed to market risks related tofluctuations in interest rates on our outstanding variable rate debt. Otherthan an interest rate swap, which expired in September 2008, used tomanage our exposure to changes in interest rates on $62.5 million of ourvariable rate-based Term Loan, we did not utilize swaps, forward or optioncontracts on interest rates, or other types of derivative financial instrumentsas of or during the three months ended September 30, 2008. We do not enterinto or hold derivatives for trading or speculative purposes.

 

Under the Term Loan agreement, we wererequired to enter into a swap agreement to hedge against risks associated withfluctuating interest rates related to $62.5 million of floating rate debt.On September 15, 2006 we entered into an interest rate swap transaction toeffectively fix the interest rate on $62.5 million in floating rate debtat 8.015% per annum for two years. The swap transaction terminated September 15,2008. The swap did not qualify for hedge accounting under SFAS No. 133, *“Accounting for Derivative Instruments and Hedging Activities.”*The fair value of the interest rate swap agreement represents the spreadbetween the interest rate we would pay and the interest rate we would receiveover the remaining life of the agreement which are considered level 2 inputsunder SFAS 157. The non-cash change in fair value of the interest rate swapagreement during the three and nine months ended September 30, 2008 was anapproximately $400,000 and $200,000 increase, respectively, and was included inother expense, net in our consolidated statements of operations and in accountspayable and accrued liabilities in our consolidated balance sheets. Inaddition, we recorded $400,000 and $1.0 million of expense for cash paymentsmade under the terms of the interest rate swap agreement during the three andnine months ended September 30, 2008, respectively, due to declininginterest rates during the periods. The counterparties to the interest rate swapagreement are financial institutions.

 

You should be aware that many of thestatements contained in this section are forward looking and should be read inconjunction with our disclosures under the heading “Forward-Looking Statements.”

 

**Item 4.  Evaluation of DisclosureControls and Procedures.**

 

**Conclusion Regarding the Effectiveness of Disclosure Controls andProcedures**

 

Our chief executive officer and chief financialofficer, with the assistance of management, evaluated the effectiveness of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) as of theend of the period covered by this report (the “Evaluation Date”). Based on thatevaluation, our chief executive officer and chief financial officer concludedthat, as of the Evaluation Date, our disclosure controls and procedures wereeffective to ensure that information required to be disclosed in our reportsunder the Exchange Act, is recorded, processed, summarized and reported withinthe time periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

However, no matter how well a control system isconceived and operated, it can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. In addition, the design of acontrol system must reflect the fact that there are resource constraints andthe benefits of controls must be considered relative to costs. Therefore, nocost-effective control system and no evaluation of controls can provideabsolute assurance that all control issues and instances of misstatements dueto error or fraud, if any, within our company have been detected.

 

**Changes in Internal Controls**

 

There have been no changes in our internal controlover financial reporting during the three months ended September 30, 2008that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

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**PART II — OTHERINFORMATION**

 

**Item 1.  Legal Proceedings.**

 

See Notes 7 and 9 to the consolidated financialstatements above, and “Item 1 - Business - Corporate Indemnification Matters”and “Item 3 - Legal Proceedings” in our Annual Report on Form 10-K for theyear ended December 31, 2007.

 

**Item 1A.  Risk Factors.**

 

In addition to the other information set forth in thisreport, you should carefully consider the factors discussed in Part I, “Item1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31,2007, which could materially affect our business, financial condition or futureresults. The risks described below and in our Annual Report on Form 10-Kare not the only risks that we face. Additional risks and uncertainties notcurrently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition and/or operatingresults.

 

Except as setforth below, there has been no material change in our risk factors aspreviously disclosed in our Form 10-K for the year ended December 31, 2007. 

 

***The homebuilding industry isundergoing a significant and sustained downturn which has, and could continueto, materially and adversely affect our business, liquidity and results ofoperations.***

 

 The homebuilding and mortgage lendingindustries are continuing to experience a significant and sustained downturn,which negatively impacted our financial and operating results during the threeand nine months ended September 30, 2008. Unprecedented levels of nationalconcern over instability in the credit markets, along with growing concernsover the likelihood of a recession, have exacerbated the decline in demand fornew homes. The conditions experienced during 2008 include, among other things:reduced consumer confidence; significant concerns over the impact ofhigher-risk mortgage loan products on the banking system and financial markets;reduced availability and higher costs of mortgage loan financing; fluctuatingenergy costs; the absence of home price stability; and continued declines inthe value of new homes. 

 

If thedownturn in the homebuilding and mortgage lending industries continues orintensifies, or if the national economy weakens further and recession concernscontinue or increase, we could continue to experience declines in the marketvalue and demand for our homes, which could have a significant negative impacton our gross margins from home sales and financial and operational results. 

 

We believe the principal factors that havecaused this downturn include each of the following, the impact of which variesbetween our inland and coastal projects:

 

·  declining homebuyer demand due to lowerconsumer confidence in the residential real estate market and an inability ofmany homebuyers to sell their existing homes;

 

·  increased inventory of new and existing homesfor sale, including the impact of increases in residential foreclosures;

 

·  reduced availability and increased cost ofmortgage financing due to the significant mortgage market disruptions; 

 

·  decreased affordability of housing as aresult of significant price appreciation in the years preceding the downturnand tightened credit standards for homebuyers; and

 

·  pricing pressures resulting from a variety offactors, including the decision of homebuilders to offer significant discountsand sales incentives to liquidate unsold inventories in order to generate cash,and the need for home prices to fall within mortgage qualification limits.

 

These conditions have led to, among other things, substantialland-related impairments. As a result, our homebuilding operations at ourinland projects incurred substantial losses and may continue to do so. Anyworsening in market conditions in the homebuilding industry could have afurther material adverse effect on our business and results of operations.

 

***Leverage places burdens on ourability to comply with the terms of our indebtedness, may restrict our abilityto operate, may prevent us from fulfilling our obligations and may adverselyaffect our financial condition.***

 

We have asignificant amount of debt. 

 

·  as ofSeptember 30, 2008, the aggregate outstanding debt under our term and revolvingloan agreements was $210 million; and 

 

·  our debtservice payments for the nine-month period ended September 30, 2008, whichinclude interest incurred (not including principal and interest on non-recoursedebt of our subsidiaries), were $18.2 million.

 

In addition, we had substantialcontractual commitments and contingent obligations, including approximately$26.0 million of performance bonds as of September 30, 2008. 

 

Oursignificant amount of debt could have important consequences. For example, itcould:

 

·  requireus to dedicate a substantial portion of our cash flow from operations to thepayment of our debt and reduce our ability to use our cash flow for otherpurposes;

 

·  limit ourflexibility in planning for, or reacting to, changes in our business;

 

 · place us at a competitive disadvantage because we have more debt thansome of our competitors; and 

 

·  make usmore vulnerable to downturns in our business and general economic conditions.

 

Our ability tomeet our debt service and other obligations will depend upon our futureperformance. We are engaged in businesses that are substantially affected bychanges in economic cycles. Our revenues and earnings vary with the level ofgeneral economic activity in the markets we serve. Our businesses are also affectedby customer sentiment and financial, political, business and other factors,many of which are beyond our control. The factors that affect our ability togenerate cash can also affect our ability to raise additional funds for thesepurposes through the sale of equity securities, the refinancing of debt, or thesale of assets. Changes in prevailing interest rates may affect our ability tomeet our debt service obligations, because borrowings under our loan agreementsbear interest at floating rates. A higher interest rate on our debt serviceobligations could result in lower earnings.

 

Our businessmay not generate sufficient cash flow from operations and borrowings may not beavailable to us under our loan agreements in an amount sufficient to enable usto pay our indebtedness or to fund our other liquidity needs. We may also needto refinance all or a portion of our debt on or before maturity, which we maynot be able to do on favorable terms or at all.

 

***Restrictive covenants in ourdebt instruments may restrict our ability to operate, and, if our financialperformance worsens, we may not be able to maintain compliance with thefinancial covenants of our debt instruments.***

 

Our loanagreements impose restrictions on our operations and activities. The mostsignificant restrictions relate to debt incurrence, sales of assets, cashdistributions, including paying stock dividends, capital stock repurchases, andinvestments by us and certain of our subsidiaries. The covenants in our loanagreements also include a borrowing base covenant, maximum leverage andloan-to-value covenants and covenants requiring minimum interest coverage ratioand minimum liquidity as of the last day of each fiscal quarter. Continuedreductions in level of home deliveries, additional impairment charges and otherfinancial performance factors may negatively impact our ability to comply withour financial covenants; and there can be no assurance that we will not violatethe financial or other covenants under our loan agreements in the future orthat the amount available under our revolving credit line will not be reduced. 

 

If we fail tocomply with any of the restrictions or covenants of our loan agreements, andare unable to obtain an amendment or a waiver, or make timely payments on theseloans, the lenders could cause our debt to become due and payable prior tomaturity. In such a situation, there can be no assurance that we would be ableto obtain alternative financing. In addition, if we are in default on theseloan agreements, we may be prohibited from drawing additional funds under therevolving loan, which could impair our ability to maintain sufficient workingcapital. Either situation could have a material adverse effect on our solvency.In the event we were to amend our loan agreements, such amendments could resultin lower available commitment amounts and less favorable terms and conditions,which could have a negative impact on our borrowing capacity and/or cash flows.

 

***The terms of our debtinstruments allow us to incur additional indebtedness.***

*** ***

Under theterms of our loan agreements, we have the ability, subject to our debtcovenants, to incur additional amounts of debt. The incurrence of additionalindebtedness could magnify the risks described above.

 

***Current credit market conditions presentuncertainty as to our ability to secure additional financing, if needed, andthe terms of such financing if it is available, and as to our ability toachieve positive cash flow from operations required to satisfy our obligations.***

 

There can be no assurance that we will be able tomeet our amended covenants, payment schedules or our other requirements in ourrevolving loan and term loan credit facilities as amended on September 30,2008 if slowing market conditions worsen. If we are unable to comply with ormeet any one or more of our obligations under these loans, we could beprecluded from incurring additional borrowings and, in the event of default,our obligation to repay indebtedness outstanding under these loans could beaccelerated in full. We can give no assurance that in such an event, we wouldhave, or be able to obtain, sufficient funds to pay all debt we are required torepay.

 

***Availability of Additional Liquidity***

 

The availability of additional capital,whether from private capital sources (including banks) or the public capitalmarkets, fluctuates as market conditions change. There may be times when theprivate capital markets and the public debt or equity markets lack sufficientliquidity or when our securities cannot be sold at attractive prices, in whichcase we would not be able to access capital from these sources. Based oncurrent market conditions, our ability to effectively access these liquiditysources is significantly limited. In addition, a further weakening of our financialcondition, including in particular a material decrease in our profitability orcash flows, could adversely affect our ability to obtain necessary funds orotherwise increase our cost of borrowing.

 

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***Our results of operations are subject tosignificant changes in the cost of raw materials and other components of ourhouses and labor that are dependent on or impacted by increases in energycosts.***

 

Recently, the cost of fuel and other sourcesof energy have increased dramatically. Some of these costs are borne by usdirectly, such as fuel for company-related motor vehicles and energy for theoffice building that we occupy. These increases in energy costs have alsoincreased costs for our suppliers, who provide raw materials and the othercomponents of our houses, and subcontractors, whose employees help constructour homes. Many of these cost increases are being passed on to us, and theseand any additional cost increases could materially and adversely affect ourcost of sales and operating profits.

 

***Changes in laws or other events thatadversely affect liquidity in the secondary mortgage market could hurt our business.***

 

The government-sponsored enterprises,principally FNMA and FHLMC, play a significant role in buying home mortgagesand creating investment securities that they either sell to investors or holdin their portfolios. These organizations provide liquidity to the secondarymortgage market. FNMA and FHLMC have recently experienced financialdifficulties. Any new federal laws or regulations that restrict or curtailtheir activities, or any other events or conditions that prevent or restrictthese enterprises from continuing their historic businesses, could affect theability of our customers to obtain the mortgage loans or could increasemortgage interest rates or credit standards, which could reduce demand for ourhomes and/or the loans that we originate and adversely affect our results ofoperations.

 

In addition, the Housing and EconomicRecovery Act of 2008 prohibits, as of October 15, 2008, seller funded downpayment assistance programs. As a result of these trends, the ability andwillingness of prospective buyers to finance home purchases or to sell theirexisting homes has been adversely affected, which has adversely affected ouroperating results. These conditions may continue or worsen.

 

***We may be unable to obtain suitable bondingfor the development of our communities.***

 

We provide bonds to governmental authoritiesand others to ensure the completion of our projects. Our ability to obtainsurety bonds primarily depends upon our past performance, capitalization,working capital, management expertise and certain external factors, includingthe overall capacity of the surety market and the underwriting practices ofsurety bond issuers. If we are unable to provide required surety bonds for ourprojects, our business operations and revenues could be adversely affected. Asa result of the recent deterioration in market conditions, surety bond capacityhas decreased and providers have become increasingly reluctant to issue newbonds and some providers are requesting credit enhancements in order tomaintain existing bonds or to issue new bonds. If we are unable to obtainrequired bonds in the future, or are required to provide credit enhancementswith respect to our current or future bonds, our liquidity could be negativelyimpacted.

 

***In the ordinary course ofbusiness, we are required to obtain performance bonds, the unavailability ofwhich could adversely affect our results of operations and/or cash flows.***

 

As iscustomary in the homebuilding industry, we often are required to provide suretybonds to secure our performance under construction contracts, developmentagreements and other arrangements. If we were unable to obtain surety bondswhen required, our results of operations and/or cash flows could be impactedadversely.

 

***The homebuilding industry is highlycompetitive and, with more limited resources than many of our competitors, wemay not be able to compete effectively.***

 

The homebuilding industry is highlycompetitive. We compete with numerous other residential construction firms,including large national and regional firms, for customers, land, financing,raw materials, skilled labor and employees. We compete for customers primarilyon the basis of the location, design, quality and price of our homes and theavailability of mortgage financing. Some of our competitors have substantiallylarger operations and greater financial resources than we do and as a resultmay have lower costs of capital, labor and materials than us, and may be ableto compete more effectively.

 

Under current market conditions, we haveexperienced intense price competition in our inland markets as many buildersseek to aggressively reduce their inventory levels and land holdings. Many ofour competitors are better capitalized and have lower leverage than we do,which may position them to compete more effectively on price (which can triggerimpairments), better enable them to ride out the current industry-wide downturnand allow them to compete more effectively for land acquisitions whenconditions improve.

 

***Our controlling stockholders are able toexercise significant influence over us.***

 

Five (5) of our stockholders have over50% of the outstanding shares of our common stock. Their combined stockownership enables them to exert significant control over us, including power tocontrol the election of our Board of Directors and to approve matters presentedto our stockholders. This concentration of ownership may also make sometransactions, including mergers or other changes in control, more difficult orimpossible without their support. Also, because of their combined voting power,circumstances may occur in which their interests could be in conflict with theinterests of other stockholders.

 

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***Our net operating loss carryforwards could besubstantially limited if we experience an ownership change as defined in theInternal Revenue Code.***

 

We currently have a substantial amount of net operating loss carryforwardsand, based on recent impairments and our current financial performance, we maygenerate net operating loss carryforwards for the year ending December 31,2008, and possibly future years.

 

Section 382 of the Internal Revenue Code contains rules thatlimit the ability of a company that undergoes an ownership change, which isgenerally any change in ownership of more than 50% of its stock over athree-year period, to utilize its net operating loss carryforwards and certainbuilt in losses recognized in years after the ownership change. These rules generallyoperate by focusing on ownership changes among stockholders owning directly orindirectly 5% or more of the stock of a company or any change in ownershiparising from a new issuance of stock by a company.

 

If we undergo an ownership change for purposes of Section 382 as aresult of future transactions involving our common stock, including purchasesor sales of stock between 5% stockholders, our ability to use our net operatingloss carryforwards and recognize certain built in gains would be subject to thelimitations of Section 382. Depending on the resulting limitation, asignificant portion of our net operating loss carryforwards could expire beforewe would be able to use them. Our inability to utilize our net operating losscarryforwards could have a negative impact on our financial position andresults of operations.

 

***We are subject to current credit marketrisks.***

 

Current credit market conditions presentuncertainty as to our ability to secure additional financing, if needed, andthe terms of such financing if it is available, or as to our ability to achievepositive cash flow from operations to satisfy our obligations.

 

***Other risks.***

*** ***

For a morecomplete discussion of other risk factors that affect our business, see “RiskFactors” in our Form 10-K for the year ended December 31, 2007, which includethe following: 

 

·  Ourstrategies in responding to the adverse conditions in the homebuilding industrymay not be successful. 

 

· Market conditions in mortgage industries deteriorated significantly in2007, which adversely affected the availability of credit for home purchasers,reduced the number of potential mortgage customers. Further tightening ofmortgage lending or mortgage financing requirements could adversely affect theavailability of credit for purchasers of our homes and thereby reduce oursales. 

 

·  We have incurred a significant amount ofdebt, and we may incur significant additional debt, which could prevent us fromfulfilling our obligations and harm our financial health.

 

•  Failure to comply with the covenants andconditions imposed by the agreements governing our indebtedness could restrictfuture borrowing or cause our debt to become immediately due and payable. 

 

• Our homebuilding operations lack geographic diversification. 

 

• Our business is cyclical and downward changes in economic conditionsgenerally or in the market regions where we operate could further decreasedemand and pricing for new homes in these areas.

 

• Inflation may result in increased costs that we may not be able torecoup if demand declines. 

 

•  Severe weather conditions and naturaldisasters could delay deliveries, increase costs and decrease demand for newhomes in affected areas. 

 

• When mortgage-financing costs are high, or as credit quality declines,customers may be unwilling or unable to purchase our homes.

 

• Some homebuyers may cancel their home purchases because the requireddeposits are small and generally refundable, if new home prices decline,interest rates increase or there is a downturn in the economy. 

 

• Competition for homebuyers, labor and materials could reduce ourdeliveries or decrease our profitability.

 

• Slow or no growth initiatives have been or may be adopted in regionswhere we operate, which could adversely affect our ability to build or timelybuild in these areas. 

 

• We are subject to substantial legal and regulatory requirementsregarding the development of land, the homebuilding process and protection ofthe environment, and compliance with federal, state and local regulationsrelated to our business could have substantial costs both in time and money,and some regulations could prohibit or restrict some homebuilding projects.

 

• Changing market conditions may adversely impact our ability to sellhomes at expected prices, which could reduce our margins.

 

•  Home prices and sales activity in theparticular markets and regions in which we do business impact our results ofoperations because our business is concentrated in these markets.

 

• Product liability litigation and warranty claims that arise in theordinary course of business may be costly, which could adversely affect ourbusiness.

 

• We could be hurt by the loss of key management personnel.  

 

·  An earthquake or other natural disaster,terrorist act or nuclear accident could adversely affect our business.

 

•  Quarterly results may fluctuate and may notbe indicative of future quarterly performance.

 

•  If any taxing authorities are successful inasserting tax positions that are contrary to our positions, our income taxprovision and other tax reserves may be insufficient.

 

•  Changes in accounting principles,interpretations and practices may affect our reported revenues, earnings andresults of operations.

 

•  Future terrorist attacks against the UnitedStates or increased domestic or international instability could have an adverseeffect on our operations.

 

•  Insurance coverages and terms and conditions.

 

•  Our failure to achieve and maintain effectiveinternal controls in accordance with Section 404 of the Sarbanes-Oxley Act of2002 could have a material adverse effect on our business and the price of ourcommon stock.

 

**Item 2.  Not Applicable.**

 

**Item 3.  Defaults Upon SeniorSecurities.**

 

As disclosed in the consolidated financial statements and above,Hearthside Homes, Inc. and one of its subsidiaries received a notice offinancial covenant default from IndyMac Bank in June 2008 relating to the$30.1 million outstanding under a $54.5 million loan facility for theHellman-Corona inland development project. The loan facility is guaranteed by Hearthside Homes but is nonrecourseto our company. The noticed default related to the failure to meet specifiedabsorption rate and home closing requirements. As a consequence of thesedefaults, IndyMac Bank informed our subsidiaries that no further borrowingsunder the loan facility would be permitted until the defaults are cured.  In addition, commencing in October 2008the subsidiary has ceased to make interest payments due under this loan. As ofthe date of this quarterly report on Form 10-Q principal in the amount of$29.7 million was in default, and interest in the amount of $180,000 was inarrears.

 

Hearthside Homes, Inc. and one of its subsidiaries expect toreceive notices of default with respect to outstanding principal and interestpayments under a $14.0 million loan facility for the Lancaster and inlanddevelopment project. The loan facility is guaranteed by Hearthside Homes, Inc.but is nonrecourse to our company. As of the date of this Quarterly Report on Form 10-Q,principal in the amount of $3.9 million was in default and interest in theamount of $24,000 was in arrears.

 

**Item 4.  Not Applicable.**

 

**Item 5.  Other Information.**

 

On October 16, 2008,Thomas W. Sabin, Jr., our Chairman of the Board resigned from that postand as a director of our company due to the time commitments required by a newbusiness venture that he is pursuing. Phillip R. Burnaman II, one of our existing directors and the chairman ofour audit committee, has been appointed to succeed Mr. Sabin as Chairmanof the Board.

 

As a result of Mr. Sabin’sdeparture we are not presently in compliance with the Nasdaq Stock Market Rule thatrequires our audit committee to be comprised of at least three independentdirectors.  We intend to appoint a thirdindependent director to our audit committee prior to the date of our nextannual meeting of stockholders, presently expected to occur in May of2009, which is within the cure period provided by Nasdaq.

 

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**Item 6.  Exhibits.**

 
| 10.12(b) |   | Third  Amendment to Senior Secured Term Loan Agreement with KeyBank National  Association, incorporated by reference to Exhibit 10.2 to Form 8-K  filed September 30, 2008.        |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13(b) |   | Third  Amendment to Senior Secured Revolving Credit Agreement with KeyBank National  Association, incorporated by reference to Exhibit 10.1 to Form 8-K  filed September 30, 2008. |
| 31.1     |   | Section 302  Certificate of Raymond J. Pacini, Chief Executive Officer of California  Coastal Communities, Inc.                                                                         |
| 31.2     |   | Section 302  Certificate of Sandra G. Sciutto, Chief Financial Officer of California  Coastal Communities, Inc.                                                                         |
| 32.1     |   | Section 906  Certificate of Raymond J. Pacini, Chief Executive Officer and Sandra G.  Sciutto, Chief Financial Officer of California Coastal  Communities, Inc.*                        |

 

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*              These certifications are beingfurnished solely to accompany this report pursuant to 18 U.S.C. Section 1350,and are not being filed for purposes of Section 18 of the SecuritiesExchange Act of 1934, as amended, and are not to be incorporated by referenceinto any filing of the Company, whether made before or after the date hereof,regardless of any general incorporation language in such filing.

 

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**SIGNATURE**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| Date:  November 10, 2008 | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|-------------------------------|---------------------------------------|
|                          |                                  |
|                          |                                  |
|                          | By:                                   | /s/  Sandra G. Sciutto |
|                          |                                  | SANDRA  G. SCIUTTO |
|                          |                                  | Senior  Vice President and |
|                          |                                  | Chief  Financial Officer |

 

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