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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

** **

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period ended June 30, 2009**

** **

**OR**

** **

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the transition periodfrom                       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 filereports pursuant to Section 13 or Section 15(d) of the Act. YES o NO x

 

Indicate by check mark whether the registrant (1) has filed allreports required 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

 

Indicate by checkmark whether the registrant has submitted electronically and posted on itscorporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes o 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  ̈     |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated filer o                        |   | Smaller reporting  company x |
| (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 August 3, 2009 there were 10,995,902 shares of Common Stock,par value $.05 outstanding

 

 

 

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**CALIFORNIA COASTAL COMMUNITIES, INC.**

 

**FORM 10-Q**

 

**FOR THE QUARTER ENDED JUNE 30, 2009**

 

**INDEX**

 
| Cautionary  Statement About Forward-Looking Statements | 3                      |
|--------------------------------------------------------|------------------------|
|                                                   |                   |
| Part I -                                          | Financial Information: | 5 |
|                                                   |                   |   |   |
|                                                   | Item 1.                | Financial Statements | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Balance Sheets — June 30, 2009 (unaudited) and December 31, 2008 | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of Operations — Three and Six  Months Ended June 30, 2009 and 2008 (unaudited) | 6 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of Cash Flows -Three and Six  Months Ended June 30, 2009 and 2008 (unaudited) | 7 |
|                                                   |                   |   |   |
|                                                   |                   | Notes to Consolidated Financial Statements | 8 |
|                                                   |                   |   |   |
|                                                   | Item 2.                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 25 |
|                                                   |                   |   |   |
|                                                   | Item 3.                | Quantitative  and Qualitative Disclosures About Market Risk | 44 |
|                                                   |                   |   |   |
|                                                   | Item 4.                | Evaluation of  Disclosure Controls and Procedures | 44 |
|                                                   |                   |   |   |
| Part II -                                         | Other Information:     | 45 |
|                                                   |                   |   |   |
|                                                   | Item 1.                | Legal Proceedings | 45 |
|                                                   |                   |   |   |
|                                                   | Item 4.                | Submission of  Matters to a Vote of Security Holders | 45 |
|                                                   |                   |   |   |
|                                                   | Item 6.                | Exhibits | 45 |
|                                                   |                   |   |   |
| SIGNATURE                                              | 46                     |

 

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**CAUTIONARYSTATEMENT ABOUT FORWARD-LOOKING STATEMENTS**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 27A of the Securities Exchange Act of 1933 and Section 21Eof the Securities Exchange Act of 1934 that relate to future events or ourfuture financial performance. In addition, other statements we may make fromtime to time, such as press releases, oral statements made by our officials andother reports that we file with the Securities and Exchange Commission may alsocontain such forward-looking statements. Undue reliance should not be placed onthese statements 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 the forward-looking statements. In some cases, you canidentify forward-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, but are not limited to:

 

·                  our ability to create stockholder value;

 

·                  potential inability to comply withcovenants in our debt agreements;

 

·                  our ability to successfully complete therestructuring of our indebtedness;

 

·                  our future compliance with debt covenantsand actions we may take with respect thereto;

 

·                  economic changes nationally or in localmarkets, including changes in consumer confidence, volatility of mortgage interestrates and inflation;

 

·                  continued or increased downturn in thehomebuilding industry;

 

·                  statements about our strategies, plans,objectives, goals, expectations and intentions;

 

·                  information relating to anticipated operatingresults, financial resources, changes in revenues, changes in profitability,interest expense, growth and expansion;

 

·                  the impact of demographic trends and supplyconstraints on the demand for and supply of housing;

 

·                  housing market conditions in the geographicmarkets in which we operate;

 

·                  the number and types of homes and number ofacres of land that we may develop and sell;

 

·                  our ability to deliver homes from backlog;

 

·                  the timing and outcomes of regulatoryapproval processes or administrative proceedings, which may result in delays inthe land entitlement, development, construction, or the opening of newcommunities;

 

·                  our ability to secure materials andsubcontractors;

 

·                  our ability to produce the liquidity andcapital necessary to service our debt, fund operations, and expand and takeadvantage of future opportunities if current market conditions persist orbecome more pronounced;

 

·                  our cost of and ability to access additionalcapital;

 

·                  our ability to realize the value of our netoperating loss carry forwards;

 

·                  our ability to continue relationships withcurrent or future partners;

 

·                  the effectiveness and adequacy of ourdisclosure and internal controls;

 

·                  the impact of recent accountingpronouncements; and

 

·                  stock market valuations.

 

Any or all of the forward-looking statements included in this reportand in any other reports or public statements made by us are not guarantees offuture performance and may turn out to be inaccurate. This can occur as aresult of incorrect assumptions or as a consequence of known or unknown risksand uncertainties. These risks and uncertainties include the competitiveenvironment in which we operate; local, regional and national economicconditions; the effects of the current national credit market crisis, inflationand the 

 

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recession;our ability to comply with the covenants and amortization schedules containedin our revolving and term loan agreements; the demand for homes; adverse marketconditions that could result in additional inventory impairments, including anoversupply of unsold homes and declining home prices, among other things;declines in consumer confidence; increases in competition; fluctuations ininterest rates and the availability of mortgage financing; mortgage foreclosurerates; the availability and cost of land for future growth; the availability ofcapital, including access under our existing credit facilities; uncertaintiesand fluctuations in capital and securities markets; changes in tax laws andtheir interpretation; legal proceedings; the ability of customers to financethe purchase of homes or sell existing homes; the availability and cost oflabor and materials; the amount of our debt and the impact of restrictivecovenants in our loan agreements; adverse weather conditions; domestic andinternational political events; geopolitical risks and the uncertaintiescreated by terrorist attacks; the effects of governmental regulation, includingregulations concerning development of land, the home building industry, salesand customer financing processes, and the environment; and other risksdiscussed in our filings with the Securities and Exchange Commission. Manyfactors mentioned in this report or in other reports or public statements madeby us, such as government regulation and the competitive environment, will beimportant in determining our future performance. Consequently, actual resultsmay differ materially from those that might be anticipated from ourforward-looking statements. You should not place undue reliance on any of theseforward-looking statements because they are based on current expectations orbeliefs regarding future events or circumstances, which involve known andunknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from any futureresults, performances or achievements expressed or implied by theseforward-looking statements.

 

Althoughwe believe that our strategies, plans, objectives, goals, expectations andintentions reflected in, or suggested by these forward-looking statements arereasonable given current information available to us, we can give no assurancethat any of them will be achieved. Forward-looking statements speak only as ofthe date they are made. We undertake no obligation to publicly update anyforward-looking statements, whether as a result of new information, futureevents or otherwise.  However, any furtherdisclosures made on related subjects in our subsequent reports on Forms 10-K,10-Q and 8-K should be consulted.

 

Theseforward-looking statements should be considered in light of the informationincluded in this report and our other filings with the Securities and ExchangeCommission, including, without limitation, the “Risk Factors” and 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, 2008. You shouldalso read the following “Consolidated Financial Statements” and the relatednotes.

 

Weassume no, and hereby disclaim any, obligation to update any of the foregoingor any other forward-looking statements, whether as a result of newinformation, future events, changed circumstances or any other reason after thedate of this Form 10-Q. We nonetheless reserve the right to make suchupdates from time to time by press release, periodic report or other method ofpublic disclosure without the need for specific reference to this Form 10-Qor any other report filed by us. No such update shall be deemed to indicatethat other statements not addressed by such update remain correct or create anobligation to provide any other updates.

 

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**PART I - FINANCIAL INFORMATION**

 

**Item1.  Financial Statements.**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                   | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                    |       | $                       | 10.0       |                        | $          | 2.3 |   |
| Restricted cash                                                                                                                              |       | 3.3                     |       | 5.4                         |       |
| Real estate inventories                                                                                                                      |       | 251.7                   |       | 260.7                       |       |
| Deferred tax assets                                                                                                                          |       | 21.6                    |       | 37.1                        |       |
| Other assets, net                                                                                                                            |       | 4.0                     |       | 7.0                         |       |
|                                                                                                                                         |       |                    |       |                        |       |
|                                                                                                                                         |       | $                       | 290.6      |                        | $          | 312.5 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                    | ** ** | ** **              | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                 |       |                    |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                     |       | $                       | 6.0        |                        | $          | 5.0 |   |
| Senior secured project revolver                                                                                                              |       | 80.4                    |       | 74.4                        |       |
| Senior secured term loan                                                                                                                     |       | 102.3                   |       | 107.4                       |       |
| Model home financing                                                                                                                         |       | 22.5                    |       | 22.5                        |       |
| Other project debt                                                                                                                           |       | 11.1                    |       | 38.9                        |       |
| Other liabilities                                                                                                                            |       | 8.9                     |       | 8.8                         |       |
|                                                                                                                                         |       |                    |       |                        |       |
| Total liabilities                                                                                                                            |       | 231.2                   |       | 257.0                       |       |
|                                                                                                                                         |       |                    |       |                        |       |
| Commitments and contingencies                                                                                                                |       |                    |       |                        |       |
|                                                                                                                                         |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                   |       |                    |       |                        |       |
| Common Stock—$.05 par value; 13,500,000 shares  authorized; 10,995,902 and 10,870,902 shares issued and outstanding,  respectively |       | .5                      |       | .5                          |       |
| Excess Stock—$.05 par value; 13,500,000 shares  authorized; no shares outstanding                                                       |       | —                  |       | —                      |       |
| Additional paid-in capital                                                                                                                   |       | 59.4                    |       | 59.4                        |       |
| Retained earnings (accumulated deficit)                                                                                                      |       | 2.3                     |       | (1.6                        | )          |
| Accumulated other comprehensive loss                                                                                                         |       | (2.8                    | )          | (2.8                        | )          |
| Total stockholders’ equity                                                                                                              |       | 59.4                    |       | 55.5                        |       |
|                                                                                                                                         |       |                    |       |                        |       |
|                                                                                                                                         |       | $                       | 290.6      |                        | $          | 312.5 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2009**                                        | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                    | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | $                                               | 10.5       |                                          | $          | 10.4 |   | $ | 23.3 |   | $ | 15.4 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Costs of sales:                               |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | 8.6                                             |       | 8.2                                           |       | 17.4 |   | 12.1 |   |
| Loss on impairment of real estate inventories |       | —                                          |       | 5.0                                           |       | 3.2 |   | 5.0 |   |
|                                          |       | 8.6                                             |       | 13.2                                          |       | 20.6 |   | 17.1 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Gross operating (loss) profit                 |       | 1.9                                             |       | (2.8                                          | )          | 2.7 |   | (1.7 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general and administrative expenses  |       | 1.0                                             |       | 1.9                                           |       | 2.5 |   | 3.5 |   |
| Interest expense                              |       | .1                                              |       | —                                        |       | .8 |   | — |   |
| Gain on debt restructuring                    |       | —                                          |       | —                                        |       | (20.7 | ) | — |   |
| Income from unconsolidated joint ventures     |       | —                                          |       | (.1                                           | )          | — |   | (.1 | ) |
| Other expense, net                            |       | .3                                              |       | .6                                            |       | .7 |   | 1.2 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Income (loss) before income taxes             |       | .5                                              |       | (5.2                                          | )          | 19.4 |   | (6.3 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Income tax expense (benefit)                  |       | 7.8                                             |       | (2.1                                          | )          | 15.5 |   | (2.5 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net income (loss)                             |       | $                                               | (7.3       | )                                             | $          | (3.1 | ) | $ | 3.9 |   | $ | (3.8 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net earnings (loss) per common share:         |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted                             |       | $                                               | (.66       | )                                             | $          | (.28 | ) | $ | .36 |   | $ | (.35 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Common equivalent shares:                     |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted                             |       | 11.0                                            |       | 10.9                                          |       | 11.0 |   | 10.9 |   |

 

See theaccompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                                      | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2009**                                      | ** ** | **2008** | ** ** |
|                                                                                            |       |                                          |       |   |   |
| Cash flows from operating activities:                                                           |       |                                          |       |   |   |
| Net income (loss)                                                                               |       | $                                             | 3.9        |   | $ | (3.8 | ) |
| Adjustments to reconcile net income (loss) to cash  provided by (used in) operating activities: |       |                                          |       |   |   |
| Gain on debt restructuring (Note 7)                                                             |       | (20.7                                         | )          | — |   |
| Model homes depreciation                                                                        |       | .2                                            |       | .5 |   |
| Stock-based compensation expense                                                                |       | —                                        |       | .1 |   |
| Distributions from unconsolidated joint ventures                                                |       | —                                        |       | .1 |   |
| Equity in earnings of unconsolidated joint  ventures                                            |       | —                                        |       | (.2 | ) |
| Loss on change in fair value of derivative  instrument                                          |       | —                                        |       | .2 |   |
| Deferred taxes                                                                                  |       | 15.5                                          |       | (2.5 | ) |
| Gains on sales of real estate inventories                                                       |       | (5.9                                          | )          | (3.3 | ) |
| Loss on impairment of real estate inventories                                                   |       | 3.2                                           |       | 5.0 |   |
| Proceeds from sale of real estate inventories, net                                              |       | 22.6                                          |       | 14.9 |   |
| Investments in real estate inventories                                                          |       | (16.1                                         | )          | (21.7 | ) |
| Changes in assets and liabilities:                                                              |       |                                          |       |   |   |
| Decrease in other assets                                                                        |       | 2.0                                           |       | — |   |
| Increase (decrease) in accounts payable, accrued  and other liabilities                         |       | 3.0                                           |       | (6.0 | ) |
|                                                                                            |       |                                          |       |   |   |
| Cash provided by (used in) operating activities                                                 |       | 7.7                                           |       | (16.7 | ) |
|                                                                                            |       |                                          |       |   |   |
| Cash flows from investing activities:                                                           |       |                                          |       |   |   |
| Investments in unconsolidated joint ventures                                                    |       | —                                        |       | (.3 | ) |
| Change in restricted cash                                                                       |       | .4                                            |       | .1 |   |
|                                                                                            |       |                                          |       |   |   |
| Cash provided by (used in) investing activities:                                                |       | .4                                            |       | (.2 | ) |
|                                                                                            |       |                                          |       |   |   |
| Cash flows from financing activities:                                                           |       |                                          |       |   |   |
| Borrowings of senior secured project revolver                                                   |       | 22.1                                          |       | 33.2 |   |
| Repayments of senior secured project revolver                                                   |       | (16.1                                         | )          | (21.2 | ) |
| Repayments of senior secured term loan                                                          |       | (5.1                                          | )          | (3.3 | ) |
| Borrowings of other project debt                                                                |       | —                                        |       | 1.0 |   |
| Repayments of other project debt                                                                |       | (1.1                                          | )          | (6.3 | ) |
| Deferred financing costs                                                                        |       | (.2                                           | )          | (.4 | ) |
|                                                                                            |       |                                          |       |   |   |
| Cash provided by (used in) financing activities                                                 |       | (.4                                           | )          | 3.0 |   |
|                                                                                            |       |                                          |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                           |       | 7.7                                           |       | (13.9 | ) |
|                                                                                            |       |                                          |       |   |   |
| Cash and cash equivalents - beginning of period                                                 |       | 2.3                                           |       | 24.3 |   |
|                                                                                            |       |                                          |       |   |   |
| Cash and cash equivalents - end of period                                                       |       | $                                             | 10.0       |   | $ | 10.4 |   |
|                                                                                            |       |                                          |       |   |   |
| Supplemental disclosures of cash flow information:                                              |       |                                          |       |   |   |
| Cash paid during the period for income taxes                                                    |       | $                                             | .1         |   | $ | — |   |
|                                                                                            |       |                                          |       |   |   |
| Supplemental disclosures of non-cash investing and  financing activities:                       |       |                                          |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories                |       | $                                             | 1.2        |   | $ | .5 |   |
| Decrease in project debt and accrued liabilities  due to debt restructuring                     |       | $                                             | 28.7       |   | $ | — |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATED FINANCIAL 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, 2008 and the current year’s previouslyissued Quarterly Report on Form 10-Q. Intercompany accounts andtransactions have been eliminated.

 

The results for interim periods are not necessarily indicative of the resultsto be expected for the full year. This report contains forward-lookingstatements. Readers are cautioned that any such forward-looking statements arenot guarantees of future performance and involve risks and uncertainties thatactual events or results may differ materially from those described herein as aresult of various factors, including without limitation, the factors discussedgenerally in this report.

 

**Note 2 -Significant Accounting Policies**

 

*Basis of Consolidation*

 

The accompanying consolidated financial statements include the accountsof the Company and all majority-owned and controlled subsidiaries and jointventures. Certain of the Company’s wholly-owned subsidiaries are members injoint ventures involved in the development and sale of residential projects andresidential loan production. The financial statements of joint ventures inwhich the Company has a controlling or majority economic interest (and thus arecontrolled by the Company) are consolidated with the Company’s financial statements.The Company’s investments in unconsolidated joint ventures are accounted forusing the equity method when the Company does not have voting or economiccontrol of the venture operations, as further described in Note 4 to theconsolidated financial statements included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2008. All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

*Liquidity, Debt Compliance and Plans of Management*

 

Continuing negative conditions in the housing and credit markets giverise to uncertainty as to the Company’s present and future ability to meet itsprojected home sale closings and whether modified or new financings can beobtained in order for the Company to meet its debt obligations. The Company,like many other homebuilders, is constantly evaluating potential alternativesregarding its capital structure including, but not limited to, variousstrategies for restructuring existing debt financings and raising additionalcapital. There can be no assurance that the Company will be successful in anyof these endeavors. As weakness in the national credit markets continues, thereis limited availability of financing for small businesses which presentsuncertainty as to the ability of the Company to secure new financing, ifneeded, and the terms of such financing if it is available. The current housingand mortgage markets also present uncertainty as to the Company’s ability toachieve sufficient positive cash flow from operations required to satisfy itsdebt obligations and meet financial covenant requirements. See Notes 4, 5and 7 for further discussion.

 

The Company depends on cash flows generated from operations andavailable borrowing capacity to fund its Brightwater development, and to meetits debt service and working capital requirements. However, the Company’sability to continue to generate sufficient cash flows has been and willcontinue to be adversely affected by continued difficulties in the homebuildingindustry and continued weakness in the California economy. In addition, on September 30,2009 the Company’s borrowing capacity under its senior secured revolving creditagreement (“Revolving Loan”) is scheduled to be reduced to $80 million at atime when the Company expects to need in excess of that amount for theconstruction of new homes at Brightwater.

 

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During the last five months (March — July), the Company hasgenerated 20 net sales orders at Brightwater, increased construction startsduring the second quarter to keep pace with sales orders, and startedconstruction of a limited number of speculative homes which are in greaterdemand in today’s market than contract homes that are constructed over a fiveto seven month period. While sales of the Trails and Sands products, which aregenerally under $1.0 million, have increased during the first half of 2009,sales of the Company’s larger Cliffs and Breakers homes continue to bechallenged by the downturn in the housing market and limitations onjumbo-mortgage financing, which have reduced demand for homes exceeding $1.0million.

 

As a result of the debt repayments made in connection with the December 2008model sale and leaseback transaction, as well as home deliveries through June 30,2009, the Company has met its loan repayment requirement for the senior securedterm loan (“Term Loan”) through September 30, 2009 and, with additionaldeliveries expected during the third quarter, the Company expects to be able topay the amount due on the Revolving Loan on September 30, 2009.  However, due to cash requirements foron-going home construction and scheduled debt amortization, the Company’sability to meet its loan repayment requirements for the Revolving Loan and TermLoan through December 31, 2009 will depend on the results of negotiationswith the Company’s lenders, as discussed below. Based on Brightwater sales thus far in 2009, which have been primarilyfor the smallest Brightwater home product (The Trails), the current product mixof home sales is not expected to generate sufficient cash flow to meet theCompany’s December 31, 2009 scheduled loan repayments of $10.0 millionon the Revolving Loan and $12.3 million on its Term Loan, as described ingreater detail in Notes 5 and 6. Based on current projections of Brightwater closings for the nine monthsending March 31, 2010, the Company does not expect to generate cash from operationsin an amount sufficient to allow it to make the $25 million in loan repaymentsdue on March 31, 2010. In addition, the Company does not expect to be ableto repay the Revolving Loan by its June 30, 2010 maturity date or to makethe $10.0 million Term Loan payment also due on June 30, 2010.

 

Therefore, the Company is scaling back construction of speculativehomes and making further reductions in general and administrative costs inorder to reduce expenditures and retain cash for required expenditures. TheCompany is discussing amendments to its Revolving Loan and Term Loan agreementswith the agent bank for its loan syndicates in order to accommodate Brightwater’spresently anticipated sales volume and product mix, and to provide theliquidity needed to fund construction of additional new homes.  The Company intends to negotiate amendmentsthat will defer the amortization payments due by December 31, 2009,provide an extension of the maturity date of the Revolving Loan, restructurepayments due in 2010 and 2011, and modify the loan covenants of the RevolvingLoan and Term Loan agreements.  TheCompany is striving to complete these amendments during the fourth quarter of2009. In addition, the Company continues to examine potential financial andstrategic alternatives to generate capital from other sources. There can be noassurance that amended or future debt or equity financings will be available tothe Company in an amount sufficient to enable it to meet its obligations or tofund its other liquidity needs, in the event that sufficient cash flow is notgenerated from home sales during the 12 months ending June 30, 2010.

 

While the Company will continue to diligently pursue and evaluatevarious financing alternatives, unless the Company is successful in amendingand extending the terms of the Revolving Loan and Term Loan agreements, or inobtaining new financing, the Company does not believe that its cash, cashequivalents and future real estate sales proceeds will be sufficient to meetits debt obligations due on December 31, 2009, March 31, 2010 and June 30,2010; or to meet anticipated operating and project development costs forBrightwater, and general and administrative expenses for the next12 months.

 

*Subsequent Events*

 

The Company evaluated events through the filing date of this QuarterlyReport on Form 10-Q on August 7, 2009.

 

*Real Estate*

 

Real estate inventories primarily consist of homes available for sale,homes under construction and lots under development and are carried at thelower of cost or fair value less costs to sell. The estimation process involvedin the determination of fair value is inherently uncertain because it requiresestimates as to future events and market conditions. Such estimation processassumes the Company’s ability to complete development and dispose of its realestate properties in the ordinary course of business based on management’spresent plans and intentions. Economic, market, and environmental conditionswill affect management’s development and marketing plans. In addition, theimplementation of such development and marketing plans could be affected by theavailability of future financing for development and construction activities.Accordingly, the ultimate values of the Company’s real estate properties dependupon future economic and market conditions, and the availability of financing.

 

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The cost of sales of multi-unit projects is computed using the relativesales value method. Interest and other carrying costs are capitalized to realestate projects during their development and construction period.

 

*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of real estate inventories andother long-lived assets in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets”* (“SFAS 144”),which requires that long-lived assets be reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. As provided by SFAS 144, impairment isevaluated by comparing an asset’s carrying value to the undiscounted estimatedcash flows expected from the asset’s operations and eventual disposition. Ifthe sum of the undiscounted estimated future cash flows is less than thecarrying value of the asset, an impairment loss is recognized based on the fairvalue of the asset. If impairment occurs, the fair value of an asset forpurposes of SFAS 144 is deemed to be the amount a willing buyer would paya willing seller for such asset in a current transaction. Additionally, asappropriate, the Company identifies alternative courses of action to recoverthe carrying value of its long-lived assets and evaluates all likelyalternatives under a probability-weighted approach as described inSFAS 144.

 

During the three and six months ended June 30, 2009, the Companyrecorded inland project impairment charges totaling zero and $3.2 million,respectively. See Note 3 — Real Estate Inventories.

 

In accordance with SFAS 144, in developing estimated future cashflows for impairment testing for its real estate inventories, the Company hasincorporated its own market assumptions including those regarding home prices,sales pace, sales and marketing costs, infrastructure and home-building costs,and financing costs regarding real estate inventories. The Company’sassumptions 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 the Company builds and sells homes. These assumptions cansignificantly affect the Company’s estimates of future cash flows. For thosecommunities deemed to be impaired, the Company determines fair value based ondiscounted estimated future cash flows using estimated absorption rates foreach community.

 

The estimation process involved in the determination of value isinherently uncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and disposition of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions. Economicand market conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. Accordingly, the amount ultimately realized from suchproject may differ materially from current estimates and the project’s carryingvalue.

 

The Company believes that accounting for the impairment of long-livedassets is a critical accounting policy because the valuation analysis involvesa number of assumptions that may differ from actual results and the impact ofrecognizing impairment losses has been material to the Company’s consolidatedfinancial statements. The critical assumptions in the Company’s evaluation ofreal estate inventories impairment included projected sales prices, anticipatedsales pace within each community, and applicable discount rates, any of whichcould change materially as economic conditions change.

 

*Fair Value of Financial Instruments*

 

The Company adopted SFAS No. 157, *“FairValue Measurements,”* as it applies to financial assets andliabilities measured at fair value on a recurring basis on January 1, 2008and as it applies to non-financial assets and liabilities on January 1,2009. The carrying amounts of the Company’s financial instruments includingcash and cash equivalents, restricted cash, accounts payable and accruedliabilities, model home financing, and other liabilities approximate theirrespective fair values because of the relatively short period of time betweenorigination of the instruments and their expected realization. The carryingamounts of the Company’s senior secured project revolver and senior securedterm loan approximate fair value as of June 30, 2009 given the September 2008amendments and the frequency of the LIBOR and prime margins repricings. Thecarrying amounts of the project debt approximate fair value given its currentmaturities.

 

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The following table summarizes the Company’s fair value measurements atJune 30, 2009 (in millions):

 
| **Description**         | ** ** | **Fair Value  Hierarchy** | ** ** | **Fair Value (a)** | ** ** | **Impairment Charges for  the Six Months Ended  June 30, 2009** | ** ** |
|-------------------------|------------|---------------------------|------------|--------------------|------------|----------------------------------------------------------------------|------------|
| Real estate inventories |       | Level 3                   |       | $                  | 3.0        |                                                                 | $          | 3.2 |   |
|                         |            |                           |            |                    |            |                                                                      |            |  |  |

 

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(a)   Amount represents theaggregate fair value for a community where the Company recognized a noncashinventory impairment charge during the period, as of the date that the fairvalue measurement was made. The carrying value for this community may havesubsequently increased or decreased from the fair value reflected due toactivity that has occurred since the measurement date.

 

In accordance with SFAS 144, real estate inventories with a carryingvalue of $6.2 million were determined to be impaired during the three monthsended March 31, 2009, and were written down to their estimated fair valueof $3.0 million, resulting in an impairment charge of $3.2 million. See “*Impairment of Real Estate Inventories*” above and Note 3 —Real Estate Inventories.

 

*Income Taxes*

 

The Company accounts for income taxes on the liability method, inaccordance with SFAS No. 109, “*Accountingfor Income Taxes.”* Deferred income taxes are determined based on thedifference between the financial statement and tax bases of assets andliabilities, using enacted tax rates in effect in the years in which thesedifferences are expected to reverse. The liability method requires anevaluation of the probability of being able to realize the future benefitsindicated by deferred tax assets. A valuation allowance is established againsta deferred tax asset if, based on the available evidence, it is “more likelythan not” that such asset will not be realized. The realization of a deferredtax asset ultimately depends on the existence of sufficient taxable income ineither the carryback or carryforward periods under tax law. The Companyevaluates on a quarterly basis, whether a valuation allowance should beestablished based on its determination of whether it is “more likely than not”that some portion or all of the deferred tax assets will be realized. In theCompany’s assessment, appropriate consideration is given to all positive andnegative evidence related to the realization of the deferred tax assets. Thisassessment considers, among other matters, the nature, frequency and magnitudeof current and cumulative income and losses, forecasts of future profitability,the duration of statutory carryback or carryforward periods, the Company’sexperience with operating loss and tax credit carryforwards not expiringunused, and tax planning alternatives.

 

The Company’s assessment of the need for a valuation allowance on itsdeferred tax assets includes assessing the likely future tax consequences ofevents that have been recognized in the Company’s consolidated financialstatements or tax returns. The Company bases its estimate of deferred taxassets and liabilities on current tax laws and rates and, in certain cases, onbusiness plans and other expectations about future outcomes. Changes inexisting tax laws or rates could affect the Company’s actual tax results andits future business results may affect the amount of the Company’s deferred taxliabilities or the valuation of its deferred tax assets over time.

 

Due to uncertainties in the estimation process, particularly withrespect to changes in facts and circumstances in future reporting periods(carryforward period assumptions), it is reasonably possible that actualresults could differ from the estimates used in the Company’s historicalanalyses. The Company’s assumptions require significant judgment because theresidential homebuilding industry is cyclical and is highly sensitive tochanges in economic conditions. The Company’s current assessment of the needfor a valuation allowance is primarily dependent upon utilization of tax netoperating losses in the carryforward period and its future projected income. Ifthe Company’s results of operations are more or less than projected and thereis objectively verifiable evidence to support the realization of a differentamount of its deferred tax assets, an adjustment to the Company’s valuationallowance may be required to reflect greater expected utilization or furtherreduce or eliminate the Company’s deferred tax assets.

 

*Homebuilding Revenues and Cost of Sales*

 

The Company’s homebuilding operation generates revenues from the saleof homes to homebuyers. The majority of these homes are designed to appeal tomove-up homebuyers and are generally offered for sale in advance of theirconstruction. Sales contracts are usually subject to certain contingencies suchas the buyer’s ability to qualify for financing. Revenue from the sale of homesis recognized at the close of escrow when title passes to the buyer and theearnings process is complete. As a result, the Company’s revenue recognitionprocess does not involve significant judgments or estimates. However, theCompany does rely on certain 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. The Company’s constructioncosts are comprised of direct and allocated costs, including estimated costsfor future warranties and indemnities. The Company’s estimates are based on historicalresults, adjusted for current factors.

 

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*Earnings Per Common Share*

 

Earnings per common share is accounted for in accordance with SFAS No. 128,“*Earnings Per Share*.” Basicearnings per common share is computed using the weighted-average number ofcommon shares outstanding for the period. Diluted earnings per common share iscomputed using the weighted-average number of common shares outstanding and thedilutive effect of potential common shares outstanding.

 

*New Accounting Pronouncements*

 

In June 2009, the FASB issued SFAS No. 168, “*The FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles — a replacement of FASB Statement No. 162*”(“SFAS 168”), which establishes the FASB Accounting Standards Codification asthe source of authoritative accounting principles recognized by the FASB to beapplied by nongovernmental entities in the preparation of financial statementsin conformity with generally accepted accounting principles in the UnitedStates of America. SFAS 168 is effective for interim and annual reportingperiods ending after September 15, 2009. The Company does not expect theadoption of SFAS 168 to have a material effect on its consolidated financialstatements.

 

In June 2009, the FASB issued SFAS No. 165, “*Subsequent Events”* (“SFAS 165”),which establishes general standards of accounting and disclosure for eventsthat occur after the balance sheet date but before financial statements areissued or available to be issued. SFAS 165 is applicable for interim and annualperiods ending after June 15, 2009. The adoption of SFAS 165 during thesecond quarter of 2009 did not have a material effect on the Company’sconsolidated financial statements.

 

In April 2009, the FASB issued FASB Staff Position No. 157-4,“*Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly*” (“FSP 157-4”). FSP157-4 (i) affirms that the objective of fair value when the market for anasset is not active is the price that would be received to sell the asset in anorderly transaction; (ii) clarifies and includes additional factors fordetermining whether there has been a significant decrease in market activityfor an asset when the market for that asset is not active; (iii) eliminatesthe proposed presumption that all transactions are distressed (not orderly)unless proven otherwise. FSP 157-4 instead requires an entity to base itsconclusion about whether a transaction was not orderly on the weight of theevidence; (iv) includes an example that provides additional explanation onestimating fair value when the market activity for an asset has declinedsignificantly; and (v) requires an entity to disclose a change invaluation technique (and the related inputs) resulting from the application ofFSP 157-4 and to quantify its effects, if practicable. FSP 157-4 applies to allfair value measurements when appropriate. FSP 157-4 must be appliedprospectively and retrospective application is not permitted. FSP 157-4 iseffective for interim and annual periods ending after June 15, 2009. Theadoption of FSP 157-4 did not have a material effect on the Company’sconsolidated financial statements.

 

In April 2009, the FASB issued FASB Staff Position No. 107-1and APB 28-1, “*Interim Disclosures about Fair Value ofFinancial Instruments*” (“FSP 107-1”). FSP 107-1 amends SFAS No. 107,“*Disclosures about Fair Value of FinancialInstruments*” (“SFAS 107”) to require an entity to providedisclosures about fair value of financial instruments in interim financialinformation. This FSP also amends Accounting Principles Board Opinion No. 28,“*Interim Financial Reporting*” to requirethose disclosures in summarized financial information at interim reportingperiods. Under FSP 107-1, a publicly traded company shall include disclosuresabout the fair value of its financial instruments whenever it issues summarizedfinancial information for interim reporting periods. In addition, an entityshall disclose in the body or in the accompanying notes of its summarizedfinancial information for interim reporting periods and in its financialstatements for annual reporting periods the fair value of all financialinstruments for which it is practicable to estimate that value, whetherrecognized or not recognized in the statement of financial position, asrequired by SFAS 107. FSP 107-1 is effective for interim periods ending after June 15,2009. The Company has adopted FSP 107-1 and provided the required disclosures,as applicable, which did not have a material effect on the Company’sconsolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161, “*Disclosures About Derivative Instruments and HedgingActivities—an amendment of FASB Statement No. 133”* (“SFAS 161”),which expands the disclosure requirements for derivative instruments andhedging activities required by Statement No. 133. The adoption of SFAS 161on January 1, 2009 did not have a material effect on the Company’sconsolidated financial statements.

 

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In December 2007, the FASB issued SFAS No. 160, *“Noncontrolling Interests in Consolidated FinancialStatements—an amendment of ARB No. 51”* (“SFAS 160”), whichclarifies 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 withinequity.  The adoption of SFAS 160 on January 1,2009 did not have a material effect on the Company’s consolidated financialstatements.

 

In September 2006, the FASB issued SFAS No. 157, *“Fair Value Measurements”* (“SFAS 157”),which defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. In February 2008, the FASB issued FASB Staff Position No. 157-2,“*Effective Date of FASB Statement No. 157*,”(“FSP 157-2”) which delayed for one year the applicability of SFAS 157’sfair value measurements to certain nonfinancial assets and liabilities. TheCompany adopted SFAS 157 as it applies to financial assets and liabilitieson January 1, 2008 and as it applies to non-financial assets andliabilities on January 1, 2009. The adoption of SFAS 157 and FSP157-2 did not have a material effect on the Company’s consolidated financialstatements.

 

**Note 3 — Real Estate Inventories**

 

Real estate inventories primarily consist of homes under constructionand lots under development at Brightwater in coastal Orange County and threeinland communities in Riverside and Los Angeles counties. As of June 30,2009, real estate inventories aggregated 512 lots and homes, including 21 modelhomes, four standing inventory homes completed and unsold, eight homescompleted and in escrow, and eight homes under construction and in escrow. Realestate inventories at June 30, 2009 included $239.7 million recordedfor 293 lots and homes under development and 17 model homes held under afinancing lease at the Brightwater community which is located on a 105-acreparcel on a mesa north of the Bolsa Chica wetlands in Huntington Beach,California. An additional $12.0 million in real estate inventories isrecorded for 202 lots and homes at the Company’s subsidiaries’ various inlandprojects. The Company capitalizes carrying costs including interest andproperty taxes, as well as direct construction costs, to real estateinventories during the development and construction period.

 

On March 31, 2009, a subsidiary of Hearthside Homes completed adeed-in-lieu transaction for the Hearthside Lane project in the City of Coronawith the investor that had acquired the project loan secured by the propertyfrom IndyMac Federal Bank. The subsidiary conveyed the remaining 134 finishedlots to the investor in exchange for a $28.7 million reduction in the notebalance and retained seven homes which secured the then remaining note balanceof $2.5 million. See Note 8 for additional discussion.

 

The Brightwater planned community offers a broad mix of home choices,averaging 2,860 square feet and ranging in size from 1,710 square feet to 4,339square feet. The community also has 37 acres of open space and conservationarea. With 349 homes permitted on 68 acres, the resulting low-density planequates to approximately five homes per acre, consistent and compatible withthe neighboring Huntington Beach communities.

 

The Company began selling homes at The Trails and The Sands in August 2007and began delivering homes for these products during December 2007.Construction of models for the larger two products, The Cliffs and TheBreakers, was completed in January 2008. In February 2008, theCompany began selling homes to homebuyers who had previously registered on theBrightwater priority list. The Company held a grand opening for these productsin March 2008 and began delivering homes at The Cliffs and The Breakersneighborhoods during the third quarter of 2008.

 

The Company recorded inland project impairment charges totaling $zeroand $3.2 million, respectively, during the three and six months ended June 30,2009, compared with $5.0 million during the same periods in 2008. Theimpairment charges recorded during the first quarter of 2009 relate to asubsidiary’s Woodhaven project in Beaumont, California and reflect recent salesprice reductions by large competitors and the Company’s current intention toattempt to negotiate a short-sale for the property in 2009 in order to maximizeutilization of tax loss carryforwards in 2010 and future years. 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, which may involve turnover of theproperty securing the loan to the lender. In accordance with EITF Issue No. 91-2,“*Debtor’s Accounting for Forfeiture of Real EstateSubject to a Nonrecourse Mortgage*” (“EITF 91-2”), and a FASB staffinterpretation thereof, the Company reduced the carrying value of the Woodhavenreal estate project to its estimated fair value during the first quarter of2009. If the Woodhaven project is sold to a third party or transferred to thelender in full settlement of the loan without further recourse or obligation,the Company will recognize a gain as a result of debt cancellation. However,there can be no assurance that the lender will agree to a consensualresolution.

 

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During 2007 and 2008, the Company recorded impairment chargesaggregating $67.0 million related to five of its 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 actualresults if market conditions change. As required by SFAS 144, shouldmarket conditions deteriorate in the future or other events occur that indicatethe carrying amount of the Company’s real estate inventories may not berecoverable, the Company will reevaluate the expected cash flows from eachproject to determine whether any additional impairment exists at any point intime.

 

Capitalizedinterest is allocated to real estate inventories when incurred and charged tocost of sales when the related property is delivered. Changes in capitalizedinterest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                        | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
| Capitalized interest, beginning of period |       | $                                               | 35.7       |                                          | $          | 29.6 |   | $ | 37.3 |   | $ | 26.2 |   |
| Interest incurred and capitalized         |       | 3.2                                             |       | 3.5                                           |       | 7.2 |   | 7.5 |   |
| Charged to cost of sales                  |       | (1.4                                            | )          | (.8                                           | )          | (2.8 | ) | (1.4 | ) |
| Charged to gain on debt restructuring     |       | —                                          |       | —                                        |       | (4.2 | ) | — |   |
| Capitalized interest, end of period       |       | $                                               | 37.5       |                                          | $          | 32.3 |   | $ | 37.5 |   | $ | 32.3 |   |

 

**Note 4 — Senior Secured ProjectRevolver**

 

On September 30, 2008, the Company entered into the thirdamendment to the $100 million Revolving Loan with KeyBank NationalAssociation, as a lender and as agent for the other loan syndicate members. TheRevolving Loan is secured by a first trust deed on the Brightwater project, andstock pledges of the Company’s material subsidiaries.

 

As of June 30, 2009 and December 31, 2008, $80.4 million and$74.4 million, respectively, was outstanding under the Revolving Loan atweighted average rates of 3.58% and 5.09%, respectively, based upon the Company’selected rates. As of June 30, 2009, the undrawn availability was$4.5 million. Currently, one syndicate member holding 12% of the loan isin default. The terms of the facility prevent a defaulting member fromreceiving repayments and due to frequent repayments related to home deliveries,this has not affected the Company’s ability to draw funds as needed to date.However, approximately $600,000 of the undrawn availability relates to thedefaulting member.

 

Outstanding advances bear interest based on the following loan-to-valuegrid:

 
| **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 the average, outstandingdaily balance and is paid monthly. Interest incurred on the Revolving Loan forthe three and six months ended June 30, 2009 was $1.0 million and $2.2million, respectively, at weighted-average interest rates of 3.67% and 3.74%,respectively. Interest incurred on the Revolving Loan for the three and sixmonths ended June 30, 2008 was $1.0 million and $1.9 million,respectively, at weighted-average interest rates of 4.79% and 5.18%,respectively. As of August 3, 2009, the Revolving Loan weighted averageinterest rate is 3.55%. Rate options based on the Prime rate and various LIBORterms are available.

 

During March 2009, the Company exercised its option to extend theRevolving Loan maturity from September 15, 2009 to June 30, 2010. TheRevolving Loan is subject to mandatory repayments and commitment reductionsbased on 40% of the $600,000 release price on the first 70 units closed at theBrightwater project, and 40% of the $1 million release price per unitthereafter. As of June 30, 2009, the Company has delivered 63 of the first70 homes. These mandatory repayments

 

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areapplicable to the commitment reductions set forth below. The commitment amountunder the Revolving Loan reduces to zero by the final maturity as follows (inmillions):

 
| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|----------------|------------|
| June 30, 2009      |       | $                         | —     |           | 84.9       |   |
| September 30, 2009 |       | 4.9                       |       | 80.0           |       |
| December 31, 2009  |       | 10.0                      |       | 70.0           |       |
| March 31, 2010     |       | 10.0                      |       | 60.0           |       |
| June 30, 2010      |       | 60.0                      |       | —         |       |
|                         |            |                           |            |                |            |  |

 

During the three and six months ended June 30, 2009, the Companydelivered nine and 14 homes, respectively, at Brightwater and made mandatoryrepayments on the Revolving Loan of $2.2 million and $3.4 million,respectively. As of June 30, 2009, the Company has made cumulative mandatoryrepayments for the Revolving Loan of $15.1 million, reflecting 63 homesdelivered to date, including the 17 model homes included in the sale-leasebacktransaction completed on December 31, 2008. Availability under the$100.0 million Revolving Loan has been reduced to $84.9 million.  As of September 30, 2009, availabilityunder the Revolving Loan will be reduced to $80.0 million.  Due to cash requirements for on-going homeconstruction, the Company’s ability to meet its loan repayment requirement throughSeptember 30, 2009 is dependent upon sales and home delivery results overthe remainder of the quarter ended September 30, 2009.

 

As of June 30, 2009 and December 31, 2008, approximately$900,000 and $1.4 million, respectively, of deferred loan fees and closingcosts related to the Revolving Loan are included in other assets and amortizedover the life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories and charged tocost of sales when the related homes are delivered.

 

Under the Revolving Loan, the Company is required to comply with anumber of covenants, including the following financial covenants which theCompany considers to be the most restrictive of all of the debt covenants:

 

·                  A leverage covenant thatprohibits the Company’s ratio of consolidated total liabilities to consolidatedtangible net worth from exceeding a maximum ratio of 2.5 to 1.0. Thecalculation of the covenant excludes impairment charges related to the HearthsideLane project in Corona and the Las Colinas project in Lancaster and valuationallowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Revolver Loan debt outstanding to borrowingbase value from exceeding a maximum ratio:

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

 

·                  A minimum consolidatedtangible net worth covenant of $80 million, excluding impairment charges forthe Hearthside Lane and Las Colinas projects and valuation allowances ondeferred tax assets.

 

As of June 30, 2009, the Company’s consolidated total liabilitiesare $231.2 million, tangible net worth after excluding the 2008 HearthsideLane and Las Colinas impairment charges and valuation allowances on deferredtax assets is $105.9 million and the leverage ratio is 2.18. Theloan-to-value ratio is 27% and the Company is in compliance with the covenantsof the Revolving Loan as of June 30, 2009.

 

While the sales pace at Brightwater is close to expectations at thebeginning of 2009, the mix is heavily weighted towards smaller homes which aregenerating less liquidity than the larger homes.  Therefore, the Company does not expect to beable to meet its mandatory principal repayments due on December 31, 2009,as well as March 31, 2010, or fully re-pay the Revolving Loan by itsmaturity date on June 30, 2010 from cash flow from operations.  The Company is preparing to commence negotiationswith its lenders to restructure the Revolving Loan and Term Loan to deferscheduled amortization payments in order to accommodate the expected sales paceof the Brightwater project and provide sufficient liquidity to fundconstruction. The Company is striving to complete amendments to its RevolvingLoan and Term Loan during the fourth 

 

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quarterof 2009.  There can be no assurance thatthe Company will be successful in any of these endeavors. As weakness in thenational credit markets continues, there is limited availability of financingfor small businesses, which presents significant uncertainty as to the abilityof the Company to secure additional financing, and the terms of such financingif available. The current housing and mortgage markets also present uncertaintyas to the ability of the Company to achieve sufficient positive cash flow fromoperations required to satisfy its debt obligations.

 

**Note 5 —Senior Secured Term Loan**

 

On September 30, 2008, the Company entered into the thirdamendment to the five-year, $125 million Term Loan with KeyBank NationalAssociation, as a lender and as agent for the other loan syndicate members. TheTerm Loan is secured by a second trust deed on the Brightwater project, and ageneral 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.  In January 2009, a major shareholder ofthe Company purchased 6% of the Term Loan from certain members of the loansyndicate.

 

As of June 30, 2009 and December 31, 2008, $102.3 million and$107.4 million, respectively, was outstanding under the Term Loan at ratesof 4.33% and 6.38%, respectively, based upon the Company’s elected rates. Theoutstanding balance currently bears interest based on the followingloan-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              |       |

 

Interest on the facility is calculated on the average, outstandingdaily balance and is paid monthly. Interest incurred on the Term Loan for thethree and six months ended June 30, 2009 was $1.5 million and$3.2 million, respectively, at weighted-average interest rates of 4.41%and 4.74%, respectively. Interest incurred on the Term Loan for the three andsix months ended June 30, 2008 was $1.8 million for both periods, atweighted-average interest rates of 5.34% and 5.90%, respectively. As of August 3,2009, the Term Loan interest rate is 4.30%. Rate options based on Prime rateand various LIBOR terms are available.

 

The Term Loan is subject tomandatory repayments and commitment reductions based on 60% of the $600,000release price on the first 70 units closed at the Brightwater project, and 60%of the $1 million release price per unit thereafter. As of June 30,2009, the Company has delivered 63 of the first 70 homes.

 

These mandatory repayments are applicable to the commitment reductionsset forth below. Debt repayments are due as follows until the final maturity onSeptember 15, 2011 (in millions):

 
| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **End of Period  Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|-------------------------------|------------|
| June 30, 2009      |       | $                         | —     |                          | 102.3      |   |
| September 30, 2009 |       | —                    |       | 102.3                         |       |
| December 31, 2009  |       | 12.3                      |       | 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                          |       |
| September 15, 2011 |       | 12.5                      |       | —                        |       |
|                         |            |                           |            |                               |            |  |

 

During the three and six months ended June 30, 2009, the Companydelivered nine and 14 homes, respectively, at Brightwater and made mandatoryrepayments on the Term Loan of $3.2 million and $5.0 million,respectively. As of June 30, 2009, the Company has made cumulativemandatory repayments for the Term Loan of $22.7 million, reflecting 63homes delivered to date, including the 17 model homes included in thesale-leaseback transaction completed on December 31, 2008. Availabilityunder the $125.0 million Term Loan has been reduced to$102.3 million.  The Company has metthe minimum debt repayments as of September 30, 2009, which requires themaximum outstanding under the Term Loan to be $105.0 million.

 

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As of June 30, 2009 and December 31, 2008, approximately $2.4million and $3.1 million, respectively, of deferred loan fees and closingcosts related to the Term Loan are included in other assets and amortized overthe life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories, and charged tocost of sales when the related homes are delivered.

 

Under the Term Loan, the Company is required to comply with a number ofcovenants, including the following financial covenants which the Companyconsiders to be the most restrictive of all of the debt covenants:

 

·                  A leverage covenant thatprohibits the Company’s ratio of consolidated total liabilities to consolidatedtangible net worth from exceeding a maximum ratio of 2.50 to 1.0. Thecalculation of the covenant excludes impairment charges related to theHearthside Lane project in Corona and the Las Colinas project in Lancaster andvaluation allowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Term Loan debt outstanding to borrowing basevalue from exceeding a maximum ratio:

 
| **Reporting Period**                                 | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| 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                                | %          |

 

·                  An interest coveragecovenant which prohibits the Company’s ratio of EBITDA to interest incurredfrom being less than the following:

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

 

·                  A minimum consolidatedtangible not worth covenant of $80 million, excluding impairment charges forthe Hearthside Lane and Las Colinas projects and valuation allowances ondeferred tax assets.

 

As of June 30, 2009, the Company’s consolidated total liabilitiesare $231.2 million, tangible net worth after excluding the 2008 HearthsideLane and Las Colinas impairment charges and valuation allowances on deferredtax assets is $105.9 million and the leverage ratio is 2.18. The loan-to-valueratio is 62% and the Company is in compliance with covenants of the Term Loanas of June 30, 2009.

 

While the sales pace at Brightwater is close to expectations at thebeginning of 2009, the mix is heavily weighted towards smaller homes which aregenerating less liquidity than the larger homes.  Therefore, the Company does not expect to beable to make the mandatory repayments due on December 31, 2009, as well asMarch 31, 2010, under the Term Loan and the Revolving Loan. The Company ispreparing to commence negotiations with its lenders to restructure theRevolving Loan and Term Loan to defer scheduled amortization payments in orderto accommodate the expected sales pace of the Brightwater project and providesufficient liquidity to fund construction. The Company is striving to completeamendments to its Revolving Loan and Term Loan during the fourth quarter of2009. There can be no assurance that the Company will be successful in any ofthese endeavors. As weakness in the national credit markets continues, there islimited availability of financing for small business, which presentsuncertainty as to the ability of the Company to secure additional financing,and the terms of such financing, if available. The current housing and mortgagemarkets also present uncertainty as to the ability of the Company to achievesufficient positive cash flow from operations required to satisfy its debtobligations.

 

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**Note 6—Model Home Financing**

 

On December 31, 2008, the Company entered into a sale-leasebacktransaction for 17 model homes at its Brightwater project with an unrelatedthird party investor for $25.0 million, consisting of $22.5 millioncash, $2.0 million deferred and payable in two years provided there hasnot been a significant decrease in the value of the model homes, and $500,000payable for conversion of the model homes for sale to homebuyers upontermination of the lease agreement. The Company has an option to repurchase themodel homes after at least 90% of the homes of the respective model type havesold, but no earlier than January 1, 2011. If the Company does notrepurchase the models, after the lessor receives a 16% internal rate of return,the Company is entitled to receive 75% of any profit resulting from the sale ofthe models at the end of the lease. Due to the Company’s repurchase option andprofit participation which constitute continuing interest, and in accordancewith SFAS 98, “*Accounting for Leases*,”the Company accounted for the transaction as a financing transaction ratherthan as a sale and recorded model home financing debt of $22.5 million.

 

The Company utilized $10.2 million of the model home financingproceeds to make mandatory repayments under the Revolving Loan and the TermLoan, thereby reducing the payments that would have been due in 2009. TheCompany used an additional $10.7 million of the proceeds to reduce thebalance outstanding under the Revolving Loan, which amount can be re-borrowedunder the terms of the Revolving Loan agreement. See Notes 4 and 5 foradditional discussion.

 

In connection with the sale-leaseback transaction, the Company agreedto assign the first $500,000 of proceeds from sales commissions resulting fromthe eventual resale of the model homes, or additional purchase price received,to its partner in the Oxnard joint venture, which is an affiliate of theinvestor who purchased the model homes. The $500,000 payment representsadditional capital contributions that become payable upon the dissolution ofthe joint venture.

 

The model home lease allows the Company to utilize the 17 model homesfor continued customer display for a term of three years expiring December 31,2011, with two renewal options for one year each. As required by the leaseagreement, the Company prepaid six months of rent totaling $1.6 million onDecember 31, 2008 and will make monthly rent payments thereafter of$262,500 per month beginning July 2009 through December 2010, and$279,167 per month in 2011. The future minimum lease payments under the termsof the related lease agreement are as follows (in millions):

 

| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2009     |       | $          | 1.6        |   |
| 2010     |       | 3.2        |       |
| 2011     |       | 3.3        |       |
| Total    |       | $          | 8.1        |   |

 

**Note 7 —Other Project Debt**

 

In conjunction with the acquisition of single-family residential lots,the Company’s homebuilding subsidiary, Hearthside Homes, Inc. and itssubsidiaries, entered into construction loan agreements with commercial banks.These loan facilities finance a portion of land acquisitions and the majorityof the construction of infrastructure and homes. Each loan facility requires aguaranty of project completion and an environmental indemnity by HearthsideHomes, Inc., however these loans are nonrecourse to California CoastalCommunities, Inc. The loans are secured by first trust deeds and bear aninterest rate of prime to prime plus one-half. The Lancaster loan facilitycurrently bears interest at the default rate of 10.25% and has a minimuminterest rate of 7.25%. During the six months ended June 30, 2009,Hearthside Homes, Inc. and its subsidiaries did not enter into any newloan facilities.

 

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The following amounts were available and outstanding under these loanfacilities as of June 30, 2009 and December 31, 2008 ($ in millions):

 
| ** **     | ** ** | ** **                   | ** ** | **Interest**          | ** ** | ** **                | ** **                                   | **Number**                | ** ** | ** **         | ** ** | **Outstanding at** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------|------------|---------------------------|----------------------------------------------|---------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Rate   at 6/30/09** | ** ** | **Lender**                | ** **                                   | **of Lots /  Homes** | ** ** | **Maturity  Date** | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|           |       |                         |       |                  |       |                      |                                         |                      |       |               |       |                    |       |   |   |
| Lancaster      |       | $                            | 14.0       | (1)                   | 10.25      | %                         | IndyMac  Federal Bank/ OneWest of California |                      | 55         |               | 9/30/08    |                    | $          | 2.4 |   | $ | 2.7 |   |
| Beaumont       |       | 17.9                         |       | 3.50                  | %          | Comerica  Bank       |                                         | 68                        |       | 9/17/09            |       | 6.6                     |       | 7.0 |   |
| Corona-Hellman |       | 2.5                          |       | 3.25                  | %          | Third  party investor (2) |                                         | 6                         |       | 3/31/10            |       | 2.1                     |       | 29.2 |   |
|           |       |                         |       |                  |       |                      |                                         |                      |       |               |       |                    |       |   |   |
|           |       |                         |       |                  |       |                      |                                         |                      |       |               |       | $                       |  11.1 |   | $ | 38.9 |   |
|                |            |                              |            |                       |            |                           |                                              |                           |            |                    |            |                         |            |  |  |  |  |  |

 

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(1)          The Lancaster loan facilityis currently in default as discussed below.

(2)          IndyMac Federal Bank soldthe Corona-Hellman loan facility to a third party investor in December 2008.

 

On March 31, 2009, a subsidiary of Hearthside Homes, Inc.completed a deed-in-lieu transaction with a third party investor that acquiredthe Corona-Hellman loan facility (“Hellman Loan”) from IndyMac Federal Bank in December 2008.  As a result of this transaction, the Companyrecognized a pre-tax gain on debt restructuring of $20.7 million. Thetransaction was accounted for in accordance with SFAS 15, “*Accountingby Debtors and Creditors for Troubled Debt Restructurings*” and thegain was determined as follows (in millions):

 
| Net book value of real  estate inventories |   | $    | 6.2    |   |
|--------------------------------------------|--------|------|--------|--------|
| Restricted cash assigned  to investor      |   | 1.7  |   |
| Transaction costs                          |   | 0.1  |   |
| Total consideration                        |   | 8.0  |   |
| Debt balance at  March 31, 2009       |   | 26.7 |   |
| Accrued interest and  property taxes       |   | 2.0  |   |
| Carrying amount of debt  settled in full   |   | 28.7 |   |
| Gain on debt restructuring                 |   | $    | (20.7  | )      |

 

The Hellman Loan is nonrecourse to California Coastal Communities, Inc.;however, Hearthside Homes guaranteed payment of the debt. The subsidiaryconveyed the remaining 134 finished lots to the investor in exchange for a$28.7 million reduction in the note balance and retained seven completed homeswhich secured the then remaining note balance of $2.5 million. The modifiednote bears interest at the prime rate and matures on March 31, 2010.Subject to certain conditions, after all seven homes have been sold, theguaranty of this debt by Hearthside Homes will be released and any remainingbalance on the note will be cancelled. The subsidiary also assigned $1.7million of restricted cash related to the project to the investor as part ofthe transaction.  During the secondquarter of 2009, the subsidiary delivered one home and delivered threeadditional homes during July 2009. The Company expects to deliver the remainingthree homes during August, at which time the related debt will have been paidin full.

 

In June 2009, a subsidiary of Hearthside Homes received a noticeof default relating to the loan facility which matured on September 30,2008 for development of the Las Colinas project in Lancaster. The Companyexpects that the lender will foreclose on the property (one completed home and54 lots) secured by the loan in the second half of 2009. The loan isnonrecourse to California Coastal Communities, Inc.; however, thesubsidiary’s parent, Hearthside Homes, Inc., guaranteed payment of thedebt. During the third quarter of 2008, in accordance with EITF 91-2 and aFASB staff interpretation thereof, the Company reduced the carrying value ofthe Las Colinas real estate project to its estimated fair value. During January 2009,the Company delivered one home at the Las Colinas project resulting in a loanrepayment of $291,000 and, as of August 3, 2009, the final completed modelhome is in escrow.

 

Hearthside Homes’ subsidiary is continuing its efforts to negotiate aconsensual resolution of the Lancaster loan with OneWest of California, whichrecently acquired IndyMac Federal Bank. Any such resolution will likely involveturnover of the property securing the loan to the lender. If the property istransferred to the lender in full settlement of the loan without furtherrecourse or obligation, the Company expects to recognize a nominal gain as aresult of debt cancellation. However, there can be no assurance that the lenderwill agree to a consensual resolution of the loan default.

 

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A subsidiary of Hearthside Homes is currently engaged in discussionswith the lender for its Woodhaven project in Beaumont, California. 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, which may involve a short sale of theproperty securing the loan. In accordance with EITF 91-2, and a FASB staffinterpretation thereof, the Company reduced the carrying value of the Woodhavenreal estate project to its estimated fair value during the first and secondquarters of 2009. If the Woodhaven project is sold on behalf of the lender infull settlement of the loan without further recourse or obligation, the Companywill recognize a gain as a result of debt cancellation. However, there can beno assurance that the lender will agree to a consensual resolution.

 

**Note 8 - Other Liabilities**

 

Otherliabilities were comprised of the following (in millions):

 
| ** **                                         | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                      |       | $                       | 5.8        |                        | $          | 5.9 |   |
| Home warranty reserves                             |       | 1.8                     |       | 1.7                         |       |
| Contingent indemnity and environmental obligations |       | 1.1                     |       | 1.1                         |       |
| Capital contribution due to joint venture          |       | 0.5                     |       | 0.5                         |       |
| Unamortized discount                               |       | (.3                     | )          | (.4                         | )          |
|                                               |       | $                       | 8.9        |                        | $          | 8.8 |   |

 

Contingent indemnity and environmental obligations primarily reflectreserves before related discount (recorded pursuant to Fresh-Start Reporting in1997) for contingent indemnity obligations for businesses disposed of by formeraffiliates and unrelated to the Company’s current operations.

 

*HomeWarranty 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 warranty reserve activity ispresented below (in millions):

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2009**                                        | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
| Balance at beginning of period       |       | $                                               | 1.7        |                                          | $          | 2.1 |   | $ | 1.7 |   | $ | 2.3 |   |
| Provision                            |       | .1                                              |       | —                                        |       | .1 |   | — |   |
| Adjustment due to change in estimate |       | —                                          |       | —                                        |       | — |   | (.1 | ) |
| Payments                             |       | —                                          |       | (.1                                           | )          | — |   | (.2 | ) |
| Balance at end of period             |       | $                                               | 1.8        |                                          | $          | 2.0 |   | $ | 1.8 |   | $ | 2.0 |   |

 

**Note 9 -Income Taxes**

 

The following is a summary of thetax expense (benefit):

 
| ** **                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                                        | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
| Current taxes                               |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes                              |       | .2                                              |       | (2.1                                          | )          | 7.9 |   | (2.5 | ) |
| Valuation allowances on deferred tax assets |       | 7.6                                             |       | —                                        |       | 7.6 |   | — |   |
| Income tax expense (benefit)                |       | $                                               | 7.8        |                                          | $          | (2.1 | ) | $ | 15.5 |   | $ | (2.5 | ) |

 

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The net deferredtax balance at June 30, 2009 and December 31, 2008 is primarilycomposed of federal net operating losses (“NOLs”). During the second quarter of2009, the Company concluded it was not “more likely than not” that theCompany would be able to generate sufficient taxable income in 2009, 2010 and2011 to realize certain expiring federal NOLs and recorded valuation allowancesof $7.6 million. While the Company expects to report profitable operationsfor 2009, it expects to report a taxable loss due to tax losses recognized upondispositions of inland properties. These tax losses were previously recognizedfor financial statement purposes when impairment losses were recorded. TheCompany monitors the availability of real estate for development ateconomically viable prices, market conditions and other objectively verifiableeconomic factors affecting the Company’s operations, as well as other positiveand negative factors, as it assesses valuation allowances against its deferredtax assets. The most critical uncertainties are whether the Company will beable to continue selling homes at its Brightwater project using currentlyprojected sales prices and absorption rates in light of the continuingdeterioration in the housing and credit markets and the timing of dispositionsof inland properties and the related recognition of losses for tax reportingpurposes.

 

The federal NOLs available as of June 30, 2009 were approximately$151 million. The amount of federal NOLs which expire if not utilized is$11 million in 2009, $49 million in 2010, $42 million in 2011,zero in 2012 and 2013, and $49 million thereafter.

 

The Internal Revenue Code (the “Code”) generally limits theavailability of NOLs if an ownership change occurs within any three-year periodunder 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 (4.48% as of August 2009)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 21% as of August 3,2009, 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 June 30, 2009 may not be fully realizable.

 

In September 2006, the Company’s Board of Directors suspendedenforcement of the Company’s charter documents that restrict stockholders fromacquiring more than 5% of the outstanding shares of Common Stock. The Boarddetermined that such restrictions were not currently required to preserve thetax benefits of the Company’s $151 million of NOLs. While the Companyremains subject to Code section 382, which limits the availability of NOLsin the event of an ownership change, the Company would have five years from thedate of any such ownership change to recognize its built in gains and utilizeits NOLs. However, the Board may reinstitute the 5% ownership limitation ifrequired by currently unanticipated events.

 

Pursuant to SFAS 123(R), the Company has elected to recognizestock option deductions on the tax law ordering method, which maximizes therealization of the stock option deductions in the current year. While theCompany 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 additional paid-incapital.

 

*Uncertain Tax Positions*

 

The Company adopted the provisions of FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007. As aresult of the implementation of FIN 48, during the first quarter of 2007,the Company recorded a $5.1 million decrease in deferred tax assets forunrecognized tax benefits, which was offset by an increase in deferred taxassets of $1.8 million for assets re-evaluated as recognizable. The netchange in deferred tax assets of $3.3 million was recorded as a cumulativeeffect of a change 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.

 

Of the Company’s unrecognized tax benefits of $5.1 million at June 30,2009, $100,000 would decrease the Company’s effective tax rate if recognized.The Company does not expect that its unrecognized tax benefits willsignificantly fluctuate or change within 12 months of the reporting date.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of June 30, 2009,the Company has not recorded any interest or penalties related to unrecognizedtax benefits, due to the substantial NOLs available.

 

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Certain tax year filings remain open to Federal and Californiaexamination, which are the Company’s primary tax jurisdictions. The years 2005through 2008 and the years 2004 through 2008 remain open for Federal andCalifornia purposes, respectively, for which the Company utilized NOLsgenerated between 1990 and 1993 to offset taxable income. Except as reserved,the Company expects to utilize Federal NOLs generated between 1994 and 1997 andin 1999, 2006 and 2007 in future years. In addition, the Company expects toutilize California NOL generated in 2007 in future years.

 

**Note 10 -Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company has outstanding performance and surety bonds, for thebenefit of city and county jurisdictions, related principally to itsobligations for site improvements and fees at various projects as of June 30,2009. At this time, the Company does not believe that a material amount of anycurrently outstanding performance or surety bonds will be called. The Companybelieves that all work required to be completed at this time under the bondingagreements has been completed and, therefore, draws upon these bonds, if any,will not have a material effect on the Company’s financial position, results ofoperations or cash flows.

 

*Legal Proceedings*

 

There are various lawsuits and claims pending against the Company andcertain subsidiaries. In the opinion of the Company’s management, ultimateliability, if any, will not have a material adverse effect on the Company’sfinancial condition or results of operations.

 

*California Department of Toxic Substances Control*

 

In October 2006, the California Department of Toxic SubstancesControl (“DTSC”) filed a civil complaint against the Company’s HearthsideResidential Corp. subsidiary (“HRC”) in the Federal District Court for theSouthern Division of the Central District of California The DTSC’s complaintrequests that HRC pay for approximately $1.0 million of costs incurred bythe DTSC, together with interest on that amount, primarily in connection withthe oversight and remediation of PCB contamination found on residentialproperties never owned by HRC adjacent to a 43-acre site where HRC completedthe removal of PCB contaminated soil during September 2005. HRC’sremediation process was approved by the DTSC in December 2005 when itissued a final acceptance of the remediation work. The complaint also seeks anorder for HRC to pay any future costs which may be incurred in connection withfurther remediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has received invoices from DTSC seekingreimbursement for these costs; however, HRC contends, based upon advice ofcounsel, that it is not responsible for such costs because neither HRC nor anyaffiliate ever developed or built the neighboring residential properties,neither HRC nor any affiliate generated the contamination, the contaminationdid not emanate from the 43-acre site that HRC remediated, and, even if thecontamination did emanate from the 43-acre site, it did not do so while HRCowned the site. Furthermore, HRC has also disputed such charges due to the factthat DTSC improperly submitted its bill. The Company’s subsidiary is vigorouslydefending itself in this matter. Therefore, the Company has not accrued for anyof DTSC’s approximately $1.0 million of claims related to theseresidential properties.

 

Prior to the commencement of trial that was scheduled for December 2,2008, the District Court ruled that HRC can be held liable as a “current owner”of the site under applicable law. HRC applied to have that ruling certified forappeal. In March 2009, the District Court granted permission to hear HRC’sappeal and the appellate process commenced. HRC currently expects that it couldtake three to six months to complete the appellate process. There can beno assurance that HRC will receive a favorable ruling that it is not deemed tobe a current owner of the site.  Once theappellate process is complete, the parties will return to the District Courtwithin 30 to 60 days to commence a trial.

 

See Note 8 for a discussion of other contingencies.

 

*Corporate Indemnification Matters*

 

The Company and its former affiliates have, through a variety oftransactions effected since 1986, disposed of several assets and businesses,many of which are unrelated to the Company’s current operations. By operationof law or contractual indemnity provisions, the Company may have retainedliabilities relating to certain of these assets and businesses. There isgenerally 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

 

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**Note 11 —Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

The 1993 Stock Option/Stock Issuance Plan (“1993 Plan”) was approved atthe 1994 Annual Meeting of Stockholders, reserving 7.5 million shares eachof Series A Preferred Stock and Class A Common Stock for issuance toofficers, key employees and consultants of the Company and its subsidiaries andthe non-employee members of the Board of Directors (the “Board”). On April 28,1997, in connection with the Recapitalization, a new class of Common Stockreplaced the Series A Preferred Stock and Class A Common Stock, andthe Compensation Committee of the Board authorized the grant of stock optionsfor 759,984 shares, equivalent at that time to 6% of the Company’s fullydiluted equity, for certain 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 2009 and 2008, the Company issued a total of 125,000shares and 15,817 shares, respectively, of its common stock to threeindependent directors in 2009 and four independent directors in 2008, under theDirector Fee Program, which is a component of the 1993 Plan. These restrictedshares vest at a rate of 25% per quarter during 2008 and 2009, respectively. OnOctober 16, 2008, one of the Company’s independent directors resigned fromthe Board and forfeited 878 unvested restricted shares.

 

The Company did not grant any options during the six months ended June 30,2009 and 2008. Pursuant to SFAS 123(R), the Company recorded $35,000 and$53,000 of compensation expense during the six months ended June 30, 2009and 2008, respectively, which is reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993 plan for the six monthsended June 30, 2009 follows:

 
| ** **                                   | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                  |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                      |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                    |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, June 30                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.60 years |   |
|                                         |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at June 30 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.60 years |   |
|                                         |       |                        |       |                                  |       |                                  |       |
| Available for future grants at June 30  |       | 221,794                     |       |                                  |       |                                  |       |

 

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(a)           Adjusted for specialdividend of $12.50

 

As of June 30, 2009, there were 17,500 options outstanding with aweighted-average exercise price of $21.58 (ranging from $13.35 to $25.99) and aweighted-average remaining life of 6.60 years. All outstanding stockoptions are fully vested. The aggregate intrinsic value of all outstanding,fully-vested and exercisable stock options at June 30, 2009 was zero.Following the January 2009 issuance of 125,000 shares of restricted stockunder the Director Fee Program, there are 221,794 options available for futuregrants.

 

The Company adopted SFAS 123(R) in the first quarter of 2006using the modified prospective method. Similar to SFAS 123, which theCompany adopted in 2003, SFAS 123(R) requires the cost of allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair valuesmeasured 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 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 temporary differencesas prescribed by SFAS 109, ***“****Accounting forIncome 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

 

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ultimatelyrealized on the tax return, if any, will be charged to income tax expense whenthe restrictions lapse or stock options are exercised or expire unless theCompany has an available additional paid-in capital pool (“APIC Pool”), asdefined pursuant to SFAS 123(R). The Company is required to assess whetherthere is an available APIC Pool when the stock options are exercised or expire.

 

SFAS 123(R) also amended SFAS 95, *“Statement of Cash Flows,”* to requirecompanies to change the classification in the statement of cash flows of anytax benefits realized upon the exercise of stock options or issuance ofnonvested share unit awards in excess of that which is associated with theexpense recognized for financial reporting purposes. These amounts are requiredto be reported as a financing cash inflow rather than as a reduction of incometaxes paid in operating cash flows.

 

In addition, SFAS 123(R) requires a calculation to establishthe beginning pool of excess tax benefits, or the additional paid-in capitalpool (“APIC pool”), available to absorb any tax deficiencies recognized afterthe adoption of SFAS 123(R). The Company has elected the alternativetransition method, which includes a simplified calculation method, set forth inFASB Staff Position No. FAS 123(R)-3, *“Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards”* to calculate its beginning APIC pool.

 

The Company estimates the fair value of its stock options using theBlack-Scholes option pricing model (the “Option Model”). The Option Modelrequires the use of subjective and complex assumptions, including the option’sexpected term and the estimated future price volatility of the underlyingstock, which determine the fair value of the share-based awards. The Company’sestimate of expected term is determined based on the weighted-average period oftime that options granted are expected to be outstanding considering currentvesting schedules and the historical exercise patterns of the existing optionplan. The expected volatility assumption used in the Option Model is based onhistorical volatility on traded options on the Company’s stock in accordancewith guidance provided in SFAS 123(R) and SAB 107. The risk-freeinterest rate used in the Option Model is based on the yield of U.S. Treasurieswith a maturity closest to the expected term of the Company’s stock options.

 

**Note 12 — Stockholders’ Equity**

 

As of June 30,2009, total stockholders’ equity is $59.4 million, reflecting beginningstockholders’ equity of $55.5 million and net income of $3.9 million during thesix months ended June 30, 2009.

 

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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, 2008.

 

**Overview of California Coastal Communities, Inc.and Recent Industry Events.**

 

We are a residential land development and homebuilding company withproperties owned or controlled primarily in Orange County, California and alsoin two other Southern California counties (Los Angeles and Riverside). Ourprimary asset is a 356-home luxury coastal community known as Brightwater inHuntington Beach, California. Our principal activities include:

 

·                  obtaining zoning and otherentitlements for land we own;

 

·                  improving the land forresidential development; and

 

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

 

Once our residential land is entitled, we may build homes, sellunimproved land to other developers or homebuilders, sell improved land tohomebuilders, or participate in joint ventures with other developers, investorsor homebuilders to finance and construct infrastructure and homes. The majorityof our homes are designed to appeal to move-up homebuyers and are generallyoffered for sale in advance of their construction.

 

During the first quarter of 2009, our homebuilding subsidiary,Hearthside Homes, Inc., completed a deed-in-lieu transaction for theHearthside Lane project in Corona, California and recognized a pre-tax gain ondebt restructuring of $20.7 million. In exchange for a $28.7 million reductionin the loan balance secured by the project, the subsidiary conveyed theremaining 134 finished lots to the lender. The subsidiary retained sevencompleted homes which secure the remaining note balance which is due in March 2010.Subject to certain conditions, after all seven homes have been delivered, theguaranty of this debt by Hearthside Homes will be released and any remainingbalance on the note will be cancelled. As of June 30, 2009, one home had been delivered and the remainingbalance on the note was $2.1 million. As of August 3, 2009, the subsidiaryhas delivered three of the remaining six homes. The final three homes in escroware expected to be delivered by the end of August, at which time the note willhave been repaid in its entirety.

 

A subsidiary of Hearthside Homes is currently in the process ofdisposing the remaining assets of the Woodhaven project in Beaumont,California. The loan securing the property is non-recourse to CaliforniaCoastal Communities, Inc., however, the subsidiary’s parent, HearthsideHomes, Inc., guaranteed payment of the debt. Hearthside Homes’ subsidiaryis attempting to negotiate a consensual resolution of the loan with the lender,which may involve a bulk sale of the property securing the loan. However, therecan be no assurance that the lender will agree to a bulk sale in fullsatisfaction of the outstanding debt.

 

We depend on cash flows generated from operations and availableborrowing capacity to fund our Brightwater development, and to meet our debtservice and working capital requirements. However, our ability to continue togenerate sufficient cash flows has been and will continue to be adverselyaffected by continued difficulties in the homebuilding industry and continuedweakness of the California economy. In addition, on September 30, 2009 ourborrowing capacity under the revolving loan is scheduled to be reduced to $80million at a time when we expect to need in excess of that amount for theconstruction of new homes at Brightwater.

 

During the last five months (March — July), we have generated 20net sales orders at Brightwater, increased construction starts during thesecond quarter to keep pace with sales orders, and started construction of alimited number of speculative homes which are in greater demand in today’smarket than contract homes that are constructed over a five to seven monthperiod. While sales of the Trails and Sands products, which are generally under$1.0 million, have increased during the first half of 2009, sales of our largerCliffs and Breakers homes continue to be challenged by the downturn in thehousing market and limitations on jumbo-mortgage financing, which have reduceddemand for homes exceeding $1.0 million. Since the majority of sales anddeliveries at Brightwater have been for The Trails, which is the smallestBrightwater home product, the current product mix of home sales is not expectedto generate sufficient cash flow to meet our December 31, 2009 scheduledloan repayments of $10.0 million on the revolving loan and $12.3 millionon the term loan, as described in greater detail in Notes 5 and 6 to “Item1. Financial Statements” above.

 

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As a result of the debt repayments made in connection with the December 2008model homes sale and leaseback transaction, as well as home deliveries through June 30,2009, we have met our loan repayment requirement for the term loan through September 30,2009 and, with additional deliveries expected during the third quarter, weexpect to be able to pay the amount due on the revolving loan on September 30,2009.  However, due to cash requirementsfor on-going home construction and scheduled debt amortization, our ability tomeet the loan repayment requirements for the revolving loan and term loanthrough December 31, 2009 will depend on the results of negotiations withour lenders, as discussed below. Based on Brightwater sales thus far in 2009,which have been primarily for the smallest Brightwater home product (TheTrails), the current product mix of home sales is not expected to generatesufficient cash flow to meet the December 31, 2009 scheduled loanrepayments of $10.0 million on the revolving loan and $12.3 million on the termloan, as described in greater detail in Notes 5 and 6. Based on currentprojections of Brightwater closings during the nine months ending March 31,2010, we do not expect to generate cash from operations in an amount sufficientto allow us to make the $25 million in loan repayments due on March 31,2010. In addition, we do not expect to be able to repay the Revolving Loan byits June 30, 2010 maturity date or to make the $10.0 million Term Loanpayment also due on June 30, 2010.

 

Therefore, we are scaling back construction of speculative homes andmaking further reductions in general and administrative costs in order toreduce expenditures and retain cash for required expenditures. As discussed ingreater detail below in “Liquidity and Capital Resources,” we are discussingamendments to our revolving and term loans with the agent bank for our loansyndicates in order to accommodate Brightwater’s presently anticipated salesvolume and product mix, and to provide the liquidity needed to fundconstruction of additional new homes. We intend to negotiate amendments thatwill defer the amortization payments due by December 31, 2009, provide anextension of the maturity date of the revolving loan, restructure payments duein 2010 and 2011, and modify the loan covenants of the revolving loan and termloan agreements. We are striving to complete these amendments during the fourthquarter of 2009. In addition, we continue to examine potential financial andstrategic alternatives to generate capital from other sources. There can be noassurance that amended or future debt or equity financings will be available tous in an amount sufficient to enable us to meet our debt obligations or to fundour other liquidity needs, in the event that sufficient cash flow is notgenerated from home sales during the 12 months ending June 30, 2010.

 

In view of the continuing significant economic downturn in the housingmarket, during the remaining six months of 2009 and continuing into 2010our new home construction will be limited to our 356-home Brightwater projectlocated on the Bolsa Chica mesa in Huntington Beach, California; and ouroperations in other markets will focus on the sale of standing inventory andresolution of certain existing project loans.

 

During the remaining six months of 2009, our primary goals will be to:

 

·                  continue selling anddelivering homes at Brightwater;

 

·                  modify our existing debtsecured by the Brightwater project;

 

·                  continue evaluatingpotential alternatives regarding our capital structure including, but notlimited to, various strategies for restructuring our debt and evaluatingprospects for raising additional capital;

 

·                  complete delivery ofstanding inventories and thereby maximize deliveries and revenues at our otherhomebuilding projects in Los Angeles and Riverside counties;

 

·                  pursue consensual resolutionof a subsidiary’s loan default on one nonperforming inland development projectin Lancaster, California; and

 

·                  pursue a bulk sale of theinland development project in Beaumont, California and negotiate satisfactionof the related subsidiary’s project debt for less than 100% of the principalbalance due on such debt, which matures on September 17, 2009.

 

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

 

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Despite the challenges of the current national homebuilding market andour inland market, we believe the potential for our Brightwater project remainshigh. Brightwater has not been immune to the effects of the unstable mortgageand housing markets; however, that impact appears less severe than the weaknesswe are seeing in our inland markets. We believe that the reduced impact is aresult of Brightwater’s superior coastal location, the extremely limited supplyof new homes on the coast of Southern California and the absence of significantcompetition from other homebuilders in the Huntington Beach market due to thelack of available land for the development of new single family detached homes.We believe that Brightwater is in a location that is difficult to replace andin a market where approvals are increasingly difficult to achieve. We alsobelieve that Brightwater has substantial embedded value that should not besacrificed under current depressed market conditions but, rather, should berealized over time. Finally, we believe that Brightwater’s demographics remainstrong due to the continuing regulation-induced constraints on lot supplies andthe significant number of affluent households along the coast of SouthernCalifornia. Therefore, we remain optimistic about continuing sales atBrightwater.

 

Our total revenues for the three months ended June 30, 2009 and2008 were $10.5 million and $10.4 million, respectively, and $23.3 millionand $15.4 million for the six months ended June 30, 2009 and 2008,respectively. For the three months ended June 30, 2009 and 2008 wedelivered 12 and 15 homes, respectively, and for the six months ended June 30,2009 and 2008 we delivered 19 and 23 homes, respectively. Our total assets asof June 30, 2009 and December 31, 2008 were $290.6 million and$312.5 million, respectively, with Brightwater constituting$239.7 million (82% of total assets) and $238.5 million (76% of totalassets), respectively. Our homebuilding subsidiary, Hearthside Homes, Inc.,has delivered over 2,100 homes to families throughout Southern California sinceits formation in 1994.

 

Prior to obtaining the Coastal Development Permit for our Brightwaterproject in December 2005, we historically maintained a minimal amount ofleverage. In September 2006, we obtained $225 million of debtfinancing, as described in Notes 6 and 7 to “Item 1. Financial Statements”above, which provided $100 million for Brightwater construction and$125 million to fund a $12.50 per share special dividend paid to ourstockholders in September 2006. As of June 30, 2009, we had $216.3million of debt (including the model home financing) against $59.4 millionof book equity.

 

We were formed in 1988 and our executive offices are located at 6Executive Circle, Suite 250, Irvine, California 92614. Our website addressis http://www.californiacoastalcommunities.com and our telephone number is(949) 250-7700. Through our website we make available our annual report onForm 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to these reports filed or furnished pursuant to Section 13(d) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after they are filed with, or furnished to, the Securities andExchange Commission. Copies of our annual report on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K, and amendments tothese reports are available free of charge upon request. In addition, at ourwebsite: http://www.californiacoastalcommunities.com, we post copies of ourSecurities and Exchange Commission filings and press releases, as well ascurrent versions of our code of ethics, audit committee charter and nominatingcommittee charter.

 

**Outlook and Operating Strategy**

 

The financial crisis and economic recession that worsened in 2008 andexacerbated the existing downturn in the homebuilding market, has persistedduring the first six months of 2009. Weakness in the homebuilding environmenthas continued as unemployment increased, the availability of jumbo-mortgagesremains limited and the economic recession continued. Specifically, the creditmarkets and the mortgage industry have been experiencing a period ofunparalleled turmoil and disruption characterized by bankruptcy, financialinstitution failure, consolidation and an unprecedented level of interventionby the United States federal government. While the ultimate outcome of these eventscannot be predicted, it has made it more difficult for homebuyers to obtainacceptable financing. In addition, the supply of new and resale homes in themarketplace remained excessive for the levels of consumer demand, furtherchallenged by an increased number of foreclosed homes offered at substantiallyreduced prices. These pressures in the marketplace resulted in the use ofincreased sales incentives and price reductions in an effort to generate salesand reduce inventory levels by us and many of our competitors.

 

Concern about the state of the economy and the job market continues tonegatively affect consumer confidence, as unemployment rates continued to risein almost all of the metropolitan areas tracked by the U.S. Department ofLabor. The unemployment rate in California was 11.6% at the end of the secondquarter of 2009 compared with 8.7% at the end of 2008, while the unemploymentrate in Orange County was 9.2% in June 2009 compared with 6.5% in December 2008.These adverse conditions have now persisted to varying degrees since thebeginning of 2006 and their impact is reflected in our results for the threeand six months ended June 30, 2009 and 2008.  We believe that the weak demand we areexperiencing, particularly for homes over $1.0 million, reflects homebuyers’reluctance to make a purchasing decision until they are comfortable that homeprice declines are near bottom and that economic conditions have stabilized. Webelieve the current conditions could continue during the remaining six months of2009 and perhaps beyond, and we expect that our operations may sustain periodiclosses until the homebuilding industry and economy as a whole begin to rebound.

 

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Thus far during 2009, the U.S. economy remains in a severe recessionand the homebuilding industry continues to face adverse pressures. Weak buyerconfidence and significantly tighter mortgage lending standards, coupled withan oversupply of new and existing homes for sale (boosted by foreclosures),continue to weigh on the housing market and may cause further deterioration inoperating conditions and sales results. While some positive signs are occurring,such as rising stock markets and reduced number of new unemployment claims, itremains uncertain when the housing market or the broader economy willexperience a meaningful recovery. Actions taken or announced by federal, state, and local governments to supporthousing may soften, but are not expected to reverse, the impact of thesepressures.

 

In addition, the recently enacted California tax credit (which does notcontain income or first-time buyer restrictions and is limited to new homes)appears to have boosted demand somewhat; however, the federal stimulus plan hasnot had much impact on the homebuilding industry due to its income andfirst-time buyer restrictions. As of August 3, 2009, approximately 78% ofthe $100 million in California tax credits has been issued and approximately3,500 additional tax credit applications are being processed, which theCalifornia Franchise Tax Board anticipates will utilize all of the remainingtax credits. Key housing metrics, including starts, new home sales and existinghome sales may continue to weaken or remain stagnant during the remaining sixmonths of 2009. We therefore expect fierce price competition to persist in ourinland markets throughout 2009 and into 2010. This could lead to inventoryimpairments in amounts which we are unable to presently predict or estimate.

 

We are also concerned about the dislocation in the secondary mortgagemarket. We maintain relationships with various mortgage providers and, with fewexceptions, the mortgage providers that furnish our customers with mortgagescontinue to issue new commitments. Our buyers generally have been able toobtain adequate financing but the number of potential home buyers that canqualify under the tightened lending standards has diminished. The availabilityof certain mortgage financing products continues to be constrained due toincreased scrutiny of once commonly-used mortgage products such as sub-prime,Alt-A, and other non-prime mortgage products. Further, the interest rates onjumbo mortgages continue to be significantly greater than interest rates onconforming mortgages, with spreads approximating 1% compared with historicalspreads in the range of only .25% to .35%. Mortgage market liquidity issues andhigher borrowing rates may impede some of our home buyers from closing, whileothers may find it more difficult to sell their existing homes as their buyersface the problem of obtaining a mortgage. Because we cannot predict theshort-and long-term liquidity of the credit markets, we continue to cautionthat, with the uncertainties in these markets, the pace of home sales couldremain depressed or slow further until these markets improve.

 

While standing inventory in our inland markets has been reduced from 14homes as of June 30, 2008 to four homes as of June 30, 2009, theprice reductions and additional incentives have resulted in impairment reservesand significantly reduced gross profits for our inland projects. In response tothe ongoing crisis in the housing market and national credit markets, duringthe first six months of 2009 we have:

 

·                  terminated further inlandmarket construction activity until those markets improve;

 

·                  reduced sales prices andoffered incentives for all of our inland homes in order to eliminate ourstanding inventory;

 

·                  completed a deed-in-lieutransaction for our subsidiary’s Hearthside Lane project in Corona, whichresulted in a pre-tax gain on debt restructuring of $20.7 million;

 

·                  continued negotiations withour lender in an attempt to reach a consensual resolution of our subsidiary’sloan default on the Las Colinas property in Lancaster;

 

·                  offered our remainingBeaumont models and lots for sale to attempt to reach a consensual resolutionof our subsidiary’s loan which matures in September 2009.

 

We expect these changes to produce tangible benefits in the form ofselling, general and administrative expense reductions in future quarters, andwe will continue to reduce these costs. We expect to continue to operate withfewer active communities until we see reasonable signs of a housing marketrecovery. Although we took an inventory impairment charge of $3.2 millionrelated to our inland project in Beaumont, California during the six monthsended June 30, 2009, if market conditions decline further, we may need totake additional charges for inventory impairments in future quarters. Inaddition, our results for the remaining six months of 2009 could be adverselyaffected if general economic conditions do not improve or continue todeteriorate, if consumer confidence remains weak or declines further, if joblosses continue or accelerate, if foreclosures or distressed sales increase, orif consumer mortgage lending becomes less available or more expensive, any orall of which would further diminish the prospects for a recovery in housingmarkets.

 

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We believe that stability in the credit and capital markets and aneventual renewal of confidence in the national economy will play a major rolein any turnaround in the homebuilding and mortgage lending industries. We alsobelieve that a meaningful improvement in housing market conditions will requirethe restoration of consumer and credit market confidence that will support adecision to buy a home, which will in turn require a sustained decrease ininventory levels, price stabilization and reduced foreclosure rates.

 

As the housing market downturn continues to unfold, we continue toadjust and reevaluate our operating strategy in an effort to reduce standinginventories while monitoring our margins and liquidity. Recognizing thechallenges presented by the downturn in the homebuilding market, our currentoperating strategy includes:

 

·                  adjusting our cost structureto today’s market conditions by reducing our headcount and overhead andrebidding subcontracts and materials in line with reduced demand;

 

·                  exercising tight controlover cash flows;

 

·                  changing sales and marketingefforts to generate additional traffic;

 

·                  offering more incentives andprice reductions to reduce standing inventories and achieve acceptable levelsof sales volume and cash flow;

 

·                  ceasing construction andsales efforts at our inland projects where we are unable to generate acceptablelevels of sales volume and cash flow until the housing market improves;

 

·                  limiting construction startsto better align product available for sale with sales activity; and

 

·                  seeking to balance ourshort-term goal of selling homes in a depressed market and our long-term goalof maximizing the value of our communities.

 

During the three and six months ended June 30, 2009, we delivered12 and 19 homes, respectively, and as of August 3, 2009, six additionalhomes have been delivered and 16 additional homes are in escrow, as discussedfurther under “Our Current and Future Homesites” below.

 

Despite the challenges of the current California homebuilding market,we believe the potential for our Brightwater project remains high. Brightwaterhas not been immune to the effects of the unstable mortgage and housingmarkets; however, that impact appears less severe than the weakness we haveseen in our inland markets. Brightwater continues to have significant weeklytraffic and the number of prospects considered to be motivated buyers appearsto have increased since the end of the quarter. We believe that the reducedimpact is a result of Brightwater’s superior coastal location, the extremelylimited supply of new homes on the coast of Southern California and the absenceof significant competition from other homebuilders in the Huntington Beachmarket due to the lack of available land for the development of new singlefamily detached homes. We believe that Brightwater is in a location that isdifficult to replace and in a market where approvals are increasingly difficultto achieve. We also believe that Brightwater has substantial embedded valuethat should not be sacrificed under current depressed market conditions but,rather, should be realized over time. Finally, we believe that Brightwater’sdemographics remain strong due to the continuing regulation-induced constraintson lot supplies and the significant number of affluent households along thecoast of Southern California. Therefore, we remain optimistic about continuingsales at Brightwater.

 

We currently believe that market conditions will continue to bechallenging throughout 2009 and into 2010, as unemployment rates are rising,foreclosure activity continues to be significant and consumer confidencecontinues to be eroded. Although substantially reduced home prices andrelatively low consumer mortgage interest rates for conforming loans haveimproved housing affordability, many potential homebuyers remain tepid aboutpurchasing a home in this unstable economic environment. This demand-sidedynamic, in conjunction with rising foreclosures, is sustaining the oversupplyof unsold new and existing homes and competitive pricing pressures that havegenerated the extremely challenging conditions our industry has experiencedsince the beginning of 2006. We remain hopeful that the federal government’sinitiatives to stabilize the credit markets and restore confidence in thefinancial system and economy will be effective.

 

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In view of the continuing significant economic downturn in the housingmarket, during the remaining six months of 2009 our new home construction willbe limited to our 356-home Brightwater project located on the Bolsa Chica mesain Huntington Beach, California. We expect that continuing operations in ourinland markets will focus on the sale of standing inventory with noconstruction starts. In addition, we are attempting to negotiate a consensualresolution with our lender with respect to a loan default on our subsidiaries’Las Colinas (Lancaster) property and we are attempting to sell our Beaumontproperty in satisfaction of the related project debt. However, there can be noassurance that these strategies or any alternatives will prove successful.

 

While it is difficult to predict when a housing market and economicrecovery will occur, we believe we have responded with the right strategies tothe current and expected near-term housing market environment. We continue toevaluate additional operating and financing strategies to position ourselvesfor future opportunities. Longer term, we believe favorable demographics andpopulation growth in southern California and a continuing desire for homeownership will drive demand for new homes in our markets, which will allow usto capitalize on the recovery in those markets when it comes.

 

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 remaining six months of 2009could be adversely affected if housing, credit market, or general economicconditions deteriorate further, if job losses accelerate, if consumer mortgagelending becomes less available or more expensive, or if consumer confidencecontinues to fall, any or all of which would further diminish the prospects fora recovery in the housing market. We believe that there will not be ameaningful improvement in the housing market until there is a sustaineddecrease in inventory levels, price stabilization, reduced foreclosure rates,greater availability of mortgage financing, and the restoration of consumerconfidence that can support a decision to buy a home.

 

**Our Current and Future Homesites**

 

We currently have on-going Southern California homebuilding projectsin:

 

·                  Orange County in theHuntington Beach area;

 

·                  Riverside County in the Cityof Corona and in the City of Beaumont; and

 

·                  Northern Los Angeles Countyin the City of Lancaster.

 

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The following chart describes our current projects, their location andour lot and standing home inventories as of June 30, 2009:

 
| **Project**                             | ** ** | **Location**      | ** ** | **Models(a)** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|-----------------------------------------|------------|-------------------|------------|---------------|------------|-------------|------------|-------------------------|------------|---------------------|------------|--------------------------|------------|
| Brightwater in Orange County:           |       |              |       |          |       |        |       |                    |       |                |       |                     |       |
| The Trails                              |       | Huntington  Beach |       | 4             |       | 7           |       | —                  |       | 36                  |       | 47                       |       |
| The Sands                               |       | Huntington  Beach |       | 4             |       | —      |       | —                  |       | 61                  |       | 65                       |       |
| The Cliffs                              |       | Huntington  Beach |       | 4             |       | 1           |       | —                  |       | 96                  |       | 101                      |       |
| The Breakers                            |       | Huntington  Beach |       | 5             |       | 1           |       | 2                       |       | 89                  |       | 97                       |       |
| *Subtotal—Orange County*           |       |              |       | 17            |       | 9           |       | 2                       |       | 282                 |       | 310                      |       |
| Inland Empire/Lancaster:                |       |              |       |          |       |        |       |                    |       |                |       |                     |       |
| Hearthside Lane                         |       | Corona            |       | —        |       | 6           |       | —                  |       | —              |       | 6                        |       |
| Woodhaven                               |       | Beaumont          |       | 4             |       | 1           |       | 1                       |       | 62                  |       | 68                       |       |
| Las Colinas                             |       | Lancaster         |       | —        |       | —      |       | 1                       |       | 54                  |       | 55                       |       |
| Other unimproved lots                   |       | Lancaster         |       | —        |       | —      |       | —                  |       | 73                  |       | 73                       |       |
| *Subtotal—Inland Empire/Lancaster* |       |              |       | 4             |       | 7           |       | 2                       |       | 189                 |       | 202                      |       |
| *Total—All Projects*               |       |              |       | 21            |       | 16          |       | 4                       |       | 471                 |       | 512                      |       |

 

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(a)                                  While we soldour 17 Brightwater models to an independent third-party investor on December 31,2008, the transaction is accounted for as a financing and therefore those homesare included in our home inventories.

 

As of June 30, 2009, we had standing inventory of four homes, includingtwo homes at Brightwater and two homes at our inland projects. During thesecond quarter of 2009, net new orders decreased to 20 homes compared with 26homes during the comparable period in 2008 due to fewer active communities atour inland projects. Cancellations as a percentage of new orders were 9% duringthe second quarter of 2009, compared with approximately 19% during thecomparable period in 2008. Backlog as of June 30, 2009 decreased to 16 homescompared with 23 homes as of June 30, 2008 primarily due to the initial ordersin 2008 related to the grand opening at The Breakers and The Cliffs and feweractive inland communities.

 

*Brightwater at Bolsa Chica*

 

Brightwater is our coastal Orange County residential community, locatedon the 110-acre Bolsa Chica mesa in the City of Huntington Beach, approximately35 miles south of downtown Los Angeles. Brightwater was annexed into the Cityof Huntington Beach in 2008. Brightwater offers a broad mix of home choicesaveraging 2,860 square feet and ranging in size from 1,710 square feet to 4,339square feet. Located near Pacific Coast Highway and overlooking the PacificOcean, Huntington Harbor and the recently restored 1,300-acre Bolsa ChicaWetlands, 62 of the 356 homes at Brightwater will have unobstructed oceanand/or wetlands views.

 

Brightwater is the largest property in our portfolio, representingapproximately 95% of our real estate inventories as of June 30, 2009. Thisproject is located on one of the last large undeveloped coastal properties inSouthern California. Brightwater is bordered on the north and east by residentialdevelopment in the City of Huntington Beach and Huntington Harbor, to the southby open space and the 1,300-acre Bolsa Chica wetlands, and to the west by 120acres of publicly-owned conservation land and open space on the lower bench ofthe Bolsa Chica mesa, Pacific Coast Highway, Bolsa Chica State Beach, and thePacific Ocean. Brightwater also has 37 acres of open space and conservationarea.

 

We completed construction of eight model homes at The Trails and TheSands neighborhoods in July 2007, held a grand opening in August 2007 anddelivered the first nine homes in December 2007. We delivered seven homes atThe Trails and The Sands during both three month periods ended June 30, 2009and 2008, respectively, and eight and nine homes during the six months ended June30, 2009 and 2008, respectively. We generated $6.3 million and $7.2 million inrevenue, respectively, during the three months ended June 30, 2009 and 2008 andgenerated gross operating margins of 14.3% and 28.2%, respectively. During thesix months ended June 30, 2009 and 2008, we generated $7.3 million and $9.4million in revenue, respectively, and generated gross operating margins of16.5% and 29.5%, respectively. The decrease in margins reflects pricereductions required to be competitive under current market conditions,additional incentives to sell standing inventory and greater use of third-partyreal estate brokers. Homes at The Trails and The Sands are presently beingoffered at prices ranging from $798,000 to $1.1million. As of August 3, 2009,10 homes are in escrow at The Trails and The Sands.

 

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During January 2008, we completed construction of nine additional modelhomes for The Cliffs and The Breakers and in February 2008 began selling homesto buyers who previously registered on our priority list. We held a grandopening for these neighborhoods in March 2008. These homes are larger than TheTrails and The Sands, ranging from 2,724 to 4,339 square feet. We begandelivering homes at The Cliffs and The Breakers during the third quarter of2008. We delivered two and six homes at The Cliffs and The Breakers during thethree and six months ended June 30, 2009, respectively. We generated revenue of$3.4 million and $14.5 million, respectively, during the three and six monthsended June 30, 2009 and gross operating margins of 23.5% and 31.2%,respectively. Homes at The Cliffs and The Breakers are presently being offeredat prices ranging from $1.4 to $3.2 million for 2,724 to 4,339 square foothomes. As of August 3, 2009, one home is in escrow at The Cliffs.

 

Key facts and assumptions regarding the Brightwater development projectinclude the following:

 

·                  Brightwater is expected toconsist of 356 homes, including 106 homes at The Breakers, 109 homes at TheCliffs, 79 homes at The Sands and 62 homes at The Trails.

 

·                  There are 62 homes atBrightwater which will have unobstructed views of the Pacific Ocean and/or theBolsa Chica wetlands, including 35 homes at The Breakers (five delivered todate), 25 homes at The Cliffs and two homes at The Sands.

 

·                  Build-out of productionhomes, which is subject to market conditions, is currently expected to takeapproximately four years and be completed in 2013.

 

·                  Costs to improve the lotsfrom their raw condition to finished lots, including County permits, Cityannexation fees and school fees, approximate $200,000 per lot.

 

·                  The direct costs (excludingindirect costs such as supervision, overhead, sales and marketing, warranty,insurance, etc.) of building homes at Brightwater are currently expected torange from approximately $125 to $145 per square foot.

 

·                  Indirect costs are expectedto approximate 6% of sales revenues.

 

·                  Based on current sales priceand cost projections, the various Brightwater products are currently expectedto generate gross margins of approximately 9% to 28% due to our low carryingvalue in Brightwater. Gross margins for the larger homes at The Cliffs and TheBreakers are currently expected to approximate 23% to 28%, while gross marginsat The Trails and The Sands are currently expected to approximate 9% to 22%.The decrease in expected margins reflects price reductions required to becompetitive under current market conditions, additional incentives to sellstanding inventory and greater use of third-party real estate brokers.

 

The estimation process involved in the determination of value isinherently uncertain because it requires estimates as to future events andmarket conditions. This estimation process assumes our ability to completedevelopment and disposition of our real estate inventories in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, and environmental conditions may affect our development andmarketing plans. The development of Brightwater depends upon various factors.Accordingly, the amount ultimately realized from the Brightwater project maydiffer materially from our current estimates and the project’s carrying value.

 

*Homebuilding*

 

Our homebuilding operations include active projects in the HuntingtonBeach and the Inland Empire (Beaumont) area of Southern California.  In addition, we are actively selling allremaining inventory in our Corona and Lancaster (Quartz Hill) projects. Wedelivered 12 homes during the three months ended June 30, 2009, compared with15 deliveries during the comparable period of 2008, as detailed below. Duringthe six months ended June 30, 2009 and 2008, we delivered 19 and 23 homes,respectively. We acquired no single-family residential lots during the threeand six months ended June 30, 2009 and 2008 and we have no contracts to acquireland or lots.

 

During the second quarter of 2009, difficult conditions persisted inthe Inland Empire and Lancaster markets. We have reduced sales prices andoffered incentives for all of our homes in these markets in order to reduce ourstanding inventory and remain competitive during this continuing significanteconomic downturn in the housing market. The price reductions and additionalincentives have resulted in reductions to gross profits for Inland Empire homesales.

 

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Following the completion of the deed-in-lieu transaction for theHearthside Lane project in Corona in which Hearthside Homes’ subsidiaryconveyed 134 finished lots to the lender and retained seven completed homes, wereduced sales prices and, of the seven remaining homes, we delivered one homeduring the second quarter of 2009, three homes in July and expect to deliverthe final three homes during August 2009. We delivered two additional homes atour Beaumont project during the second quarter of 2009, and during July 2009 wedelivered one additional home and entered into a sales contract for the oneremaining production home at the Beaumont project. We also entered into a salescontract for the last remaining home at our Las Colinas project in Lancaster.We do not expect any further development at these projects.  As of August 3, 2009, the remaining fivehomes (excluding the four model homes in Beaumont) are in escrow at our inlandprojects.

 

We recorded non-cash impairment charges of $3.2 million for ourWoodhaven project in Beaumont, California during the six months ended June 30,2009, compared with $5.0 million of impairment charges during the comparableperiod in 2008. The current year impairment charge reflects recent sales pricereductions by large competitors and our current intention to attempt tonegotiate a sale of the property in full satisfaction of our project subsidiary’sdebt for less than 100% of the principal balance in 2009 in order to maximizeutilization of tax loss carryforwards in 2010 and future years. The impairmentcharges were calculated based on market conditions and assumptions made bymanagement that reflect current conditions, which may differ materially fromactual results if market conditions change. As required by Statement ofFinancial Accounting Standards No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” (“SFAS 144”), we will reevaluate the expectedcash flows from our homebuilding projects to determine whether any additionalimpairment exists should events or circumstances change.

 

In view of the continuing downturn in the housing market, we currentlyexpect that, during the remaining six months of 2009 and continuing into 2010,our only new home construction will be at our 356-home Brightwater project inHuntington Beach; and that our operations in other markets will involve onlythe sale or transfer of home and lot inventories.

 

Our homebuilding projects are described below:

 

 
| ** **                      | ** ** | ** **        | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Deliveries**   | ** ** |
|---------------------------------|------------|-------------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------------|------------|
| ** **                      | ** ** | ** **        | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Three Months** | ** ** | **Six Months** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | **Ended**        | ** ** | **Ended** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | **Land**        | ** ** | **Commenced**    | ** ** | **Commenced** | ** ** | **June 30,**     | ** ** | **June 30,** | ** ** |
| ** **                      | ** ** | **Location**      | ** ** | **Acquisition** | ** ** | **Construction** | ** ** | **Sales**     | ** ** | **2009**         | ** ** | **2008** | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | ** **      | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater                     |       |              |       |            |       |             |       |          |       |             |       |   |   |   |   |   |   |
| The Trails                      |       | Huntington  Beach |       | 1970            |       | 2006             |       | 2007          |       | 4                |       | 4 |   | 4 |   | 5 |   |
| The Sands                       |       | Huntington  Beach |       | 1970            |       | 2006             |       | 2007          |       | 3                |       | 3 |   | 4 |   | 4 |   |
| The Cliffs                      |       | Huntington  Beach |       | 1970            |       | 2006             |       | 2008          |       | 1                |       | — |   | 2 |   | — |   |
| The Breakers                    |       | Huntington  Beach |       | 1970            |       | 2006             |       | 2008          |       | 1                |       | — |   | 4 |   | — |   |
|                            |       |              |       |            |       |             |       |          |       |             |       |   |   |   |   |   |   |
| *Total Brightwater*             |       |              |       |            |       |             |       |          |       | 9                |       | 7 |   | 14 |   | 9 |   |
| * *                        | * *   | * *          | * *   | * *        | * *   | * *         | * *   | * *      | * *   | * *         | * *   | * * | * * | * * | * * | * * | * * |
| Inland Empire/Lancaster         |       |              |       |            |       |             |       |          |       |             |       |   |   |   |   |   |   |
| Completed Projects              |       | Various           |       | n/a             |       | n/a              |       | n/a           |       | —           |       | 2 |   | — |   | 5 |   |
| Woodhaven                       |       | Beaumont          |       | 2005            |       | 2005             |       | 2006          |       | 2                |       | 2 |   | 3 |   | 3 |   |
| Hearthside Lane                 |       | Corona            |       | 2005            |       | 2005             |       | 2007          |       | 1                |       | 4 |   | 1 |   | 5 |   |
| Quartz Hill                     |       | Lancaster         |       | 2005            |       | 2006             |       | 2006          |       | —           |       | — |   | 1 |   | 1 |   |
| Future Community                |       | Lancaster         |       | 2005            |       | —           | (a)        | —        | (a)        | —           |       | — |   | — |   | — |   |
|                            |       |              |       |            |       |             |       |          |       |             |       |   |   |   |   |   |   |
| *Total Inland Empire/Lancaster* |       |              |       |            |       |             |       | 3             |       | 8                |       | 5 |   | 14 |   |
| * *                        | * *   | * *          | * *   | * *        | * *   | * *         | * *   | * *      | * *   | * *         | * *   | * * | * * | * * | * * | * * | * * |
| *Total Deliveries*              |       |              |       |            |       |             |       |          |       | 12               |       | 15 |   | 19 |   | 23 |   |

 

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(a)                                  To be determinedsubject 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 completedconstruction of nine model homes for The Cliffs and The Breakers in January 2008and began selling homes in February 2008. We delivered nine homes at an averageprice of $1.2 million, or $609 per square foot during 2007 and 23 homes during2008, at an average price of $1.4 million, or approximately $564 per squarefoot. We delivered 14 homes at an average price of $1.6 million (includingthree Breakers view homes averaging $3.2 million) during the six months ended June30, 2009 and two additional homes at the Trails at an average price of $950,000in July 2009. As of August 3, 2009, 11 Brightwater homes (including one homewith wetland and ocean views) are in escrow at an average price of $1.0million, or approximately $518 per square foot, and 18 additional homes arecompleted or under construction and have been released for sale.

 

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*Corona.*  On March 31, 2009, we completed adeed-in-lieu transaction with the investor that purchased the loan secured bythe Hearthside Lane project. In exchange for a $28.7 million reduction in thenote balance and waiver of other costs, we conveyed 134 remaining finished lotsto the investor and assigned approximately $1.7 million of restricted cash. Weretained seven completed homes which secure the then remaining note balance of$2.5 million. During the second quarter of 2009, the subsidiary delivered oneof the remaining seven homes at a price of $400,000. During July 2009, wedelivered three of the remaining six homes at an average price of $426,000 andthe final three homes in escrow are expected to be delivered by the end ofAugust, at which time we will have fully repaid the remaining note balance.

 

*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 15 homesduring 2006 at an average price of $387,000, 10 homes during 2007 at an averageprice of $304,000 and six homes during 2008 at an average price of $269,000. Wedelivered three homes during the six months ended June 30, 2009 at an averageprice of $236,000 and one additional home during July 2009 at a price of$224,000. As of August 3, 2009, one additional home is completed and in escrowand 62 finished lots, along with our four model homes, are being marketed for abulk sale.

 

During the first quarter of 2009, we reduced the carrying value of theBeaumont real estate project to its estimated fair value and recorded animpairment charge of $3.2 million. See “Impairment of Long-Lived Assets”discussion below.

 

*Lancaster.*  In April 2005, we acquired 73 unentitled lotsin the City of Lancaster in northern Los Angeles County through a subsidiary ofHearthside Homes, Inc. We have deferred the construction start for this 73-unitproject, which has no recorded loan, until sales activity in this market hasimproved. The tentative map for this project is prepared, but we have delayedfiling for approval in order to defer the entitlement fees required to be paidat the time of filing.

 

In December 2005, we acquired 77 additional lots in an area known asQuartz Hill in the City of Lancaster. The homes in this community are on 10,000square foot lots and average 3,640 square feet. We opened for sales during July2006 and delivered 21 homes from 2006 through 2008. During the six months endedJune 30, 2009, we delivered one additional home at a price of $330,000. As of August3, 2009, the final model home is in escrow at a price of $240,000. A subsidiaryof Hearthside Homes, Inc. is currently in default on the $2.4 million loanfacility secured by this project and is attempting to negotiate a consensualresolution of the loan default with the lender, OneWest of California whichrecently acquired IndyMac Federal Bank. In June 2009, a subsidiary ofHearthside Homes received a notice of default relating to the loan facilitywhich matured on September 30, 2008 for development of the Las Colinas projectin Lancaster. We expect that the lender will foreclose on the property,including 54 lots and one completed home if the home is not delivered as aresult of the open escrow, in the second half of 2009. The loan is non-recourseto California Coastal Communities, Inc.; however, the subsidiary’s parent,Hearthside Homes, Inc. guaranteed payment of the debt. There can be noassurance that the lender will agree to a consensual resolution.

 

**OxnardLand Development - Unconsolidated Joint Venture**

 

We were unable to renegotiate the land purchase option contracts toreflect current economic conditions and therefore the joint venture did notexercise its extension options during the first quarter of 2009, whicheffectively resulted in abandoning the project. During the year ended December 31, 2008, we recorded an investment lossof $4.6 million related to our investment in the joint venture.

 

**Critical Accounting Policies and Estimates**

 

In the preparation of our consolidated financial statements, we appliedaccounting principles generally accepted in the United States of America. Theapplication of generally accepted accounting principles may require managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying results. Listed below are those policiesand estimates that we believe are critical and require the use of complexjudgment in their application. In particular, our critical accounting policiesand estimates include the evaluation of the impairment of long-lived assets andthe evaluation of the probability of being able to realize the future benefitsindicated by our significant federal tax net operating losses, as discussedfurther in Notes 2, 3 and 9 to “Item 1. Financial Statements” above.

 

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*Basis ofConsolidation*

 

Our consolidated financial statements include our accounts and all ofour majority-owned and controlled subsidiaries and joint ventures. Certain ofour wholly-owned subsidiaries are members in joint ventures involved in thedevelopment and sale of residential projects and residential loan production.The financial statements of joint ventures in which we generally have acontrolling or majority economic interest (and thus are controlled by us) areconsolidated with our financial statements. Our investments in unconsolidatedjoint ventures are accounted for using the equity method when we do not havevoting or economic control of the venture operations, as further discussed inNote 2 to “Item 1. Financial Statements” above. All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

*Impairment of Long-Lived Assets*

 

We recorded inland project impairment charges totaling $zero and $3.2million during the three and six months ended June 30, 2009, respectively,compared with impairment charges of $5.0 million during the three and sixmonths ended June 30, 2008. The impairment charges recorded during the firstand second quarters of 2009 relate to the Woodhaven project in Beaumont andreflect recent sales price reductions by large competitors and our intention toattempt to negotiate a short-sale for the property in 2009 in order to maximizeutilization of tax loss carryforwards in 2010 and future years. The loan isnon-recourse to California Coastal Communities, Inc., however, the subsidiary’sparent, Hearthside Homes, Inc., which has a negative net worth of approximately$50 million, has guaranteed payment of the debt. Hearthside Homes’ subsidiaryis attempting to negotiate a consensual resolution of the loan with the lender,which may involve turnover of the property securing the loan to the lender. Inaccordance with EITF Issue No. 91-2, “Debtor’s Accounting for Forfeiture ofReal Estate Subject to a Nonrecourse Mortgage” (“EITF 91-2”), and a FASB staffinterpretation thereof, we reduced the carrying value of the Woodhaven realestate project to its estimated fair value during the first quarter of 2009. Ifthe Woodhaven project is transferred to the lender in full settlement of theloan without further recourse or obligation, we will recognize a gain as aresult of debt cancellation. However, there can be no assurance that the lenderwill agree to a consensual resolution.

 

During 2007 and 2008, we recorded impairment charges aggregating $67.0 millionrelated to five of our inland projects. The impairment charges were calculatedbased on market conditions and assumptions made by management that reflectedcurrent market conditions at the time such impairment charges were determined,which may differ materially from actual results if market conditions change. Asrequired by SFAS 144, should market conditions deteriorate in the future orother events occur that indicate the carrying amount of our real estateinventories may not be recoverable, we will reevaluate the expected cash flowsfrom each project to determine whether any additional impairment exists at anypoint in time.

 

We assess the impairment of real estate inventories and otherlong-lived assets in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 144, “*Accounting for theImpairment or Disposal of Long-Lived Assets*,” (“SFAS 144”) whichrequires that long-lived assets be reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. As provided by SFAS 144, impairment is evaluated by comparingan asset’s carrying value to the undiscounted estimated cash flows expectedfrom the asset’s operations and eventual disposition. If the sum of theundiscounted estimated future cash flows is less than the carrying value of theasset, an impairment loss is recognized based on the fair value of the asset.If impairment occurs, the fair value of an asset for purposes of SFAS 144 isdeemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction. Additionally, as appropriate, we identifyalternative courses of action to recover the carrying value of our long-livedassets and evaluate all likely alternatives under a probability-weightedapproach as described in SFAS 144.

 

In accordance with SFAS No. 144, in developing estimated future cashflows for impairment testing for our real estate inventories, we incorporatedour own market assumptions including those regarding home prices, sales pace,sales and marketing costs, infrastructure and home-building costs, andfinancing costs regarding real estate inventories. Our assumptions are based,in part, on general economic conditions, the current state of the homebuildingindustry, expectations about the short- and long-term outlook for the housingmarket, and competition from other homebuilders in the areas in which we buildand sell homes. These assumptions can significantly affect our estimates offuture cash flows. For those communities deemed to be impaired, we determinefair value based on discounted estimated future cash flows using estimatedabsorption rates for each community.

 

We evaluated our Brightwater project for impairment as of December 31,2008, and determined that no impairment was indicated based on our projectionof the project’s future cash flows, including projected revenues, costs andgross margin.  We based our assumptionson our evaluation of projected prices while reflecting current marketingefforts, review of competitive home sales, characteristics of the HuntingtonBeach housing market, and current construction costs.  Our relatively lower book basis inBrightwater of $239.7 million as of June 30, 2009, is due in part to a fairvalue adjustment recorded in September 1997 under “Fresh Start”accounting.  Since 1997, we have recordedno impairment charges for the project, primarily due to the long holding periodand significant increases in home prices since 1997, before the currentchallenging conditions and price depreciation of the past two years.

 

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The most critical factors in our Brightwater analysis are projectedhome prices and direct construction costs, as they are affected by marketfactors such as home sale competition, the availability of financing for homepurchases and competition for direct construction goods and services.  Since opening for sales at Brightwater in August2007, we have reduced prices and offered sales incentives in response to therecent difficult conditions in the housing market. We have reflected theseprice reductions in our projections which reduced projected gross margins forthe project from approximately 30%-40% in 2007 to 25%-35% as of December 2008and 9%-28% as of June 2009.  The decreasein expected margins also reflects greater use of third-party real estatebrokers.

 

Home prices and direct construction costs are the most critical factorsin our impairment analysis and we estimate that a 1% change in home prices ordirect construction costs would change gross margin by approximately .75% and..25%, respectively. Due to their subjective and interrelated nature, we cannotmeaningfully quantify the impact of potential changes for all of the factorsconsidered in our impairment analysis. While there is risk that additionalprice reductions may be necessary, it appears unlikely that any future pricereductions or direct construction cost increases would result in erosion of theentire positive cash flow that we are currently projecting and result in animpairment charge for this project. However, there can be no assurance in thatregard because economic and housing market conditions may continue to worsen orother events beyond our control may occur which could result in a change in ourassumptions.

 

In our analysis, we noted that the Brightwater project in HuntingtonBeach is in a mature housing market with very limited new home construction anda low supply of comparable resale homes with views or competitivefeatures.  Further, Huntington Beach hasrecently ranked in the top 25% of housing performance in Orange County based onpricing, sales and foreclosures.  In January2009, the City of Huntington Beach’s credit rating was raised, reflecting thecity’s built-out nature and expected economic resilience of the city’shouseholds.  Huntington Beach is incoastal Orange County which is the subject of two widely respected annualeconomic forecasts which expect a deceleration in median home price decline in2009, decreased foreclosures in Orange County in the second half of 2009, andan increase in demand due to improved affordability.  Therefore, market data support our assumptionthat our Brightwater project in Huntington Beach will fare better than mostsurrounding Orange County communities and significantly better than projects ininland areas, resulting in a projected sales pace and home pricing during 2009at levels relatively consistent with recent months and with reasonableexpectations of price increases in future years given the limited supply of newhomes along the coast of Southern California.

 

In our impairment analysis of the Brightwater project, we also considerprojected construction and related costs and the availability of mortgagefinancing for our potential homebuyers. Recent subcontracting efforts have resulted in price reductions fordirect costs of approximately 2% overall in the past year, a trend which isexpected to have a positive effect on margins during 2009 and possiblybeyond.  However, any savings experiencedin the near future would likely be diminished in future years if home pricesincrease.  While mortgage financing forour homes is still challenging, 30-year jumbo mortgage rates have decreasedfrom a national average high of 8.4% in October 2008 to approximately 6.2%currently.  With the return of theconforming loan maximum in Orange County to $729,750, a significant portion ofour potential homebuyers are able to finance a substantial portion of theirhome purchase at historically low mortgage rates approximating 5%.

 

The estimation process involved in the determination of value isinherently uncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and disposition of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions. Economicand market conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. Accordingly, the amount ultimately realized from suchproject may differ materially from current estimates and the project’s carryingvalue.

 

We believe that the accounting for the impairment of long-lived assetsis a critical accounting policy because the valuation analysis involves anumber of assumptions that may differ from actual results and the impact ofrecognizing impairment losses has been material to our consolidated financialstatements. The critical assumptions in our evaluation of real estateinventories impairment included projected sales prices, anticipated sales pacewithin each community, and applicable discount rates, any of which could changematerially as economic conditions change.

 

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*IncomeTaxes*

 

We account for income taxes on the liability method, in accordance withSFAS No. 109, “*Accounting for Income Taxes*.”Deferred income taxes are determined based on the difference between the financialstatement and tax bases of assets and liabilities, using enacted tax rates ineffect in the years in which these differences are expected to reverse. Theliability method requires an evaluation of the probability of being able torealize the future benefits indicated by deferred tax assets. A valuationallowance is established against a deferred tax asset if, based on theavailable evidence, it is “more likely than not” that such asset will not berealized. The realization of a deferred tax asset ultimately depends on theexistence of sufficient taxable income in either the carryback or carryforwardperiods under tax law. We evaluate on a quarterly basis, whether a valuationallowance should be established based on our determination of whether it is “morelikely than not” that some portion or all of the deferred tax assets will berealized. In our assessment, appropriate consideration is given to all positiveand negative evidence related to the realization of the deferred tax assets.This assessment considers, among other matters, the nature, frequency andmagnitude of current and cumulative income and losses, forecasts of futureprofitability, the duration of statutory carryback or carryforward periods, ourexperience with operating loss and tax credit carryforwards not expiringunused, and tax planning alternatives.

 

Our assessment of the need for a valuation allowance on our deferredtax assets includes assessing the likely future tax consequences of events thathave been recognized in our consolidated financial statements or tax returns.We base our estimate of deferred tax assets and liabilities on current tax lawsand rates and, in certain cases, on business plans and other expectations aboutfuture outcomes. Changes in existing tax laws or rates could affect our actualtax results and our future business results may affect the amount of ourdeferred tax liabilities or the valuation of our deferred tax assets over time.

 

We reported operating losses in 2007 and 2008 primarily reflectingresults from our inland projects which have suffered significant decreases invalue.  These losses were partiallyoffset by profits from home deliveries at our Brightwater project on the coastof Southern California.  The impairmentlosses on our inland projects are not deducted for tax purposes until realized.In 2009, we expect to continue to report profits from our Brightwater project.In addition, during the three months ended March 31, 2009, we recorded $20.7million of pre-tax income from cancellation of indebtedness related to ourCorona project for which we completed a deed-in-lieu transaction on March 31,2009, conveying 134 lots of our Corona project to the lender in exchange for a$28.7 million reduction in the note obligation.

 

While we expect to report profitable operations for 2009, we expect toreport a taxable loss due to tax losses recognized upon property dispositions.These tax losses were previously recognized for financial statement purposeswhen impairment losses were recorded. The current year expected taxable lossincludes the tax loss generated by the deed-in-lieu transaction (which includedapproximately 59% of our cumulative previously unrecognized taxable losses oninland projects) and losses expected to be generated from the disposition or foreclosureof our inland lots and homes in the cities of Corona, Lancaster and Beaumontwhich were the source of operational losses recognized in 2007 and 2008.  We delivered five additional inland homesduring the first six months of 2009, and an additional four homes during July 2009,leaving a total of five homes in escrow, four model homes available for sale inbulk sale and 116 lots as of August 3, 2009 on projects for which we haverecorded loss reserves. In addition, in June 2009, a subsidiary of HearthsideHomes received a notice of default relating to the loan facility fordevelopment of the Las Colinas project in Lancaster. We expect that the lenderwill foreclose on the property secured by the loan in the second half of 2009.Therefore, we expect that all or a significant portion of the remainingexpected taxable losses on our inland projects will be included in our fullyear 2009 results through home deliveries and possible additional lotconveyances or dispositions.  Thedisposition of the inland assets during 2009 is both an operational and taxstrategy which we have successfully begun and will continue to execute.  Therefore, we have reserved the approximately$3.8 million value of all of our NOL expiring in 2009.

 

Beginning in 2010, we expect that recognized tax losses resulting fromdeliveries of inland homes and lots will be eliminated, leaving primarilyBrightwater home deliveries to generate our operating and taxable results.  Therefore, in order to evaluate therecoverability of NOLs and other deferred tax assets in 2010 and 2011, weprojected our taxable income reflecting actual and estimated 2009 levels ofBrightwater home sales.  In addition, weevaluated expected prices based on our current marketing, expected product mixand gross margins, review of competitive home sales, market conditions andother objectively verifiable economic factors affecting our operations, as wellas other positive and negative factors. The $239.7 million book value of Brightwater at June 30, 2009 is less thanits expected market value due to the project’s long holding period and a fairvalue adjustment recorded in September 1997 under “Fresh Start” accounting. Wecurrently expect the various Brightwater products to generate gross margins ofapproximately 9% to 28%.  The project’stax basis is approximately $32.8 million less than book value which willgenerate additional taxable income in excess of book income.  Based on our projections which reflectrecently achieved operational levels, during the second quarter of 2009 wereserved approximately $7.6 million for NOLs expiring in 2010 and 2011.

 

Continuing a taxable income projection based on our recent Brightwateroperations, projected taxable income for years after 2011 is expected to allowutilization of remaining deferred tax assets, including NOLs that would beginto expire in 2017.  The evaluation ofrecovery of our deferred tax assets in 2010 and 2011 relies upon theaccomplishment of certain tax planning strategies as discussed above.  We cannot be certain that all remainingunrecognized taxable losses on inland

 

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projects will occur as projected, or thatoperational levels for 2009 and beyond will be consistent with recentoperations.  However, based upon ouranalysis, we believe that it is “more likely than not” that we will be able toutilize our remaining deferred tax assets based upon projected taxable income.

 

Due to uncertainties in theestimation process, particularly with respect to changes in facts andcircumstances in future reporting periods (carryforward period assumptions), itis reasonably possible that actual results could differ from the estimates usedin our historical analyses. Our assumptions require significant judgmentbecause the residential homebuilding industry is cyclical and is highlysensitive to changes in economic conditions. Our current assessment of the needfor a valuation allowance is primarily dependent upon utilization of tax netoperating losses in the carryforward period and our future projected income. Ifour results of operations are more or less than projected and there isobjectively verifiable evidence to support the realization of a differentamount of our deferred tax assets, an adjustment to our valuation allowance maybe required to reflect greater expected utilization or to further reduce oreliminate our deferred tax assets.

 

We remain subject to thegeneral rules of Section 382 of the Internal Revenue Code, which limit theavailability of net operating losses if an ownership change occurs. If we wereto experience another ownership change, the amount of net operating lossesavailable would generally be limited to an annual amount equal to (i) the valueof our equity immediately before the ownership change, multiplied by the long-termtax-exempt rate (4.48% as of August 2009) plus (ii) recognized built-in-gains,defined as those gains recognized within five years of the ownership changesubject to an overall limitation of the net unrealized built-in gains existingas of the ownership change date. We estimate that after giving effect tovarious transactions by stockholders who hold a 5% or greater interest in thecompany, we have experienced a three-year cumulative ownership shift ofapproximately 21% as of August 3, 2009, as computed in accordance with Section 382.In the event of an ownership change, our use of our NOLs may be limited and thedeferred tax assets recorded at June 30, 2009 may not be fully realizable.

 

*Homebuilding Revenues and Cost of Sales*

 

Our homebuilding operationgenerates revenues from the sale of homes to homebuyers. The majority of thesehomes are designed to appeal to move-up homebuyers and are generally offeredfor sale in advance of their construction. Sales contracts are usually subjectto certain contingencies such as the buyer’s ability to qualify for financing.Revenue from the sale of homes is recognized at the close of escrow when titlepasses to the buyer and the earnings process is complete. As a result, ourrevenue recognition process does not involve significant judgments orestimates. However, we do rely on certain estimates to determine the relatedconstruction costs and resulting gross margins associated with revenuesrecognized. The cost of sales is recorded based upon total estimated costs withina subdivision and allocated using the relative sales value method. Ourconstruction costs are comprised of direct and allocated costs, includingestimated costs for future warranties and indemnities. Our estimates are basedon historical results, adjusted for current factors.

 

*Litigation Reserves*

 

We and certain of oursubsidiaries have been named as defendants in various cases arising in thenormal course of business and regarding assets and businesses disposed of by usor our former affiliates. See Notes 8 and 10 to “Item 1. Financial Statements”above. We have reserved for costs expected to be incurred with respect to thesecases based upon information provided by our legal counsel. There can be noassurance that total litigation costs actually incurred will not exceed theamount of such reserve.

 

**RecentAccounting Pronouncements**

 

See discussion regarding Recent AccountingPronouncements in Note 2 to “Item 1. Financial Statements” above.

 

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**Resultsof Operations**

 

The following tables set forth key operating andfinancial data for our homebuilding operations for the three and six monthsended June 30, 2009 and 2008.

 

**Backlog as of June 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|----------------------|------------|--------------------------------|------------|--------------------------------------------------|------------|
| **2009**             | ** ** | **2008**                       | ** ** | **Change**                                       | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 16                   |       | 23                             |       | (30.4                                            | )%         | $ | 13.0 |   | $ | 32.3 |   | (59.7 | )% | $ | 812 |   | $ | 1,403 |   | (42.1 | )% |
|                      |            |                                |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Three Months Ended June 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|---------------------|------------|--------------------------------|------------|--------------------------------------------------|------------|
| **2009**            | ** ** | **2008**                       | ** ** | **Change**                                       | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 12                  |       | 15                             |       | (20.0                                            | )%         | $ | 10.5 |   | $ | 10.4 |   | 1.0 | % | $ | 872 |   | $ | 696 |   | 25.3 | % |
|                     |            |                                |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Six Months Ended June 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|---------------------|------------|--------------------------------|------------|--------------------------------------------------|------------|
| **2009**            | ** ** | **2008**                       | ** ** | **Change**                                       | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 19                  |       | 23                             |       | (17.4                                            | )%         | $ | 23.3 |   | $ | 15.4 |   | 51.3 | % | $ | 1,224 |   | $ | 670 |   | 82.7 | % |
|                     |            |                                |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Three Months Ended June 30, 2009 Compared with theThree Months Ended June 30, 2008*

 

We reported revenues of$10.5 million and gross operating profit of $1.9 million for the second quarterof 2009, compared with $10.4 million in revenues and gross operating loss of$2.8 million for the second quarter of 2008. Revenues in the current periodreflect deliveries of 12 homes, including nine deliveries at Brightwater whichgenerated revenues of $9.7 million and gross operating profit of $1.7 million,and three homes at our inland projects which generated revenues of $800,000 andgross operating profit of approximately $200,000. The comparable period of theprior year reflects deliveries of 15 homes, including seven homes atBrightwater and eight inland homes. As required by SFAS 144, should marketconditions 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.

 

Gross operating profitbefore impairment charges decreased from $2.2 million for the second quarter of2008 to $1.9 million for the second quarter of 2009 primarily due to reducedmargins for The Trails and The Sands homes at Brightwater delivered during thequarter. We delivered nine homes at Brightwater which generated a 18.1% grossmargin and gross operating profit of $1.7 million. Excluding impairmentcharges, homebuilding gross margin for the second quarter of 2009 decreased to18.1% compared with 21.2% in the comparable period of 2008 due to increasedincentives and third-party brokers’ commissions that were necessary to movestanding inventory at our communities.

 

Selling, general andadministrative expense decreased $900,000 compared with the second quarter of2008 primarily due to a $600,000 reduction in selling expenses primarilyassociated with communities which were active during the first half of 2008 buthad reduced or no activity in the current year, as well as reduced general andadministrative expenses resulting from headcount reductions and the absence ofholding costs for the Corona project, the majority of which was deeded to thelender on March 31, 2009.

 

Other expense decreased$300,000 in the second quarter of 2009 compared with the second quarter of 2008due to a $200,000 reduction in real estate holding costs and the absence in2009 of $100,000 of other expense incurred in 2008 related to an interest rateswap agreement.

 

Income tax expense for thethree months ended June 30, 2009 primarily reflects a $7.6 million non-cashvaluation allowance on deferred tax assets.

 

*Six Months Ended June 30, 2009 Compared with theSix Months Ended June 30, 2008*

 

We reported revenues of$23.3 million and gross operating profit of $2.7 for the six months ended June 30,2009, compared with $15.4 million in revenues and gross operating loss of $1.7 millionfor the comparable period of 2008. Revenues in the current period reflectdeliveries of 19 homes, including 14 deliveries at Brightwater which generatedrevenues of $21.9 million and gross operating profit of $5.7 million, and fivehomes at our inland projects which generated revenues of $1.4 million and grossoperating profit of approximately $200,000. The comparable period of the prioryear reflects deliveries of 23 homes, including nine homes at Brightwater and14 inland homes. Gross operating profit for the six months ended June 30, 2009includes non-cash impairment charges of $3.2 million, reflecting fair valuewrite-downs during the first and second quarters of 2009 for an inland projectin Beaumont. These impairment charges reflect first-quarter sales pricereductions by large competitors and our current intention to attempt tonegotiate a short-sale for the property in 2009 in order to maximizeutilization of tax loss carryforwards in 2010 and future years. As required bySFAS 144, should market 

 

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conditionsfurther deteriorate in the future or other events occur that indicate thecarrying amount 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.

 

Although we delivered fourfewer homes in the six months ended June 30, 2009 compared with 2008, wegenerated $2.6 million more in gross operating profit before impairment chargesfrom home sales as a result of delivering 14 homes at Brightwater whichgenerated a 26.0% gross margin and gross operating profit of $5.7 million.Increased gross operating profit for Brightwater was partially offset byreduced margins at our inland projects which generated gross margins of 18.9%during the six months ended June 30, 2009 due to the prolonged real estateslowdown which has resulted in lower selling prices and greater incentives andthird-party brokers’ commissions in order to remain competitive and movestanding inventories in this difficult market. Excluding impairment charges,homebuilding gross margin for the six months ended June 30, 2009 increased to25.5% compared with 21.4% in the comparable period of 2008 due to the greaterproportion of Brightwater home deliveries.

 

Gain on debt restructuringreflects a $20.7 million pre-tax gain related to a deed-in-lieu transaction forour Corona property that we completed on March 31, 2009. In exchange for a$28.7 million reduction in the note balance and related obligations secured byour Hearthside Lane project, we conveyed the remaining 134 finished lots to theinvestor that purchased the note from IndyMac Federal Bank.

 

Selling, general and administrative expenses decreased $1.0 million forthe first half of 2009 compared with the first half of 2008 primarilyreflecting a $750,000 reduction in selling expenses associated with communitieswhich were active during the first half of 2008 but had reduced or no activityin the current year and a $100,000 decrease in selling expenses related to thegrand opening for Brightwater’s Breakers and Cliffs products in March 2008,as well as reduced general and administrative expenses resulting from headcountreductions.

 

The $800,000 increase ininterest expense compared with the comparable period of 2008 primarily reflectsinterest incurred on projects which are no longer under construction and,therefore, must be recorded as a period cost rather than capitalized.

 

Other expense also reflectsa $100,000 increase in property tax expense during the six months ended June 30,2009 compared with the comparable period of 2008 for projects which are nolonger under construction and, therefore, must be recorded as a period costrather than capitalized.  This increasewas more than offset by the absence in 2009 of $800,000 of other expenseincurred during the six months ended June 30, 2008 related to an interest rateswap agreement.

 

The effective income taxrate for the six months ended June 30, 2009, is 80%, which reflects a $7.6million non-cash valuation allowance on deferred tax assets and a tax rate of41%.

 

*PaymentsUnder Contractual Obligations*

 

Our purchase contracts whichare made in the normal course of our homebuilding business for land acquisitionand construction subcontracts are generally cancelable at will. Othercontractual obligations including our tax liabilities, accrued benefitliability for a frozen retirement plan and other accrued pensions, homewarranty reserves and contingent indemnity and environmental obligations areestimated based on various factors. Payments are not due as of a given date,but rather are dependent upon the incurrence of professional services, thelives of annuitants and other factors. The estimation process involved in thedetermination of carrying values of these obligations is inherently uncertainsince it requires estimates as to future events and contingencies. We haveprovided additional disclosure below in “Part II Item 1. Legal Proceedings” andin Note 9 to “Item 1. Financial Statements” above.

 

**Liquidityand Capital Resources**

 

Based on current projectionsof Brightwater closings and cash requirements for ongoing home construction andscheduled debt amortization during the next 12 months, and due to theadditional $22.3 million and $25 million in loan repayments due on December 31,2009 and March 31, 2010, respectively, we do not expect to meet our obligationsunder our debt agreements, as currently structured, for the next 12 months,from cash generated by operations without further amendments or extensions toour revolving loan and term loan. If we continue to experience the declines inoperational volumes that have worsened with the current economic recession,such declines may cause us to use our cash reserves to support operations, andat some point we may not have sufficient cash or liquidity. Additionally, weexpect to require modifications to our current credit facilities and to assessthe viability of raising equity and/or debt capital in order to support ouroperations. Our goal is to have adequate liquidity during the current marketdecline and emerge with enough resources to take advantage of opportunitieswhen the market turnaround begins. There can be no assurances, however, that ifneeded, we will be able to obtain such modifications or raise such capital onterms that are acceptable to us, or at all.

 

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

 
| ** **                                       | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **June 30,**         | ** ** |
| ** **                                       | ** ** | **2009**             | ** ** | **2008** | ** ** |
| Cash and cash equivalents                        |       | $                    | 10.0       |   | $ | 10.4 |   |
| Cash provided by (used in)  operating activities |       | 7.7                  |       | (16.7 | ) |
| Cash provided by (used in)  investing activities |       | .4                   |       | (.2 | ) |
| Cash provided by (used in)  financing activities |       | (.4                  | )          | 3.0 |   |
|                                                  |            |                      |            |  |  |  |  |

 

The principal assets in ourportfolio are residential land which must be held over an extended period oftime in order to be developed to a condition that, in management’s opinion,will ultimately maximize our return. Consequently, we require significantcapital to finance our real estate development and homebuilding operations.Historically, sources of capital have included loan facilities secured byspecific projects, asset sales and available internal funds. Our unrestrictedcash and cash equivalents as of June 30, 2009 aggregated $10.0 million andfunds available to be drawn under our revolving loan were $4.5 million,providing total liquidity of $14.5 million.

 

On March 31, 2009,Hearthside Homes, Inc. completed a deed-in-lieu transaction for the HearthsideLane project in Corona. In exchange for a $28.7 million reduction in the notebalance, the subsidiary conveyed the remaining 134 finished lots to theinvestor that purchased the loan from IndyMac Federal Bank. The subsidiaryrecognized a $20.7 million pre-tax gain on debt restructuring and retainedseven completed homes that secured the then remaining $2.5 million note balancewhich matures on March 31, 2010. Subject to certain conditions, after all sevenhomes have been delivered, the guaranty of this debt by Hearthside Homes willbe released and any remaining balance on the note will be cancelled. During thesecond quarter of 2009, the subsidiary delivered one of the remaining sevenhomes. During July 2009, the subsidiary delivered three of the remaining sixhomes and the final three homes are expected to be delivered by the end ofAugust, at which time the note will have been repaid in its entirety.

 

A subsidiary of HearthsideHomes, Inc. is continuing its efforts to negotiate a consensual resolution ofthe $2.4 million Lancaster loan which matured September 30, 2008. In June 2009,our subsidiary received a notice of default and we expect that the lender willforeclose on the property secured by the loan in the second half of 2009. Theloan is nonrecourse to us; however, it is guaranteed by Hearthside Homes whichhad a negative net worth of approximately $50 million as of June 30, 2009.There can be no assurance that the lender will agree to a consensual resolutionof the loan.

 

On September 15, 2006 weentered into the $100 million revolving loan and the $125 million term loanwith KeyBank National Association, as a lender and agent for several otherlenders. These loans are described in greater detail in Notes 4 and 5 to “Item1. Financial Statements” above. On September 30, 2008, we amended the revolvingand term loans to provide greater flexibility to repay the debt and financeconstruction based on mid-2008 projections for home sales at Brightwater whichreflected market conditions at that time. In March 2009, we extended thematurity of the revolving loan from September 15, 2009 to June 30, 2010. Thecommitment reductions for the revolving and term loans are scheduled as follows(in millions):

 

**Senior Secured Revolving Loan**

 
| **Date**           | ** ** | **Commitment  Reduction** | ** ** | **End of  Period  Commitment** | ** ** |
|--------------------|------------|---------------------------|------------|--------------------------------|------------|
| June 30, 2009      |       | $                         | —     |                           | 84.9       |   |
| September 30, 2009 |       | 4.9                       |       | 80.0                           |       |
| December 31, 2009  |       | 10.0                      |       | 70.0                           |       |
| March 31, 2010     |       | 10.0                      |       | 60.0                           |       |
| June 30, 2010      |       | 60.0                      |       | —                         |       |
|                    |            |                           |            |                                |            |  |

 

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**Senior Secured Term Loan**

 
| **Date**           | ** ** | **Commitment  Reduction** | ** ** | **End of  Period  Commitment** | ** ** |
|--------------------|------------|---------------------------|------------|--------------------------------|------------|
| June 30, 2009      |       | $                         | —     |                           | 102.3      |   |
| September 30, 2009 |       | —                    |       | 102.3                          |       |
| December 31, 2009  |       | 12.3                      |       | 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 June 30, 2009, theundrawn availability on our revolving loan is $4.5 million. As of June 30, 2009and December 31, 2008, $80.4 million and $74.4 million, respectively, wasoutstanding under the revolving loan. During the six months ended June 30,2009, we made mandatory repayments of $3.4 million and $5.0 million on therevolving and term loans, respectively, in connection with 14 home deliveriesat Brightwater during the period. We depend on cash flows generated fromoperations and available borrowing capacity to fund our Brightwaterdevelopment, debt service requirements and working capital requirements.However, our ability to continue to fund these items and to reduce debt isaffected by continued difficulties in the homebuilding industry, and the severeweakening of the economy. The downturn in the housing market continues toresult in reduced home sales, sharp declines in home prices and difficultiesfor homebuyers in obtaining mortgage financing, which in turn affects ourability to sell homes. Since the majority of sales and deliveries atBrightwater have been for The Trails, which is the smallest Brightwater homeproduct, the current product mix of home sales is not expected to generatesufficient cash flow to meet our December 31, 2009 scheduled loan repayments of$10.0 million on the revolving loan and $12.3 million on the term loan, asdescribed in greater detail in Notes 5 and 6 to “Item 1. Financial Statements”above.

 

As a result of the debt repaymentsmade in connection with the December 2008 model sale and leaseback transaction,as well as home deliveries through June 30, 2009, we have met our loanrepayment requirement for the term loan through September 30, 2009 and, withadditional deliveries expected during the third quarter, we expect to be ableto pay the amount due on the revolving loan on September 30, 2009.  However, due to cash requirements foron-going home construction and scheduled debt amortization, our ability to meetthe loan repayment requirements for the revolving loan and term loan through December31, 2009 will depend on the results of negotiations with our lenders, asdiscussed below. Based on Brightwater sales thus far in 2009, which have beenprimarily for the smallest Brightwater home product (The Trails), the currentproduct mix of home sales is not expected to generate sufficient cash flow tomeet the December 31, 2009 scheduled loan repayments of $10.0 million on therevolving loan and $12.3 million on the term loan, as described in greaterdetail in Notes 5 and 6 to “Item 1. Financial Statements” above. Based oncurrent projections of Brightwater closings during the nine months ending March31, 2010, we do not expect to generate cash from operations in an amountsufficient to allow us to make the $25 million in loan repayments due on March 31,2010. In addition, we do not expect to be able to repay the Revolving Loan byits June 30, 2010 maturity date or to make the $10.0 million Term Loan paymentalso due on June 30, 2010.

 

Therefore, we are scalingback construction of speculative homes and making further reductions in generaland administrative costs in order to reduce expenditures and retain cash forrequired expenditures. We are discussing amendments to our revolving and termloans with the agent bank for our loan syndicates in order to accommodateBrightwater’s presently anticipated sales volume and product mix, and toprovide the liquidity needed to fund construction of additional new homes. Weintend to negotiate amendments that will defer the amortization payments due byDecember 31, 2009, provide an extension of the maturity date of the revolvingloan, restructure payments due in 2010 and 2011, and modify the loan covenantsof the revolving loan and term loan agreements. We are striving to completethese amendments during the fourth quarter of 2009. In addition, we continue toexamine potential financial and strategic alternatives to generate capital fromother sources. There can be no assurance that amended or future debt or equityfinancings will be available to us in an amount sufficient to enable us to meetour debt obligations or to fund our other liquidity needs, in the event thatsufficient cash flow is not generated from home sales during the 12 monthsending June 30, 2010.

 

The current housing andmortgage markets also present uncertainty as to our ability to achievesufficient positive cash flow from operations required to satisfy our debtobligations. While we continue to diligently pursue and evaluate variousfinancing alternatives, unless we are successful in amending and extending theterms of the revolving loan and term loan agreements, or in obtaining newfinancing, we do not believe that our cash, cash equivalents and future realestate sales proceeds will be sufficient to meet our debt obligations due on December31, 2009, March 31, 2010 and June 30, 2010; or to meet anticipated operatingand project development costs for Brightwater, and general and administrativeexpenses for the next 12 months.

 

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*June 30,2009 Compared with December 31, 2008*

 

Cash provided by operatingactivities of $7.7 million for the first six months of 2009 primarily reflectsnet proceeds of $21.2 million generated by 14 deliveries at Brightwater, whichwere partially offset by investments in Brightwater of $15.6 million, alongwith $900,000 of net cash flow generated by our inland projects ($1.4 milliongenerated from deliveries of five homes less $500,000 of project investments).

 

Our primary sources of cashduring the first six months of 2009 were $22.6 million of proceeds from salesof real estate inventories and $6.0 million of net borrowings from ourrevolving loan. Our primary uses of cash during the first six months of 2009include $15.6 million of investments in Brightwater and $5.1 million ofrepayments of our term loan.

 

The $15.5 million decreasein deferred tax assets primarily reflects non-cash valuation allowances of $7.6million recorded during the second quarter of 2009, as well as the provisionfor income taxes which is composed entirely of deferred taxes. There are nocurrent taxes since we have a taxable loss for the three and six months ended June30, 2009, primarily due to the recognition of real estate losses for taxpurposes that were recorded in prior years for financial statement purposes.

 

The $27.8 million decreasein other project debt primarily reflects a $26.7 reduction in the HearthsideLane note balance as a result of the deed-in-lieu transaction completed duringthe first quarter of 2009, as well as $1.1 of project debt repayments providedby home deliveries.

 

The $3.0 million decrease inother assets primarily reflects the amortization of $1.6 million of prepaidrent related to our model home financing, as well as $1.2 million of prepaidloan fees amortized during the first six months of 2009.

 

The $2.1 million decrease inrestricted cash reflects the assignment of restricted cash related to theHearthside Lane project to the investor that holds the Hearthside Lane note inconnection with the deed-in-lieu transaction and a $400,000 reduction in theinterest reserve required under the term loan.

 

*Availability of Additional Liquidity*

 

The availability of additional capital, whether from private capitalsources (including banks) or the public capital markets, fluctuates as marketconditions change. There may be times when the private capital markets and thepublic debt or equity markets lack sufficient liquidity or when our securitiescannot be sold at attractive prices, in which case we would not be able toaccess capital from these sources. Based on current market conditions and ourfinancial condition (including our prospective inability to satisfy theconditions contained in our term and revolving loan agreements that arerequired to be satisfied to permit us to incur additional indebtedness), ourability to effectively access these liquidity sources is significantly limited.In addition, a further weakening of our financial condition or strength,including in particular a material increase in our leverage or a furtherdecrease in our profitability or cash flows, could adversely affect our abilityto obtain necessary funds, and otherwise increase our cost of borrowing.

 

**OffBalance Sheet Financing**

 

In the ordinary course ofbusiness, we enter into land option contracts in order to procure land for theconstruction of homes. The use of such option agreements allows us to reducethe risks associated 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 June 30, 2009, we haveno land option deposits and no third party guarantees.

 

We also acquire land andconduct residential construction activities through participation in jointventures in which we hold less than a controlling interest. Through jointventures, we reduce and share our risk and also reduce the amount invested inland, while increasing our access to potential future home sites. The use ofjoint ventures also, in some instances, enables us to acquire land which wemight not otherwise obtain or access on as favorable terms, without theparticipation of a strategic partner. While we view the use of unconsolidatedjoint ventures as beneficial to our homebuilding activities, we do not viewthem as essential to those activities.

 

Under the requirements ofFASB Interpretation No. 46(R), “*Consolidationof Variable Interest Entities*” (“FIN 46(R)”), certain of our landoption contracts may create a variable interest for us, with the land sellerbeing identified 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 June 30, 2009, we had no deposits with VIEs.

 

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

 

Real estate and residential housing prices areaffected by a number of factors, including but not limited to uncertainty bypotential homebuyers in the stability of the United States and global economy,inflation or deflation, interest rate changes, competition and the supply ofnew and existing homes to be purchased. Uncertainty in the stability of thenational economy and significant volatility in the banking system and financialmarkets can, and has, caused potential homebuyers to refrain from committing tomake significant purchases, including the purchase of new homes. In the eventthe volatility in the banking system and financial markets continues to remainhigh and the national economy does not stabilize in the near term, our abilityto sell new homes to potential homebuyers can be impacted negatively.

 

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The long-term impact ofinflation may affect us through increased costs for land, land development,construction and overhead, as well as in increased sales prices of our homes.Our land acquisition costs are generally fixed, therefore, increases ordecreases in the sales prices of homes will affect our profits. The sales priceof each of our homes is fixed at the time a buyer enters into a contract toacquire a home. Therefore, if we sell our homes before we begin construction,any inflation of costs in excess of those anticipated may result in lower grossmargins, unless these increased costs are recovered through higher salesprices.

 

Also, deflation can causethe market value of our land and constructed homes to decline which couldnegatively impact our results of operations. If interest rates increase,construction and financing costs, as well as the cost of borrowings, could alsoincrease, which can result in lower gross margins on home sales. Increases inhome mortgage interest rates make it more difficult for our customers toqualify for home mortgage loans, potentially decreasing home sales revenue.Increases in interest rates also may affect adversely the volume of mortgageloan originations. Increases in competition and the supply of unsold new andexisting homes have had an adverse effect on our ability to generate new homeorders and maintain home orders in backlog, and have had a significant negativeimpact on our results of operations and gross margins on home sales in ourinland markets.

 

Interest rates, the lengthof time that land remains in inventory and the proportion of inventory that isfinanced affect our interest costs. If we are unable to raise sales pricesenough to compensate for higher costs, or if mortgage interest rates increasesignificantly, affecting prospective buyers’ ability to adequately finance homepurchases, our revenues, gross margins and net income would be adverselyaffected. Increases in sales prices, whether the result of inflation or demand,may affect the ability of prospective buyers to afford new homes.

 

**Item3.  Quantitative and QualitativeDisclosures About Market Risk**

 

We utilize variable ratedebt financing for acquisition, development and construction of homes. Theinterest rates on our debt approximate the current rates available for securedreal estate financing with similar terms and maturities, and as a result, theircarrying amounts approximate fair value. While changes in interest ratesgenerally may not impact the fair market value of the debt instrument, they doaffect our earnings and cash flows. Holding our variable rate debt balanceconstant as of June 30, 2009, each one point percentage increase in interestrates would result in an increase in variable rate interest incurred for thenext 12 months of approximately $1.9 million.

 

We are exposed to marketrisks related to fluctuations in interest rates on our outstanding variablerate debt. We do not utilize swaps, forward or option contracts on interestrates, or other types of derivative financial instruments. We do not enter intoor hold derivatives for trading or speculative purposes.

 

You should be aware thatmany of the statements contained in this section are forward looking and shouldbe read in conjunction with our disclosures under the heading “Forward-LookingStatements.”

 

**Item4.  Evaluation of Disclosure Controls andProcedures**

 

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

 

Our chief executive officerand chief financial officer, with the assistance of management, evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e)and 15d-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 wella control system is conceived and operated, it can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Inaddition, the design of a control system must reflect the fact that there areresource constraints and the benefits of controls must be considered relativeto costs. Therefore, no cost-effective control system and no evaluation ofcontrols can provide absolute assurance that all control issues and instancesof misstatements due to error or fraud, if any, within our company have beendetected.

 

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*Changesin Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringthe three months ended June 30, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.    Legal Proceedings.**

 

See Notes 8 and 10 to “Item 1. Financial Statements”above, and “Item 1 - Business - Corporate Indemnification Matters” and “Item 3- Legal Proceedings” in our Annual Report on Form 10-K for the year ended December31, 2008.

 

**Item 4.    Submission of Mattersto a Vote of Security Holders.**

 

Our Annual Meeting of Stockholderswas held on June 23, 2009. A quorum of common stock was present in person or byproxy. The following proposals were approved by the requisite vote of ourstockholders entitled to vote, as follows:

 

**Proposal No. 1**:  *The Director Proposal*. The director proposal recommended election of four directors to aone-year term. Set forth below is a table of how the votes were cast for eachnominee, which constituted the affirmative votes for all nominees, by theholders of at least 93.5% of the outstanding common stock represented in personor by proxy at the Annual Meeting.

 
| **Name**               | ** ** | **Votes Cast  “For Nominee”** | ** ** | **Votes “Withheld”** | ** ** |
|------------------------|------------|-----------------------------------------|------------|--------------------------------|------------|
|                   |       |                                    |       |                           |       |
| Geoffrey W. Arens      |       | 9,771,684                               |       | 394,468                        |       |
| Phillip R. Burnaman II |       | 9,771,699                               |       | 394,453                        |       |
| Marti P. Murray        |       | 9,771,699                               |       | 394,453                        |       |
| Raymond J. Pacini      |       | 9,752,817                               |       | 413,335                        |       |

 

**Proposal No. 2**:     *The Auditor Proposal*.  The holders of common stock cast 10,141,170 votes “for” and 23,774 votes“against” the proposal to ratify the appointment of Deloitte & Touche, LLPas our independent registered public accounting firm for the fiscal year endingDecember 31, 2009. Such votes constituted the affirmative vote “for” theAuditor Proposal by the holders of approximately 99.8% of the outstandingcommon stock represented in person or by proxy at the Annual Meeting. Therewere 1,208 abstentions and no broker non-votes by the holders of shares ofcommon stock with respect to the Auditor Proposal.

 

**Item 6.    Exhibits.**

 
| 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 being furnished solely toaccompany this report pursuant to 18 U.S.C. Section 1350, and are not beingfiled for purposes of Section 18 of the Securities Exchange Act of 1934, asamended, and are not to be incorporated by reference into any filing of the Company,whether made before or after the date hereof, regardless of any generalincorporation 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:  August 7, 2009 |     | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|-----------------------|----------|---------------------------------------|
|                  |     |                                  |
|                  |     |                                  |
| * *              | * * | By:                                   | */s/  Sandra G. Sciutto* |
| * *              | * * |                                  | SANDRA  G. SCIUTTO |
| * *              | * * |                                  | Senior  Vice President and Chief Financial Officer |

 

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