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**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark  One)**                                                                                                                                                                                                                                                                                                               | ** **                                                                                                    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                                                                                                    | ** **                                                                                                    |
| **x**                                                                                                                                                                                                                                                                                                                         | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **For the quarterly period ended March 31,  2009**                                                                                                                                                                                                                                                                       |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                                                         | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **For the transition period  from                         to                         ** |

 

**Commissionfile number: 0-17189**

 

**CALIFORNIACOASTAL 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 o          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| 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 May 11, 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 MARCH 31, 2009**

 

**INDEX**

 
| Cautionary  Statement About Forward-Looking Statements | 3                      |
|--------------------------------------------------------|------------------------|
|                                                   |                   |   |
| Part I -                                          | Financial Information: | 5 |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Consolidated Financial Statements | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Balance Sheets - March 31, 2009 (unaudited) and December 31, 2008 | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Statements of Operations - Three Months Ended March 31, 2009 and 2008  (unaudited) | 6 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Statements of Cash Flows -Three Months Ended March 31, 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 | 24 |
|                                                   |                   |   |   |
|                                                   | Item 3 -               | Quantitative  and Qualitative Disclosures About Market Risk | 41 |
|                                                   |                   |   |   |
|                                                   | Item 4 -               | Evaluation  of Disclosure Controls and Procedures | 42 |
|                                                   |                   |   |   |
| Part II -                                         | Other Information:     | 42 |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Legal Proceedings | 42 |
|                                                   |                   |   |   |
|                                                   | Item 6 -               | Exhibits | 42 |
|                                                   |                   |   |   |
| SIGNATURE                                              | 43                     |

 

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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 with covenants in ourdebt agreements;

 

·                  our ability to successfully complete any restructuringof our indebtedness;

 

·                  economic changes nationally or in local markets,including changes in consumer confidence, volatility of mortgage interest ratesand inflation;

 

·                  continued or increased downturn in the homebuildingindustry;

 

·                  statements about ourstrategies, plans, objectives, goals, expectations and intentions;

 

·                  information relating toanticipated operating results, financial resources, changes in revenues,changes in profitability, interest expense, growth and expansion;

 

·                  the impact of demographictrends and supply constraints on the demand for and supply of housing;

 

·                  housing market conditions inthe geographic markets in which we operate;

 

·                  the number and types ofhomes and number of acres of land that we may develop and sell;

 

·                  the ability to deliver homesfrom backlog;

 

·                  the timing and outcomes ofregulatory approval processes or administrative proceedings, which may resultin delays in the land entitlement, development, construction, or the opening ofnew communities;

 

·                  the ability to securematerials and subcontractors;

 

·                  the ability to produce theliquidity and capital necessary to service our debt, fund operations, andexpand and take advantage of future opportunities;

 

·                  our cost of and ability toaccess additional capital;

 

·                  our ability to realize thevalue of our net operating loss carry forwards;

 

·                  our ability to continuerelationships with current or future partners;

 

·                  the effectiveness andadequacy of our disclosure and internal controls;

 

·                  the impact of recentaccounting pronouncements; 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 may turn out to beinaccurate. This can occur as a result of incorrect assumptions or as aconsequence of known or unknown risks and uncertainties. These risks anduncertainties include the competitive environment in which we operate; local,regional and national economic conditions; the effects of the current nationalcredit market crisis, inflation and the 

 

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recession;the demand for homes; adverse market conditions that could result in additionalinventory impairments, including an oversupply of unsold homes and declininghome prices, among other things; declines in consumer confidence; increases incompetition; fluctuations in interest rates and the availability of mortgagefinancing; mortgage foreclosure rates; the availability and cost of land forfuture growth; the availability of capital; uncertainties and fluctuations incapital and securities markets; changes in tax laws and their interpretation;legal proceedings; the ability of customers to finance the purchase of homes orsell existing homes; the availability and cost of labor and materials; theamount of our debt and the impact of restrictive covenants in our loanagreements; adverse weather conditions; domestic and international politicalevents; geopolitical risks and the uncertainties created by terrorist attacks;the effects of governmental regulation, including regulations concerningdevelopment of land, the home building industry, sales and customer financingprocesses, and the environment; and other risks discussed in our filings withthe Securities and Exchange Commission. Many factors mentioned in this reportor in other reports or public statements made by us, such as governmentregulation and the competitive environment, will be important in determiningour future performance. Consequently, actual results may differ materially fromthose that might be anticipated from our forward-looking statements. You shouldnot place undue reliance on any of these forward-looking statements becausethey are based on current expectations or beliefs regarding future events orcircumstances, which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by these forward-looking statements.

 

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 further disclosures made on related subjectsin 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)

 
| ** **                                                                                                                                  | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                      | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                   |       | $                        | 8.4        |                        | $          | 2.3 |   |
| Restricted cash                                                                                                                             |       | 3.7                      |       | 5.4                         |       |
| Real estate inventories                                                                                                                     |       | 250.9                    |       | 260.7                       |       |
| Deferred tax assets                                                                                                                         |       | 29.4                     |       | 37.1                        |       |
| Other assets, net                                                                                                                           |       | 5.4                      |       | 7.0                         |       |
|                                                                                                                                        |       |                     |       |                        |       |
|                                                                                                                                        |       | $                        | 297.8      |                        | $          | 312.5 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                |       |                     |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                    |       | $                        | 4.9        |                        | $          | 5.0 |   |
| Senior secured project revolver                                                                                                             |       | 77.5                     |       | 74.4                        |       |
| Senior secured term loan                                                                                                                    |       | 105.6                    |       | 107.4                       |       |
| Model home financing                                                                                                                        |       | 22.5                     |       | 22.5                        |       |
| Other project debt                                                                                                                          |       | 11.7                     |       | 38.9                        |       |
| Other liabilities                                                                                                                           |       | 8.9                      |       | 8.8                         |       |
|                                                                                                                                        |       |                     |       |                        |       |
| Total liabilities                                                                                                                           |       | 231.1                    |       | 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)                                                                                                     |       | 9.6                      |       | (1.6                        | )          |
| Accumulated other comprehensive loss                                                                                                        |       | (2.8                     | )          | (2.8                        | )          |
| Total stockholders’ equity                                                                                                             |       | 66.7                     |       | 55.5                        |       |
|                                                                                                                                        |       |                     |       |                        |       |
|                                                                                                                                        |       | $                        | 297.8      |                        | $          | 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  March 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
| ** **                                    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                             |       |   |   |
| Homebuilding                                  |       | $                                                | 12.8       |   | $ | 5.0 |   |
|                                          |       |                                             |       |   |   |
| Costs of sales:                               |       |                                             |       |   |   |
| Homebuilding                                  |       | 8.8                                              |       | 3.9 |   |
| Loss on impairment of real estate inventories |       | 3.2                                              |       | — |   |
|                                          |       | 12.0                                             |       | 3.9 |   |
|                                          |       |                                             |       |   |   |
| Gross operating profit                        |       | .8                                               |       | 1.1 |   |
|                                          |       |                                             |       |   |   |
| Selling, general and administrative expenses  |       | 1.5                                              |       | 1.6 |   |
| Interest expense                              |       | .7                                               |       | — |   |
| Gain on debt restructuring                    |       | (20.7                                            | )          | — |   |
| Other expense, net                            |       | .4                                               |       | .6 |   |
|                                          |       |                                             |       |   |   |
| Income (loss) before income taxes             |       | 18.9                                             |       | (1.1 | ) |
|                                          |       |                                             |       |   |   |
| Income tax expense (benefit)                  |       | 7.7                                              |       | (.4 | ) |
|                                          |       |                                             |       |   |   |
| Net income (loss)                             |       | $                                                | 11.2       |   | $ | (.7 | ) |
|                                          |       |                                             |       |   |   |
| Net earnings (loss) per common share:         |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic and diluted                             |       | $                                                | 1.02       |   | $ | (.06 | ) |
|                                          |       |                                             |       |   |   |
| Common equivalent shares:                     |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic and diluted                             |       | 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)

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
|                                                                             |       |                                             |       |   |   |
| Cash flows from operating activities:                                            |       |                                             |       |   |   |
| Net income (loss)                                                                |       | $                                                | 11.2       |   | $ | (0.7 | ) |
| Adjustments to reconcile net loss to cash used in operating  activities:         |       |                                             |       |   |   |
| Gain on debt restructuring (Note 8)                                              |       | (20.7                                            | )          | — |   |
| Model homes depreciation                                                         |       | .1                                               |       | — |   |
| Stock-based compensation expense                                                 |       | —                                           |       | .1 |   |
| Distributions from unconsolidated joint ventures                                 |       | —                                           |       | .1 |   |
| Equity in earnings of unconsolidated joint ventures                              |       | —                                           |       | (.1 | ) |
| Loss on change in fair value of derivative instrument                            |       | —                                           |       | .5 |   |
| Deferred taxes                                                                   |       | 7.7                                              |       | (.4 | ) |
| Gains on sales of real estate inventories                                        |       | (4.0                                             | )          | (1.1 | ) |
| Loss on impairment of real estate inventories                                    |       | 3.2                                              |       | — |   |
| Proceeds from sale of real estate inventories, net                               |       | 12.5                                             |       | 4.9 |   |
| Investments in real estate inventories                                           |       | (7.6                                             | )          | (12.3 | ) |
| Changes in assets and liabilities:                                               |       |                                             |       |   |   |
| Decrease in other assets                                                         |       | 1.2                                              |       | .1 |   |
| Increase (decrease) in accounts payable, accrued and other  liabilities          |       | 1.9                                              |       | (2.7 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash provided by (used in) operating activities                                  |       | 5.5                                              |       | (11.6 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash flows from investing activities:                                            |       |                                             |       |   |   |
| Investments in unconsolidated joint ventures                                     |       | —                                           |       | (.1 | ) |
| Change in restricted cash                                                        |       | —                                           |       | .1 |   |
|                                                                             |       |                                             |       |   |   |
| Cash provided by investing activities:                                           |       | —                                           |       | — |   |
|                                                                             |       |                                             |       |   |   |
| Cash flows from financing activities:                                            |       |                                             |       |   |   |
| Borrowings of senior secured project revolver                                    |       | 13.2                                             |       | 10.5 |   |
| Repayments of senior secured project revolver                                    |       | (10.1                                            | )          | (19.5 | ) |
| Repayments of senior secured term loan                                           |       | (1.8                                             | )          | (.8 | ) |
| Borrowings of other project debt                                                 |       | —                                           |       | .7 |   |
| Repayments of other project debt                                                 |       | (.5                                              | )          | (2.2 | ) |
| Deferred financing costs                                                         |       | (.2                                              | )          | (.2 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash provided by (used in) financing activities                                  |       | .6                                               |       | (11.5 | ) |
|                                                                             |       |                                             |       |   |   |
| Net increase (decrease) in cash and cash equivalents                             |       | 6.1                                              |       | (23.1 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 2.3                                              |       | 24.3 |   |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                                | 8.4        |   | $ | 1.2 |   |
|                                                                             |       |                                             |       |   |   |
| 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 |       | $                                                | .6         |   | $ | .3 |   |
| 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 COASTALCOMMUNITIES, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 - Basis of Presentation**

 

The accompanyingfinancial statements have been prepared by California Coastal Communities, Inc.and its consolidated subsidiaries (the “Company”), without audit, pursuant tothe rules and regulations of the Securities and Exchange Commission.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with generally accepted accounting principleshave been condensed or omitted pursuant to such rules and regulations. TheCompany believes that these unaudited consolidated financial statements reflectall material adjustments (consisting only of normal recurring adjustments) anddisclosures necessary for the fair presentation of the results of operationsand statements of financial position when read in conjunction with theConsolidated Financial Statements and Notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2008.Intercompany accounts and transactions have been eliminated.

 

The results for interim periods are not necessarily indicative of theresults to 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 AccountingPolicies**

 

*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 financialstatements. The Company’s investments in unconsolidated joint ventures areaccounted for using the equity method when the Company does not have voting oreconomic control of the venture operations, as further described in Note 4to the consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2008. Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.

 

*Cash Flows and Debt Compliance*

 

Negative conditions in the current housing and credit markets give riseto uncertainty as to the Company’s present and future ability to meet itsprojected home sale closings and whether new or modified financings can beobtained, if needed. The Company, like many other homebuilders, is constantlyevaluating potential alternatives regarding its capital structure including,but not limited to, various strategies for restructuring its debt and raisingadditional capital. There can be no assurance that the Company will besuccessful in any of these endeavors. The current national credit market crisispresents uncertainty as to the ability of the Company to secure additionalfinancing, if needed, and the terms of such financing if it is available, andas to the ability of the Company to achieve positive cash flow from operationsrequired to satisfy its obligations. See Notes 5, 6 and 8 for furtherdiscussion.

 

The Company depends on cash flows generated from operations andavailable borrowing capacity to fund its Brightwater development, debt servicerequirements and working capital requirements. However, the Company’s abilityto continue to fund these items and to reduce debt is affected by continueddifficulties in the homebuilding industry and the severe weakening of theeconomy. The downturn in the housing market continues to result in reduced homesales, sharp declines in home prices and difficulties for homebuyers inobtaining mortgage financing, which in turn affects the Company’s ability tosell homes. The Company currently expects to deliver 25 to 30 homes atBrightwater during the remaining nine months of 2009 (in addition to the fivehomes delivered at Brightwater in the first quarter). This level of homes saleswould generate sufficient cash flow to meet the loan repayment requirementsthrough December 31, 2009, as set forth in Notes 5 and 6; however,there can be no assurance that the Company’s sales projections will be realizedor that the Company will otherwise generate cash flows sufficient to satisfyits obligations. As a result of the debt repayments made in connection with thesale and leaseback transaction, as well as home deliveries and additionalborrowings through May 11, 

 

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2009,the Company has met its loan repayment requirements through September 30,2009, excluding additional amounts that may be borrowed through September 30,2009. The Company’s current projections support its belief that it will be ableto satisfy its debt obligations and be in compliance with its debt covenantsthroughout 2009. In the event of noncompliance due to continuing deteriorationin the homebuilding industry and related impact on home closings, the Companybelieves that it will be able to obtain a covenant or default waiver from thelender group, or will be able to successfully amend the covenants to avoid anydefaults through December 31, 2009. Therefore, to the extent that theCompany experiences a shortfall in Brightwater home deliveries, it does notexpect any such shortfall to impair its liquidity position until December 31,2009, when $25.0 million of loan repayments come due. In the event of ashortfall, there are a number of alternatives which the Company could pursue.Among these alternatives are scaling back construction in order to reduceexpenditures, negotiating further amendments to the Company’s credit agreementsto defer a portion of the amortization payments due by December 31, 2009,or raising additional debt or equity capital.

 

Based on current projections of Brightwater closings during the 12months ending March 31, 2010, and due to the additional $25 million inloan repayments due on March 31, 2010, there is substantial doubt that theCompany will be able to meet its debt obligations on March 31, 2010 fromcash generated by operations. In addition, the Company does not expect to beable to repay the revolving loan by its maturity date of June 30, 2010.Therefore, during the fourth quarter of 2009 or the first quarter of 2010, theCompany expects to negotiate revisions to the loan covenants and timing ofcommitment reductions for the Company’s loans, and an extension of the maturitydate of the revolving loan to accommodate the expected sales pace of theBrightwater project.  In addition, theCompany continues to examine financial and strategic alternatives to generatecapital from a variety of sources, including, but not limited to, furtherrestructuring of its debt, equity offerings and issuances of new debt. Therecan be no assurance that amended or future borrowings will be available to theCompany in an amount sufficient to enable it to pay its indebtedness or to fundits other liquidity needs if the Company does not close escrow on enough homesduring the 12 months ending March 31, 2010.

 

The Company will continue to pursue and evaluate various financingalternatives, including further amendments to its revolving and termloans.  The Company does not believe thatits cash, cash equivalents and future real estate sales proceeds will besufficient to meet anticipated operating and project development costs forBrightwater and general and administrative expenses for the next12 months, particularly those debt obligations due on March 31, 2010,unless the Company is successful in amending and extending the terms of itsrevolving loan and term loan, or obtaining new financing.

 

*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.

 

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 thatlong-lived assets be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. As provided by SFAS 144, impairment is evaluated by comparingan asset’s carrying value to the undiscounted estimated cash flows expectedfrom the asset’s 

 

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operationsand eventual disposition. If the sum of the undiscounted estimated future cashflows is less than the carrying value of the asset, an impairment loss is recognizedbased on the fair value of the asset. If impairment occurs, the fair value ofan asset for purposes of SFAS 144 is deemed to be the amount a willingbuyer would pay a willing seller for such asset in a current transaction.Additionally, as appropriate, the Company identifies alternative courses ofaction to recover the carrying value of its long-lived assets and evaluates alllikely alternatives under a probability-weighted approach as described inSFAS 144.

 

During the three months ended March 31, 2009 and 2008, the Companyrecorded inland project impairment charges totaling $3.2 million and zero,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 March 31, 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.

 

The following table summarizes the Company’s fair value measurements atMarch 31, 2009 (in millions):

 
| **Description**         | ** ** | **Fair Value  Hierarchy** | ** ** | **Fair Value at  March 31,  2009** | ** ** | **Impairment Charges for  the Three Months Ended  March 31, 2009** | ** ** |
|-------------------------|------------|---------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Real estate inventories |       | Level  3                  |       | $                                       | 3.0        |                                                                    | $          | 3.2 |   |
|                         |            |                           |            |                                         |            |                                                                         |            |  |  |

 

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.

 

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*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, the Companydoes rely on certain estimates to determine the related construction costs andresulting gross margins associated with revenues recognized. The cost of salesis recorded based upon total estimated costs within a subdivision and allocatedusing the relative sales value method. The Company’s construction costs arecomprised of direct and allocated costs, including estimated costs for futurewarranties and indemnities. The Company’s estimates are based on historicalresults, adjusted for current factors.

 

*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 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 

 

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whetherthere has been a significant decrease in market activity for an asset when themarket for that asset is not active; (iii) eliminates the proposedpresumption that all transactions are distressed (not orderly) unless provenotherwise. FSP 157-4 instead requires an entity to base its conclusion aboutwhether a transaction was not orderly on the weight of the evidence; (iv) includesan example that provides additional explanation on estimating fair value whenthe market activity for an asset has declined significantly; and (v) requiresan entity to disclose a change in valuation technique (and the related inputs)resulting from the application of FSP 157-4 and to quantify its effects, if practicable.FSP 157-4 applies to all fair value measurements when appropriate. FSP 157-4must be applied prospectively and retrospective application is not permitted.FSP 157-4 is effective for interim and annual periods ending after June 15,2009. The Company is currently evaluating the impact, if any, that the adoptionof FSP 157-4 will have on its results of operations, financial position, andcash flows.

 

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 summarized financialinformation for interim reporting periods and in its financial statements forannual reporting periods the fair value of all financial instruments for whichit is practicable to estimate that value, whether recognized or not recognizedin the statement of financial position, as required by SFAS 107. FSP 107-1 iseffective for interim periods ending after June 15, 2009. The Company iscurrently evaluating the impact, if any, that the adoption of FSP 107-1 willhave on its results of operations, financial position, and cash flows.

 

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.

 

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 March 31,2009, real estate inventories aggregated 524 lots and homes, including 26 modelhomes, 15 standing inventory homes completed and unsold, three homes completedand in escrow, and five homes under construction and in escrow. Real estateinventories at March 31, 2009 included $238.4 million recorded for302 lots and homes under development and 17 model homes held under a financinglease at the Brightwater community which is located on a 105-acre parcel on amesa north of the Bolsa Chica wetlands in Huntington Beach, California. Anadditional $12.5 million in real estate inventories is recorded for 205lots and homes at the Company’s subsidiaries’ various inland projects. TheCompany capitalizes carrying costs including interest and property taxes, aswell as direct construction costs, to real estate inventories during thedevelopment 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 secure the remaining note balance of$2.5 million. See Note 8 for additional discussion.

 

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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 $3.2million and zero during the three months ended March 31, 2009 and 2008,respectively. The impairment charge recorded during the first quarter of 2009relates to a subsidiary’s Woodhaven project in Beaumont, California andreflects recent sales price reductions by large competitors and the Company’scurrent intention to attempt to negotiate a short-sale for the property in 2009in order to maximize utilization of tax loss carryforwards in 2010 and futureyears. The loan is non-recourse to California Coastal Communities, Inc.,however, the subsidiary’s parent, Hearthside Homes, Inc., guaranteedpayment of the debt. Hearthside Homes’ subsidiary is attempting to negotiate aconsensual resolution of the loan with the lender, which may involve turnoverof the property 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 transferred to the lender in full settlementof the loan without further recourse or obligation, the Company will recognizea gain as a result of debt cancellation. However, there can be no assurancethat the lender will agree to a consensual resolution.

 

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.

 

Capitalized interest isallocated to real estate inventories when incurred and charged to cost of saleswhen the related property is delivered. Changes in capitalized interest follow(in millions):

 
| ** **                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
| Capitalized interest, beginning of period |       | $                                                | 37.3       |   | $ | 26.2 |   |
| Interest incurred and capitalized         |       | 4.0                                              |       | 4.0 |   |
| Charged to cost of sales                  |       | (1.4                                             | )          | (.6 | ) |
| Charged to gain on debt restructuring     |       | (4.2                                             | )          | — |   |
| Capitalized interest, end of period       |       | $                                                | 35.7       |   | $ | 29.6 |   |

 

**Note 5 – Senior Secured ProjectRevolver**

 

On September 30, 2008, the Company entered into the thirdamendment to the $100 Million Senior Secured Revolving Credit Agreementwith KeyBank National Association, as a lender and as agent for the other loansyndicate members (the “Revolving Loan”). The Revolving Loan is secured by afirst trust deed on the Brightwater project, and stock pledges of the Company’smaterial subsidiaries.

 

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As of March 31, 2009 and December 31, 2008, $77.5 million and$74.4 million, respectively, was outstanding under the Revolving Loan atweighted average rates of 3.81% and 5.09%, respectively, based upon the Company’selected rates. As of March 31, 2009, the undrawn availability was$9.5 million. Outstanding advances currently bear interest based on thefollowing loan-to-value grid:

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

 

Interest on the facility is calculated on the average, outstandingdaily balance and is paid monthly. Interest incurred on the Revolving Loan forthe three months ended March 31, 2009 and 2008 was $1.2 million and$900,000, respectively, at weighted-average interest rates of 3.80% and 5.64%,respectively. As of May 11, 2009, the Revolving Loan weighted averageinterest rate is 3.65%. Rate options based on the Prime rate and various LIBORterms are available. 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.

 

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. These mandatory repayments are applicable to the commitment reductionsset forth below. The commitment amount under the Revolving Loan reduces to zeroby the final maturity as follows (in millions):

 
| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|----------------|------------|
| March 31, 2009     |       |                      |       | $              | 87.0       |   |
| June 30, 2009      |       | $                         | —     |           | 87.0       |   |
| September 30, 2009 |       | 7.0                       |       | 80.0           |       |
| December 31, 2009  |       | 10.0                      |       | 70.0           |       |
| March 31, 2010     |       | 10.0                      |       | 60.0           |       |
| June 30, 2010      |       | 60.0                      |       | —         |       |
|                         |            |                           |            |                |            |  |  |

 

During the three months ended March 31, 2009, the Companydelivered five homes at Brightwater and made mandatory repayments on theRevolving Loan of $1.2 million. As of March 31, 2009, the Company has madecumulative mandatory repayments for the Revolving Loan of $13.0 million,reflecting 54 homes delivered to date, including the 17 model homes included inthe sale-leaseback transaction completed on December 31, 2008.Availability under the $100.0 million Revolving Loan has been reduced to$87.0 million.

 

As of March 31, 2009 and December 31, 2008, approximately$1.2 million and $1.4 million, respectively, of deferred loan fees andclosing costs related to the Revolving Loan are included in other assets andamortized over the life of the loan. Amortization of these costs is included inthe capitalization of interest allocated to real estate inventories and chargedto cost 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 theHearthside Lane project in Corona and the Las Colinas project in Lancaster andvaluation allowances on deferred tax assets.

 

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·                  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 March 31, 2009, the Company’s consolidated total liabilitiesare $231.1 million, tangible net worth after excluding the 2008 HearthsideLane and Las Colinas impairment charges and valuation allowances on deferredtax assets is $105.6 million and the leverage ratio is 2.19. Theloan-to-value ratio is 27% and the Company is in compliance with the covenantsof the Revolving Loan as of March 31, 2009.

 

The Company, like many other homebuilders, is constantly evaluatingpotential alternatives regarding its capital structure including, but notlimited to, various strategies for restructuring its debt and raisingadditional capital. The Company does not expect to be able to meet its mandatoryprincipal repayments due on March 31, 2010 or fully re-pay the RevolvingLoan by its maturity date on June 30, 2010 from cash flow fromoperations.  Therefore, the Companyexpects to restructure the Revolving Loan and the senior secured term loan toaccommodate the expected sales pace of the Brightwater project during thefourth quarter of 2009 or the first quarter of 2010.  There can be no assurance that the Companywill be successful in any of these endeavors. The current national crisis inthe credit markets presents significant uncertainty as to the ability of theCompany to secure additional financing, and the terms of such financing ifavailable, and as to the ability of the Company to achieve positive cash flowfrom operations required to satisfy its obligations.

 

**Note 6 – Senior Secured Term Loan**

 

On September 30, 2008, the Company entered into the thirdamendment to the five-year, $125 million Senior Secured Term LoanAgreement with KeyBank National Association, as a lender and as agent for theother loan syndicate members (the “Term Loan”). The Term Loan is secured by asecond trust deed on the Brightwater project, and a general pledge andassignment of the Company’s ownership interests in all material subsidiaries.All existing material subsidiaries of the Company have provided fullunconditional guarantees. The Term Loan includes financial covenants which maylimit the amount that may be outstanding. In January 2009, a major shareholder of the Company purchased 6% ofthe Term Loan from certain members of the loan syndicate.

 

As of March 31, 2009 and December 31, 2008, $105.6 millionand $107.4 million, respectively, was outstanding under the Term Loan atrates of 5.07% and 6.38%, respectively, based upon the Company’s elected rates.The outstanding balance currently bears interest based on the following loan-to-valuegrid:

 
| **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 months ended March 31, 2009 and 2008 was $1.7 million and$2.0 million, respectively, at weighted-average interest rates of 5.07%and 6.46%, respectively. As of May 11, 2009, the Term Loan interest rateis 4.39%. Rate options based on Prime rate and various LIBOR terms areavailable.

 

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.

 

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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** | ** ** |
|-------------------------|------------|---------------------------|------------|-------------------------------|------------|
| March 31, 2009     |       |                      |       | $                             | 105.6      |   |
| June 30, 2009      |       | $                         | —     |                          | 105.6      |   |
| September 30, 2009 |       | .6                        |       | 105.0                         |       |
| December 31, 2009  |       | 15.0                      |       | 90.0                          |       |
| March 31, 2010     |       | 15.0                      |       | 75.0                          |       |
| June 30, 2010      |       | 10.0                      |       | 65.0                          |       |
| September 30, 2010 |       | 15.0                      |       | 50.0                          |       |
| December 31, 2010  |       | 12.5                      |       | 37.5                          |       |
| March 31, 2011     |       | 12.5                      |       | 25.0                          |       |
| June 30, 2011      |       | 12.5                      |       | 12.5                          |       |
| September 15, 2011 |       | 12.5                      |       | —                        |       |
|                         |            |                           |            |                               |            |  |  |

 

During the three months ended March 31, 2009, the Companydelivered five homes at Brightwater and made mandatory repayments on the TermLoan of $1.8 million. As of March 31, 2009, the Company has madecumulative mandatory repayments for the Term Loan of $19.4 million,reflecting 54 homes delivered to date, including the 17 model homes included inthe sale-leaseback transaction completed on December 31, 2008.Availability under the $125.0 million Term Loan has been reduced to$105.6 million.

 

As of March 31, 2009 and December 31, 2008, approximately$2.7 million and $3.1 million, respectively, of deferred loan fees andclosing costs related to the Term Loan are included in other assets andamortized over the life of the loan. Amortization of these costs is included inthe capitalization of interest allocated to real estate inventories, andcharged to cost 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.

 

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As of March 31, 2009, the Company’s consolidated total liabilitiesare $231.1 million, tangible net worth after excluding the 2008 HearthsideLane and Las Colinas impairment charges and valuation allowances on deferredtax assets is $105.6 million and the leverage ratio is 2.19. The loan-to-valueratio is 63% and the Company is in compliance with covenants of the Term Loanas of March 31, 2009.

 

The Company, like many other homebuilders, is constantly evaluatingpotential alternatives regarding its capital structure including, but notlimited to, various strategies for restructuring its debt and raisingadditional capital. The Company does not expect to be able to make themandatory repayments due on March 31, 2010 under the Term Loan and theRevolving Loan. Should the Company be unable to make the required repaymentsset forth above it will attempt to negotiate deferrals of commitment reductionamounts of the loans to accommodate the expected sales pace of the Brightwaterproject There can be no assurance that the Company will be successful in any ofthese endeavors. Current credit market conditions present uncertainty as to theability of the Company to secure additional financing, if needed, and the termsof such financing if it is available, and as to the ability of the Company toachieve positive cash flow from operations required to satisfy its obligations.

 

**Note 7—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 has notbeen 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 senior secured revolving creditagreement and senior secured term loan with KeyBank National Association,thereby reducing the payments that would have been due in 2009. The Companyused an additional $10.7 million of the proceeds to reduce the balanceoutstanding under the revolving credit agreement, which amount can bere-borrowed under the terms of the agreement. See Notes 5 and 6 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 allowed 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. As of March 31, 2009, approximately $800,000of prepaid rent is included in other assets and is amortized monthly through June 2009.The future minimum lease payments under the terms of the related leaseagreement are as follows (in millions):

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

 

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**Note 8 – 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 three months ended March 31, 2009,Hearthside Homes, Inc. and its subsidiaries did not enter into any newloan facilities.

 

The following amounts were available and outstanding under these loanfacilities as of March 31, 2009 and December 31, 2008 ($ inmillions):

 
| ** **     | ** ** | ** **                   | ** ** | **Interest**         | ** ** | ** **               | ** **                                   | ** **               | ** ** | ** **         | ** ** | **Outstanding at**  | ** ** |
|----------------|------------|------------------------------|------------|----------------------|------------|--------------------------|----------------------------------------------|--------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Rate  at 3/31/09** | ** ** | **Lender**               | ** **                                   | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **March 31,  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            |                                         | 70                       |       | 9/17/09            |       | 6.8                      |       | 7.0 |   |
| Corona-Hellman |       | 2.5                          |       | 3.25                 | %          | Third party investor (2) |                                         | 7                        |       | 3/31/10            |       | 2.5                      |       | 29.2 |   |
|           |       |                         |       |                 |       |                     |                                         |                     |       |               |       |                     |       |   |   |
|           |       |                         |       |                 |       |                     |                                         |                     |       |               |       | $                        |  11.7 |   | $ | 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. The transactionwas 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 secure the remaining note balance of $2.5 million. The modified notebears interest at the prime rate and matures on March 31, 2010. Subject tocertain conditions, after all seven homes have been sold, the guaranty of thisdebt by Hearthside Homes will be released and any remaining balance on the $2.5million note will be cancelled. The subsidiary also assigned $1.7 million ofrestricted cash related to the project to the investor as part of thetransaction.  As of May 11, 2009,the subsidiary has entered into sales contracts for two homes and accepted salereservations for the five model homes.

 

A subsidiary of Hearthside Homes is currently in default on a loanfacility which matured on September 30, 2008 for development of the LasColinas project in Lancaster. The subsidiary made all interest paymentsrequired to be made through September 30, 2008 and ceased making paymentsthereafter. The loan is nonrecourse to California Coastal Communities, Inc.;however, the subsidiary’s parent, Hearthside Homes, Inc., guaranteedpayment of the debt. During the third quarter of 2008, in accordance withEITF 91-2 and a FASB staff interpretation thereof, the Company reduced thecarrying value of the Las Colinas real estate project to its estimated fairvalue. During January 2009, the Company delivered one home at the LasColinas project resulting in a loan repayment of $291,000 and the finalcompleted model home is available for sale.

 

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Hearthside Homes’ subsidiary is attempting to negotiate a consensualresolution of the Lancaster loan with OneWest of California, which recentlyacquired IndyMac Federal Bank. Any such resolution will likely involve turnoverof the property (one completed home and 54 finished lots) securing the loan tothe lender. If the property is transferred to the lender in full settlement ofthe loan without further recourse or obligation, the Company expects torecognize a nominal gain as a result of debt cancellation. However, there canbe no assurance that the lender will agree to a consensual resolution of theloan default.

 

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 turnover of theproperty securing the loan to the lender. In accordance with EITF 91-2, and aFASB staff interpretation thereof, the Company reduced the carrying value ofthe Woodhaven real estate project to its estimated fair value during the firstquarter of 2009. If the Woodhaven project is transferred to the lender in fullsettlement of the loan without further recourse or obligation, the Company willrecognize a gain as a result of debt cancellation. However, there can be noassurance that the lender will agree to a consensual resolution.

 

**Note 9 - Other Liabilities**

 

Other liabilities werecomprised of the following (in millions):

 
| ** **                                         | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                      |       | $                        | 5.9        |                        | $          | 5.9 |   |
| Home warranty reserves                             |       | 1.7                      |       | 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*

 

TheCompany provides a home warranty reserve to reflect its contingent obligationfor product liability. The Company generally records a provision as homes aredelivered, based upon historical and industry experience, for the items listedin the homeowner warranty manual, which does not include items that are coveredby manufacturers’ warranties or items that are not installed by the Company’semployees or contractors. The home warranty reserve activity is presented below (in millions):

 
| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
| Balance at beginning of period       |       | $                                                | 1.7        |   | $ | 2.3 |   |
| Provision                            |       | —                                           |       | — |   |
| Adjustment due to change in estimate |       | —                                           |       | (.1 | ) |
| Payments                             |       | —                                           |       | (.1 | ) |
| Balance at end of period             |       | $                                                | 1.7        |   | $ | 2.1 |   |

 

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**Note 10 - Income Taxes**

 

Thefollowing is a summary of the tax expense (benefit):

 
| ** **                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
| Current taxes                |       | $                                                | —     |   | $ | — |   |
| Deferred taxes               |       | 7.7                                              |       | (.4 | ) |
| Income tax expense (benefit) |       | $                                                | 7.7        |   | $ | (.4 | ) |

 

The net deferredtax balance at March 31, 2009 and December 31, 2008 is primarilycomposed of federal net operating losses (“NOLs”). During 2008, the Companyconcluded it was not “more likely than not” that the Company would be able togenerate sufficient taxable income in 2008, 2009, 2010 and 2011 to realizecertain expiring federal NOLs and recorded valuation allowances of$23.2 million, including $700,000 for NOLs that expired in December 2008.While the Company expects to report profitable operations for 2009, it expectsto report a taxable loss due to tax losses recognized upon propertydispositions. These tax losses were previously recognized for financialstatement purposes when impairment losses were recorded. The Company monitorsthe availability of real estate for development at economically viable prices,market conditions and other objectively verifiable economic factors affectingthe Company’s operations, as well as other positive and negative factors, as itassesses valuation allowances against its deferred tax assets. The mostcritical uncertainties are whether the Company will be able to continue sellinghomes at its Brightwater project using currently projected sales prices andabsorption rates in light of the continuing deterioration in the housing andcredit markets and the timing of dispositions of inland properties and therelated recognition of losses for tax reporting purposes.

 

The federal NOLs available as of March 31, 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 (4.61% as of May 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 April 30,2009, 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 March 31, 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 additionalpaid-in capital.

 

*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 

 

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increasein deferred tax assets of $1.8 million for assets re-evaluated asrecognizable. The net change in deferred tax assets of $3.3 million was recordedas a cumulative effect of a change in accounting principle and resulted in adecrease to the January 1, 2007 retained earnings balance of $200,000 anda decrease to the additional paid in capital balance of $3.1 millionrelated to fresh-start accounting pursuant to a 1997 pre-packaged bankruptcy.

 

Of the Company’s unrecognized tax benefits of $5.1 million at March 31,2009, $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 twelve months of the reporting date.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of March 31,2009, the Company has not recorded any interest or penalties related tounrecognized tax benefits, due to the substantial NOLs available.

 

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 11 - Commitments andContingencies**

 

*Real Estate Matters*

 

The Company is subject to the usual obligations associated withentering into contracts for the purchase of land and improved home sites. Thepurchase of properties under these contracts is generally contingent uponsatisfaction of certain requirements by the sellers, including obtainingapplicable property entitlements. The Company also utilizes option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Option contracts generally requirethe payment of a non-refundable cash deposit of 5% to 15% of the purchase pricefor the right to acquire lots over a specified period of time (usually one totwo years) at predetermined prices. The Company has the right at its discretionto terminate its obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As of March 31,2009, the Company has no land option deposits.

 

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 March 31,2009. 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 it issueda final acceptance of the remediation work. The complaint also seeks an orderfor HRC to pay any future costs which may be incurred in connection withfurther remediation, together with court costs and attorney’s fees.

 

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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 12 to 18 months to complete the appellate process. There can be noassurance that HRC will receive a favorable ruling that it is not deemed to bea current owner of the site.  Once the appellateprocess is complete, the parties will return to the District Court within 30 to60 days to commence a trial.

 

See Note 9 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

 

**Note 12 – 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 three independentdirectors in 2009 and four independent directors in 2008, under the DirectorFee Program, which is a component of the 1993 Plan. These restricted sharesvest at a rate of 25% per quarter during 2008 and 2009, respectively. On October 16,2008, one of the Company’s independent directors resigned from the Board andforfeited 878 unvested restricted shares.

 

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The Company did not grant any options during the three months ended March 31,2009 and 2008. Pursuant to SFAS 123(R), the Company recorded $18,000 and$28,000 of compensation expense during the three months ended March 31,2009 and 2008, respectively, which is reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993 plan for the three monthsended March 31, 2009 follows:

 
| ** **                                    | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** **  |
|-----------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|-------------|
| Outstanding, January 1                   |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |        |   |
| Granted                                       |       | —                      |       | $                                     | —     |                                  |        |   |
| Exercised                                     |       | —                      |       | $                                     | —     |                                  |        |   |
| Outstanding, March 31                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.85  years |   |
|                                          |       |                        |       |                                  |       |                                  |        |
| Fully vested and exercisable at March 31 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.85  years |   |
|                                          |       |                        |       |                                  |       |                                  |        |
| Available for future grants at March 31  |       | 221,794                     |       |                                  |       |                                  |        |

 

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(a)           Adjusted for specialdividend of $12.50

 

As of March 31, 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 6.85 years. All outstanding stockoptions are fully vested. The aggregate intrinsic value of all outstanding,fully-vested and exercisable stock options at March 31, 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 temporarydifferences as prescribed by SFAS 109, ***“****Accountingfor Income Taxes.”* The tax effect of compensation deductions for taxpurposes in excess of compensation cost recognized in the financial statements,if any, will be recorded as an increase to additional paid-in capital whenrealized. A deferred tax asset recorded for compensation cost recognized in thefinancial statements that exceeds the amount that is ultimately realized on thetax return, if any, will be charged to income tax expense when the restrictionslapse or stock options are exercised or expire unless the Company has anavailable additional paid-in capital pool (“APIC Pool”), as defined pursuant toSFAS 123(R). The Company is required to assess whether there is anavailable APIC Pool when the stock options are exercised or expire.

 

SFAS 123(R) also 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 13 – Stockholders’ Equity**

** **

As of March 31, 2009,total stockholders’ equity is $66.7 million, reflecting beginning stockholders’equity of $55.5 million and net income of $11.2 million during the three monthsended March 31, 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, and below in this Form 10-Q.

 

**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 three months 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 of $2.5 million whichis due in March 2010. Subject to certain conditions, after all seven homeshave been sold, the guaranty of this debt by Hearthside Homes will be releasedand any remaining balance on the $2.5 million note will be cancelled.  As of May 11, 2009, the subsidiary hasentered into sales contracts for two of the homes and accepted salesreservations for the five model homes.

 

During the first quarter of 2009 we also extended the maturity date onour senior secured revolving credit agreement from September 15, 2009 to June 30,2010. However, based on current projections of Brightwater closings during the12 months ending March 31, 2010, and due to the additional $25 million inloan repayments due on March 31, 2010, there is substantial doubt that wewill be able to meet our debt obligations on March 31, 2010 from cashgenerated by operations. In addition, we do not expect to be able to repay therevolving loan by its maturity date of June 30, 2010. Therefore, duringthe fourth quarter of 2009 or the first quarter of 2010 we expect to negotiaterevisions to our loan covenants and the timing of commitment reductions for ourloans, and an extension of the maturity date of the revolving loan toaccommodate the expected sales pace of the Brightwater project. There can be noassurance that we will be successful in negotiating any such amendments orextensions. In addition, we continue to examine financial and strategicalternatives to generate capital from a variety of sources, including, but notlimited to, further restructuring of our debt, equity offerings and issuancesof new debt. We cannot assure you that amended or future borrowings will beavailable to us in an amount sufficient to enable us to pay our indebtedness orto fund our other liquidity needs if we do not close escrow on enough homesduring the 12 months ending March 31, 2010.

 

In view of the continuing significant economic downturn in the housingmarket, we currently expect that during the remaining nine months of 2009and continuing into 2010 our new home construction will be limited primarily toour 356-home Brightwater project located on the Bolsa Chica mesa in HuntingtonBeach, California; and that our operations in other markets will focus on thesale of standing inventory and resolution of certain existing project loans.

 

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

 

·                  continue selling anddelivering homes at Brightwater;

 

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

 

·                  continue reducing standinginventories and thereby maximize deliveries and revenues at our otherhomebuilding projects in Los Angeles and Riverside counties;

 

·                  pursue consensual resolutionof a loan default on one nonperforming inland development project in Lancaster,California; and

 

·                  pursue a sale of the inlanddevelopment project in Beaumont, California and negotiate satisfaction of therelated project debt for less than 100% of the principal balance due on suchdebt, 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.

 

Our total revenues for the three months ended March 31, 2009 and2008 were $12.8 million and $5.0 million, respectively. For the threemonths ended March 31, 2009 and 2008 we delivered seven and eight, homes,respectively. Our total assets as of March 31, 2009 and December 31,2008 were $297.8 million and $312.5 million, respectively, withBrightwater constituting $238.4 million (80% of total assets) and$238.5 million (76% of total assets), respectively. Our homebuildingsubsidiary, Hearthside Homes, Inc., has delivered over 2,100 homes tofamilies throughout Southern California since its 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 debt financing,as described in Notes 6 and 7 to the Consolidated Financial Statements,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 March 31, 2009, we had$217.3 million of debt (including the model home financing) against$66.7 million of 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 quarter of 2009. The homebuilding environment has continued todeteriorate as consumer confidence declined, unemployment increased, theavailability of home mortgage credit tightened significantly and the economycontinued to slow down. Specifically, the credit markets and the mortgageindustry have been experiencing a period of unparalleled turmoil and disruptioncharacterized by bankruptcy, financial institution failure, consolidation andan unprecedented level of intervention by the United States federal government.While the ultimate outcome of these events cannot be predicted, it has made itmore difficult for homebuyers to obtain acceptable financing. In addition, thesupply of new and resale homes in the marketplace remained excessive for thelevels of consumer demand, further challenged by an increased number offoreclosed homes offered at substantially reduced prices. These pressures inthe marketplace resulted in the use of increased sales incentives and pricereductions in an effort to generate sales and reduce inventory levels by us andmany 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 11.2% at the end of the firstquarter of 2009 compared with 8.7% at the end of 2008, while the unemploymentrate in Orange County was 8.5% in March 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 threemonths ended March 31, 2009 and 2008. We believe that the tepid demand we are experiencing reflects 

 

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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 nine monthsof 2009 and perhaps beyond, and we expect that our operations may sustainperiodic losses until the homebuilding industry and economy as a whole begin torebound.

 

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 areoccurring, such as modest improvements in consumer confidence and reducednumber of new unemployment claims, it remains uncertain when the housing marketor the broader economy will experience a meaningful recovery.

 

Recent actions taken by the federal government designed to boosthousing demand could soften the impact of the recession. While the recentlyenacted California tax credit (which does not contain income or first-time buyerrestrictions and is limited to new homes) appears to have boosted demandsomewhat, the federal stimulus plan has not had much impact on the homebuildingindustry due to its income and first-time buyer restrictions.  Key housing metrics, including starts, newhome sales and existing home sales may continue to weaken or remain stagnantduring the remaining nine months of 2009. We therefore expect fierce pricecompetition to persist in our inland markets well into 2009. This could lead tomore inventory impairments, though potentially smaller in magnitude.

 

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 greater than 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 27homes as of March 31, 2008 to six homes as of March 31, 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 quarter of 2009 we have:

 

·                  postponed further inlandmarket construction activity until those markets improve;

 

·                  reduced sales prices andoffered incentives for all of our inland homes in order to reduce our standinginventory;

 

·                  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.

 

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 three months endedMarch 31, 2009, if market conditions decline further, we may need to takeadditional charges for inventory impairments in future quarters. In addition,our results for the remaining nine months of 2009 could be adversely affectedif general economic conditions do not improve or continue to deteriorate, ifconsumer confidence remains weak or declines further, if job losses continue oraccelerate, if foreclosures or distressed sales increase, or if consumermortgage lending becomes less available or more expensive, any or all of whichwould further diminish the prospects for a recovery in housing markets.

 

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In light of the current crisis in the national financial markets,conditions in the housing market and the overall economy may deterioratefurther before they improve. We believe that stability in the credit andcapital markets and an eventual renewal of confidence in the national economywill play a major role in any turnaround in the homebuilding and mortgagelending industries. We also believe that a meaningful improvement in housingmarket conditions will require the restoration of consumer and credit market confidencethat will support a decision to buy a home, which will in turn require asustained decrease in inventory levels, price stabilization and reducedforeclosure rates. With the passage of the American Recovery and ReinvestmentAct of 2009, the United States government has taken steps to stabilize theeconomy, including measures directed specifically at stabilizing the housingmarket such as an $8,000 first-time homebuyer tax credit, subject to incomelimitations, for homes purchased by December 1, 2009 and increasedavailability of mortgage refinancing and restructuring through the HomeownerAffordability and Stability Plan. As a further incentive to homebuyers, theCalifornia legislature recently approved its budget which includes a provisionfor a $10,000 tax credit for homebuyers, not limited to first-time buyers orsubject to income limitations, for new homes purchased between March 1,2009 and up to March 2010, subject to a total limitation of$100 million, or approximately the first 10,000 homes. Approximately 55%of the $100 million available for the California tax credit has alreadybeen utilized by homebuyers.

 

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;

 

·                  temporarily ceasingconstruction and sales efforts at certain inland projects where we are unableto generate acceptable levels of sales volume and cash flow until the housingmarket 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 first quarter of 2009, we delivered seven homes and as of May 11,2009, four additional homes have been delivered and nine additional homes arein escrow, as discussed further under “Our Current and Future Homesites.”

 

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 will be realizablein the future and that this value should not be sacrificed under current depressedmarket conditions. Finally, we believe that Brightwater’s demographics remainstrong due to the continuing regulation-induced constraints on lot supplies andthe growing number of affluent households along the coast of SouthernCalifornia. Therefore, we remain optimistic about continuing sales atBrightwater.

 

We currently believe that market conditions will continue to bechallenging throughout 2009, particularly in our inland markets whereforeclosure activity continues to be significant, unemployment rates arerising, consumer mortgage lending and other credit markets continue to beunsettled and consumer confidence continues to be eroded. Althoughsubstantially reduced home prices and relatively low consumer mortgage interestrates for conforming loans have improved housing affordability, potentialhomebuyers remain tepid about purchasing a home in this unstable economicenvironment. This demand-side dynamic, in conjunction with rising foreclosures,is sustaining the oversupply of unsold new and existing homes and competitivepricing pressures that have generated the extremely challenging conditions ourindustry has experienced since the beginning of 2006. We remain hopeful thatthe federal government’s initiatives to stabilize the credit markets and restoreconfidence in the financial system and economy will be effective.

 

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In view of the continuing significant economic downturn in the housingmarket, we currently expect that during the remaining nine months of 2009 ournew home construction will likely be limited to our 356-home Brightwaterproject located on the Bolsa Chica mesa in Huntington Beach, California. Weexpect that continuing operations in our inland markets will focus on the saleof standing inventory, with limited, if any, construction starts. . Inaddition, we are attempting to negotiate a consensual resolution with ourlender with respect to a loan default on our subsidiaries’ Las Colinas(Lancaster) property and we are attempting to sell our Beaumont property insatisfaction of the related project debt. However, there can be no assurancethat 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 nine months of 2009could be adversely affected if housing, credit market, or general economicconditions continue to deteriorate, if job losses accelerate, if consumermortgage lending becomes less available or more expensive, or if consumerconfidence continues to fall, any or all of which would further diminish theprospects for a recovery in the housing market. We believe that there will not bea meaningful 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 March 31, 2009:

 
| **Project**                             | ** ** | **Location**     | ** ** | **Models(a)** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|-----------------------------------------|------------|------------------|------------|---------------|------------|-------------|------------|-------------------------|------------|---------------------|------------|--------------------------|------------|
| Brightwater in Orange County:           |       |             |       |          |       |        |       |                    |       |                |       |                     |       |
| The Trails                              |       | Huntington Beach |       | 4             |       | 4           |       | 4                       |       | 39                  |       | 51                       |       |
| The Sands                               |       | Huntington Beach |       | 4             |       | 1           |       | 1                       |       | 61                  |       | 67                       |       |
| The Cliffs                              |       | Huntington Beach |       | 4             |       | 2           |       | 1                       |       | 93                  |       | 100                      |       |
| The Breakers                            |       | Huntington Beach |       | 5             |       | —      |       | 3                       |       | 93                  |       | 101                      |       |
| *Subtotal—Orange County*           |       |             |       | 17            |       | 7           |       | 9                       |       | 286                 |       | 319                      |       |
| Inland Empire/Lancaster:                |       |             |       |          |       |        |       |                    |       |                |       |                     |       |
| Hearthside Lane                         |       | Corona           |       | 5             |       | —      |       | 2                       |       | —              |       | 7                        |       |
| Woodhaven                               |       | Beaumont         |       | 4             |       | 1           |       | 3                       |       | 62                  |       | 70                       |       |
| Las Colinas                             |       | Lancaster        |       | —        |       | —      |       | 1                       |       | 54                  |       | 55                       |       |
| Other unimproved lots                   |       | Lancaster        |       | —        |       | —      |       | —                  |       | 73                  |       | 73                       |       |
| *Subtotal—Inland Empire/Lancaster* |       |             |       | 9             |       | 1           |       | 6                       |       | 189                 |       | 205                      |       |
| *Total—All Projects*               |       |             |       | 26            |       | 8           |       | 15                      |       | 475                 |       | 524                      |       |

 

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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 March 31, 2009, we had standing inventory of 15 homes,including nine homes at Brightwater and six homes at our inland projects.During the three months ended March 31, 2009, net new orders decreased toseven homes compared with 16 homes during the comparable period in 2008 due toreduced sales activity at Brightwater compared with the first quarter 2008 whenwe held a grand opening for The Breakers and The Cliffs, as well as feweractive communities at our inland projects. Cancellations as a percentage of neworders were 30% during the three months ended March 31, 2009, comparedwith approximately 27% during the comparable period in 2008. Backlog as of March 31,2009 decreased to eight homes compared with 12 homes as of March 31, 2008primarily due to the initial orders in 2008 related to the grand opening at TheBreakers and The Cliffs and fewer active 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 March 31, 2009.This project is located on one of the last large undeveloped coastal propertiesin Southern California. Brightwater is bordered on the north and east byresidential development in the City of Huntington Beach and Huntington Harbor,to the south by open space and the 1,300-acre Bolsa Chica wetlands, and to thewest by 120 acres of publicly-owned conservation land and open space on thelower bench of the Bolsa Chica mesa, Pacific Coast Highway, Bolsa Chica StateBeach, and the Pacific Ocean. Brightwater also has 37 acres of open space andconservation area.

 

We completed construction of eight model homes at The Trails and TheSands neighborhoods in July 2007, held a grand opening in August 2007and delivered the first nine homes in December 2007. We delivered one andtwo homes at The Trails and The Sands during the three months ended March 31,2009 and 2008, respectively, and generated $1.1 million and$2.2 million in revenue, respectively. We generated gross operatingmargins of 26.4% and 33.8% for The Trails and The Sands during the three monthsended March 31, 2009 and 2008, respectively. The decrease in marginsreflects price reductions required to be competitive under current marketconditions. Homes at The Trails and The Sands are presently being offered atprices ranging from $798,000 to $1.0 million. As of May 11, 2009,five homes are in escrow at The Trails and The Sands.

 

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During January 2008, we completed construction of nine additionalmodel homes for The Cliffs and The Breakers and in February 2008 beganselling homes to buyers who previously registered on our priority list. We helda grand opening for these neighborhoods in March 2008. These homes arelarger than The Trails and The Sands, ranging from 2,724 to 4,339 square feet. Webegan delivering homes at The Cliffs and The Breakers during the third quarterof 2008. We delivered four homes at The Cliffs and The Breakers during thethree months ended March 31, 2009, including three Breakers view homesaveraging $3.2 million, and generated revenue of $11.1 million and grossoperating margins of 33.0%. Homes at The Cliffs and The Breakers are presentlybeing offered at prices ranging from $1.4 to $3.2 million for 2,724 to4,339 square foot homes. As of May 11, 2009, two homes are in escrow atThe Cliffs and The Breakers.

 

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 23% to 36% due to our low carryingvalue in Brightwater. Gross margins for the larger homes at The Cliffs and TheBreakers are currently expected to approximate 32% to 36%, while gross marginsat The Trails and The Sands are currently expected to approximate 23% to 29%.

 

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 seven homes during the three months ended March 31, 2009,compared with eight deliveries during the comparable period of 2008, asdetailed below. We acquired no single-family residential lots during the threemonths ended March 31, 2009 and 2008 and we have no contracts to acquireland or lots.

 

During the first three months of 2009, difficult conditions persistedin the 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 significantly reduced gross profits for InlandEmpire and Lancaster home sales.

 

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 have entered into two sales contracts and acceptedfive sales reservations for the seven remaining homes. We delivered twoadditional homes at our Beaumont project during April 2009 and have soldall but one of the existing model 

 

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homesat our Las Colinas project in Lancaster and will defer any further developmentof those projects pending negotiations with the lenders. Including the sevenhomes in Corona, we currently have 10 homes in escrow or available for sale atour inland projects.

 

We recorded a non-cash impairment charge of $3.2 million for ourWoodhaven project in Beaumont, California during the three months ended March 31,2009, compared with no impairment charges during the comparable period in 2008.The impairment charge reflects recent sales price reductions by largecompetitors and our current intention to attempt to negotiate a sale of theproperty in full satisfaction of the debt for less than 100% of the principalbalance in 2009 in order to maximize utilization of tax loss carryforwards in2010 and future years. The impairment charges were calculated based on marketconditions and assumptions made by management that reflect current conditions,which may differ materially from actual results if market conditions change. Asrequired by Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”), we willreevaluate the expected cash flows from our homebuilding projects to determinewhether any additional impairment exists should events or circumstances change.

 

In view of the continuing downturn in the housing market, we currentlyexpect that, during the remaining nine months of 2009 and continuing into 2010,our new home construction will primarily be at our 356-home Brightwater projectin Huntington Beach; and that our operations in other markets will involve thesale of standing inventory, with limited or no new construction.

 

Our homebuilding projects are described below:

 
| ** **              | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                       | ** ** | ** **    | ** ** | **Deliveries**     | ** ** |
|-------------------------|------------|------------------|------------|-----------------|------------|----------------------------------|------------|---------------|------------|--------------------|------------|
| ** **              | ** ** | ** **       | ** ** | **Land**        | ** ** | **Commenced**                    | ** ** | **Commenced** | ** ** | **March 31,** | ** ** |
| ** **              | ** ** | **Location**     | ** ** | **Acquisition** | ** ** | **Construction**                 | ** ** | **Sales**     | ** ** | **2009**           | ** ** | **2008** | ** ** |
| ** **              | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                       | ** ** | ** **    | ** ** | ** **         | ** ** | ** ** | ** ** |
| Brightwater             |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| The Trails              |       | Huntington Beach |       | 1970            |       | 2006                             |       | 2007          |       | —             |       | 1 |   |
| The Sands               |       | Huntington Beach |       | 1970            |       | 2006                             |       | 2007          |       | 1                  |       | 1 |   |
| The Cliffs              |       | Huntington Beach |       | 1970            |       | 2006                             |       | 2008          |       | 1                  |       | — |   |
| The Breakers            |       | Huntington Beach |       | 1970            |       | 2006                             |       | 2008          |       | 3                  |       | — |   |
|                    |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| * *                |       |             |       |            |       | *Total  Brightwater*             |       | 5             |       | 2                  |       |
|                    |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| Inland Empire/Lancaster |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| Completed Projects      |       | Various          |       | n/a             |       | n/a                              |       | n/a           |       | —             |       | 3 |   |
| Woodhaven               |       | Beaumont         |       | 2005            |       | 2005                             |       | 2006          |       | 1                  |       | 1 |   |
| Hearthside Lane         |       | Corona           |       | 2005            |       | 2005                             |       | 2007          |       | —             |       | 1 |   |
| Quartz Hill             |       | Lancaster        |       | 2005            |       | 2006                             |       | 2006          |       | 1                  |       | 1 |   |
| Future Community        |       | Lancaster        |       | 2005            |       | —                           | (a)        | —        | (a)        | —             |       | — |   |
|                    |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| * *                |       |             |       |            |       | *Total  Inland Empire/Lancaster* |       | 2             |       | 6                  |       |
|                    |       |             |       |            |       |                             |       |          |       |               |       |   |   |
| * *                |       |             |       |            |       | *Total  Deliveries*              |       | 7             |       | 8                  |       |

 

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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 completed construction of nine model homes for The Cliffs and The Breakersin January 2008 and began selling homes to homebuyers who previouslyregistered on our priority list in February 2008. We held a grand openingfor The Cliffs and The Breakers on March 15, 2008. We delivered nine homesat an average price of $1.2 million, or $609 per square foot during 2007and 23 homes during 2008, at an average price of $1.4 million, orapproximately $564 per square foot. We delivered five homes at an average priceof $2.4 million (including three Breakers view homes averaging $3.2 million)during the three months ended March 31, 2009 and two additional homes atan average price of $865,000 in April and May 2009. As of May 11,2009, seven Brightwater homes (including one home with wetland and ocean views)are in escrow at an average price of $1.2 million, or approximately $525per square foot, and 13 additional homes are completed or under constructionand 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 remaining note balance of $2.5million. As of May 11, 2009, the subsidiary has entered into salescontracts for two of the remaining homes at an average price of $408,000 andaccepted sales reservations for the five model homes.

 

*Beaumont.*  We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. We delivered 15homes during 2006 at an average price of $387,000, 10 homes during 2007 at anaverage price of $304,000 and six homes during 2008 at an average price of$269,000. We delivered one home during the three months ended March 31, 2009at a price of $290,000 and two additional homes in April 2009 at anaverage price of $240,000. As of May 11, 2009, two additional homes arecompleted and available for sale and 62 finished lots remain available fordevelopment.

 

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 unentitledlots in the City of Lancaster in northern Los Angeles County through asubsidiary of Hearthside Homes, Inc. We have deferred the constructionstart for this 73-unit project, which has no recorded loan, until salesactivity in this market has improved. The tentative map for this project isprepared, but we have delayed filing for approval in order to defer theentitlement fees required to be paid at the time of filing.

 

In December 2005, we acquired 77 additional lots in an area knownas Quartz Hill in the City of Lancaster. The homes in this community are on10,000 square foot lots and average 3,640 square feet. We opened for salesduring July 2006 and delivered 21 homes from 2006 through 2008. During thethree months ended March 31, 2009, we delivered one additional home at aprice of $330,000. As of May 11, 2009, the final model home is availablefor sale. A subsidiary of Hearthside Homes, Inc. is currently in defaulton the $2.4 million loan facility secured by this project and isattempting to negotiate a consensual resolution of the loan default with thelender, OneWest of California which recently acquired IndyMac Federal Bank.Such a resolution could involve turning over the property (one home and 54finished lots) securing the loan to the lender. The loan is non-recourse toCalifornia 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 have been unable to renegotiate the land purchase option contractsto reflect current economic conditions and therefore the joint venture did notexercise its extension options during the first quarter of 2009, which effectivelyresults in abandoning the project. During the year ended December 31, 2008, we recorded an investmentloss of $4.6 million related to our investment in the joint venture.

 

**Critical Accounting Policies and Estimates**

 

In the preparation of the 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 10 to the Consolidated Financial Statements.

 

*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 the Consolidated Financial Statements. All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

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* *

*Cash Flowsand Debt Compliance*

 

Negative conditions in the current housing and credit markets give riseto uncertainty as to our present and future ability to meet our projected homesale closings and whether new or modified financings can be obtained, ifneeded. We, like many other homebuilders, are constantly evaluating potentialalternatives regarding our capital structure including, but not limited to,various strategies for restructuring our debt and raising additional capital.There can be no assurance that we will be successful in any of these endeavors.The current national credit market crisis presents uncertainty as to ourability to secure additional financing if needed, and the terms of suchfinancing if it is available, and as to our ability to achieve positive cashflow from operations required to satisfy our obligations. See Notes 2, 5and 6 to the Consolidated Financial Statements for further discussion.

 

*Impairment of Long-Lived Assets*

 

We recorded inland project impairment charges totaling $3.2 million andzero during the three months ended March 31, 2009 and 2008, respectively.The impairment charge recorded during the first quarter of 2009 relates to theWoodhaven project in Beaumont and reflects recent sales price reductions bylarge competitors and our intention to attempt to negotiate a short-sale forthe property in 2009 in order to maximize utilization of tax loss carryforwardsin 2010 and future years. The loan is non-recourse to California CoastalCommunities, Inc., however, the subsidiary’s parent, Hearthside Homes, Inc.,which has a negative net worth of $49 million, has 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 Estate Subject to a NonrecourseMortgage” (“EITF 91-2”), and a FASB staff interpretation thereof, we reducedthe carrying value of the Woodhaven real estate project to its estimated fairvalue during the first quarter of 2009. If the Woodhaven project is transferredto the lender in full settlement of the loan without further recourse orobligation, we will recognize a gain as a result of debt cancellation. However,there can be no assurance that the lender will agree to a consensualresolution.

 

During 2007 and 2008, we recorded impairment charges aggregating$67.0 million related to five of our inland projects. The impairmentcharges were calculated based on market conditions and assumptions made bymanagement that reflected current market conditions at the time such impairmentcharges were determined, which may differ materially from actual results ifmarket conditions change. As required by SFAS 144, should marketconditions deteriorate in the future or other events occur that indicate thecarrying amount of our real estate inventories may not be recoverable, we willreevaluate the expected cash flows from each project to determine whether anyadditional impairment exists at any point in time.

 

We assess the impairment of real estate inventories and otherlong-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, we identify alternative courses of action to recover the carryingvalue of our long-lived assets and evaluate all likely alternatives under aprobability-weighted approach as described in SFAS 144.

 

In accordance with SFAS No. 144, in developing estimated futurecash flows for impairment testing for our real estate inventories, weincorporated our 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. Our assumptions arebased, in part, on general economic conditions, the current state of thehomebuilding industry, expectations about the short- and long-term outlook forthe housing market, and competition from other homebuilders in the areas inwhich we build and sell homes. These assumptions can significantly affect ourestimates of future cash flows. For those communities deemed to be impaired, wedetermine fair value based on discounted estimated future cash flows usingestimated absorption 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 $238 million as of December 31, 2008, is due in part to afair value 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 August 2007,we have reduced prices and offered sales incentives in response to the recentdifficult conditions in the housing market. We have reflected these pricereductions in our projections which reduced projected gross margins for theproject from approximately 30%-40% in 2007 to 25%-35% as of December 2008and 23%-36% as of March 2009.  Homeprices and direct construction costs are the most critical factors in ourimpairment analysis and we estimate that a 1% change in home prices or directconstruction 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 January 2009,the City of Huntington Beach’s credit rating was raised, reflecting the city’sbuilt-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 6.4%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% or less.

 

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.

 

*IncomeTaxes*

 

We account for income taxes on the liability method, in accordance withSFAS No. 109, “*Accounting for IncomeTaxes*.” Deferred income taxes are determined based on the differencebetween the financial statement and tax bases of assets and liabilities, usingenacted tax rates in effect in the years in which these differences areexpected to reverse. The liability method requires an evaluation of theprobability of being able to realize the future benefits indicated by deferredtax assets. A 

 

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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$20.7 million of pre-tax income from cancellation of indebtedness related toour Corona 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 orforeclosure of our inland lots and homes in the cities of Corona, Lancaster andBeaumont which were the source of operational losses recognized in 2007 and2008.  We delivered two additional inlandhomes during the first quarter of 2009 and two more during April 2009,leaving a total of 14 homes and 116 lots as of April 30, 2009 on projectsfor which we have recorded loss reserves. We expect that a significant portion of the remaining expected taxablelosses on our inland projects will be included in our full year 2009 resultsthrough home deliveries and possible additional lot conveyances ordispositions.  The disposition of theinland assets during 2009 is both an operational and tax strategy which we havesuccessfully 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 significantly diminished oreliminated, leaving primarily Brightwater home deliveries to generate ouroperating and taxable results. Therefore, in order to evaluate the recoverability of NOLs and otherdeferred tax assets in 2010 and 2011, we projected our taxable incomereflecting the 2008 level of Brightwater home sales, without sales pacegrowth.  In addition, we evaluatedexpected prices based on our current marketing, expected product mix, review ofcompetitive home sales, market conditions and other objectively verifiableeconomic factors affecting our operations, as well as other positive andnegative factors.  The $238 million bookvalue of Brightwater at March 31, 2009 is substantially less than itsexpected market value due to the project’s long holding period and a fair valueadjustment recorded in September 1997 under “Fresh Start” accounting. Wecurrently expect the various Brightwater products to generate gross margins ofapproximately 23% to 36%.  The project’stax basis is approximately $33 million less than book value which will generateadditional taxable income in excess of book income.  Based on our projections which reflectrecently achieved operational levels, during 2008 we reserved approximately$18.7 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 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.

 

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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 our historical analyses. Ourassumptions require significant judgment because the residential homebuildingindustry is cyclical and is highly sensitive to changes in economic conditions.Our current assessment of the need for a valuation allowance is primarilydependent upon utilization of tax net operating losses in the carryforwardperiod and our future projected income. If our results of operations are moreor less than projected and there is objectively verifiable evidence to supportthe realization of a different amount of our deferred tax assets, an adjustmentto our valuation allowance may be required to reflect greater expectedutilization or to further reduce or eliminate our deferred tax assets.

 

We remain subject to the general rules of Section 382 of theInternal Revenue Code, which limit the availability of net operating losses ifan ownership change occurs. If we were to experience another ownership change,the amount of net operating losses available would generally be limited to anannual amount equal to (i) the value of our equity immediately before theownership change, multiplied by the long-term tax-exempt rate (4.61% as of May 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. Weestimate that after giving effect to various transactions by stockholders whohold a 5% or greater interest in the company, we have experienced a three-yearcumulative ownership shift of approximately 21% as of April 30, 2009, ascomputed in accordance with Section 382. In the event of an ownershipchange, our use of our NOLs may be limited and the deferred tax assets recordedat March 31, 2009 may not be fully realizable.

 

*HomebuildingRevenues and Cost of Sales*

 

Our homebuilding operation generates revenues from the sale of homes tohomebuyers. The majority of these homes are designed to appeal to move-uphomebuyers and are generally offered for sale in advance of their construction.Sales contracts are usually subject to certain contingencies such as the buyer’sability to qualify for financing. Revenue from the sale of homes is recognizedat the close of escrow when title passes to the buyer and the earnings processis complete. As a result, our revenue recognition process does not involvesignificant judgments or estimates. However, we do rely on certain estimates todetermine the related construction costs and resulting gross margins associatedwith revenues recognized. The cost of sales is recorded based upon totalestimated costs within a subdivision and allocated using the relative salesvalue method. Our construction costs are comprised of direct and allocatedcosts, including estimated costs for future warranties and indemnities. Ourestimates are based on historical results, adjusted for current factors.

 

*LitigationReserves*

 

We and certain of our subsidiaries have been named as defendants invarious cases arising in the normal course of business and regarding assets andbusinesses disposed of by us or our former affiliates. See Notes 9 and 11to our Consolidated Financial Statements. We have reserved for costs expectedto be incurred with respect to these cases based upon information provided byour legal counsel. There can be no assurance that total litigation costsactually incurred will not exceed the amount of such reserve.

 

**Recent Accounting Pronouncements**

 

See discussion regarding Recent AccountingPronouncements in Note 2 to the consolidated financial statements.

 

**Resultsof Operations**

 

The following tables set forth key operating andfinancial data for our homebuilding operations for the three months ended March 31,2009 and 2008.

 

**Backlog as of March 31**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2009**                       | ** ** | **2008**                                 | ** ** | **Change**                                                      | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 8                              |       | 12                                       |       | (33.3                                                           | )%         | $ | 9.1 |   | $ | 17.4 |   | (47.7 | )% | $ | 1,134 |   | $ | 1,447 |   | (21.6 | )% |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Three Months Ended March 31**

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2009**                 | ** ** | **2008**                                 | ** ** | **Change**                                                      | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 7                        |       | 8                                        |       | (12.5                                                           | )%         | $ | 12.8 |   | $ | 5.0 |   | 156.0 | % | $ | 1,829 |   | $ | 625 |   | 192.6 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*Three Months Ended March 31, 2009 Comparedwith the Three Months Ended March 31, 2008*

 

We reported revenues of $12.8 million and gross operating profitof $800,000 for the first quarter of 2009, compared with $5.0 million inrevenues and gross operating profit of $1.1 million for the first quarterof 2008. Revenues in the current period reflect deliveries of seven homes,including five deliveries at Brightwater which generated revenues of$12.2 million and gross operating profit of $3.9 million, and two homes atour inland projects which generated revenues of $600,000 and gross operatingprofit of approximately $100,000. The comparable period of the prior yearreflects deliveries of eight homes, including two homes at Brightwater and sixinland homes. Gross operating profit for the first quarter of 2009 includes anon-cash impairment charge of $3.2 million, reflecting a fair value write-downfor an inland project in Beaumont. This impairment charge reflects recent salesprice reductions 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 conditions further deteriorate in the future or otherevents occur that indicate the carrying amount of our real estate inventoriesmay not be recoverable, we will reevaluate our expected cash flows from eachproject to determine whether any additional impairment exists at any point intime.

 

Although we delivered one less home in the first quarter of 2009compared with 2008, we generated $2.9 million more in gross operatingprofit before impairment charges from home sales as a result of delivering fivehomes at Brightwater which generated a 32.2% gross margin and gross operatingprofit of $12.2 million. Increased gross operating profit for Brightwater waspartially offset by reduced margins at our inland projects which generatedgross margins of 9.6% in the first quarter of 2009 compared with 12.5% in thecomparable 2008 period due to the prolonged real estate slowdown which hasresulted in lower selling prices and greater incentives in order to remaincompetitive and move standing inventories in this difficult market. Excludingimpairment charges, homebuilding gross margin for the first quarter of 2009increased to 31.3% compared with 22.0% in the comparable period of 2008 due tothe greater proportion of Brightwater home deliveries.

 

Gain on debt restructuring reflects a $20.7 million pre-tax gainrelated to a deed-in-lieu transaction for our Corona property that we completedon March 31, 2009. In exchange for a $28.7 million reduction in the notebalance and related obligations secured by our Hearthside Lane project, weconveyed the remaining 134 finished lots to the investor that purchased thenote from IndyMac Federal Bank.

 

The $700,000 increase in interest expense compared with the firstquarter of 2008 primarily reflects interest incurred on projects which are nolonger under construction and, therefore, must be recorded as a period costrather than capitalized.

 

Other expense also reflects a $300,000 increase in property tax expensein the first quarter of 2009 compared with the first quarter of 2008 forprojects which are no longer under construction and, therefore, must berecorded as a period cost rather than capitalized.  This increase was more than offset by a$700,000 decrease related to the absence in 2009 of $700,000 of other expenseincurred in the first quarter of 2008 related to an interest rate swapagreement.

 

*PaymentsUnder Contractual Obligations*

 

Our purchase contracts which are made in the normal course of ourhomebuilding business for land acquisition and construction subcontracts aregenerally cancelable at will. Other contractual obligations including our taxliabilities, accrued benefit liability for a frozen retirement plan and otheraccrued pensions, home warranty reserves and contingent indemnity andenvironmental obligations are estimated based on various factors. Payments arenot due as of a given date, but rather are dependent upon the incurrence ofprofessional services, the lives of annuitants and other factors. Theestimation process involved in the determination of carrying values of theseobligations is inherently uncertain since it requires estimates as to futureevents and contingencies. We have provided additional disclosure below in Part IIItem 1. “Legal Proceedings” and in Note 9 to our consolidatedfinancial statements above.

 

**Liquidityand Capital Resources**

 

While we believe we have adequate liquidity for the remaining ninemonths of 2009, based on current projections of Brightwater closings during thenext 12 months, and due to the additional $25 million in loan repayments due onMarch 31, 2010, there is substantial doubt that we will be able to meetour debt obligations for the next twelve months, particularly those repaymentsdue on March 31, 2010, from cash generated by operations without furtheramendments or extensions to our revolving loan and term loan. If we continue toexperience the declines in operational volumes that have worsened with thecurrent economic recession, such declines may cause us to use our cash reservesto support operations, and at some point we may not have sufficient cash orliquidity. Additionally, if our financial condition deteriorates, we may berequired to further modify 

 

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ourcurrent credit facilities and assess the viability of raising equity and/ordebt capital. 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.

 

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

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** |
| ** **                                      | ** ** | **2009**                         | ** ** | **2008** | ** ** |
| Cash and cash equivalents                       |       | $                                | 8.4        |   | $ | 1.2 |   |
| Cash provided by (used in) operating activities |       | 5.5                              |       | (11.6 | ) |
| Cash provided by investing activities           |       | —                           |       | — |   |
| Cash provided by (used in) financing activities |       | .6                               |       | (11.5 | ) |
|                                                 |            |                                  |            |  |  |  |  |

 

The principal assets in our portfolio are residential land which mustbe held over an extended period of time in order to be developed to a conditionthat, in management’s opinion, will ultimately maximize our return.Consequently, we require significant capital to finance our real estatedevelopment and homebuilding operations. Historically, sources of capital haveincluded loan facilities secured by specific projects, asset sales andavailable internal funds. Our unrestricted cash and cash equivalents as of March 31,2009 aggregated $8.4 million and funds available to be drawn under ourrevolving loan were $9.5 million, providing total liquidity of$17.9 million.

 

On March 31, 2009, Hearthside Homes, Inc. completed adeed-in-lieu transaction for the Hearthside Lane project in Corona. In exchangefor a $28.7 million reduction in the note balance, the subsidiary conveyed theremaining 134 finished lots to the investor that purchased the loan fromIndyMac Federal Bank. The subsidiary recognized a $20.7 million pre-tax gain ondebt restructuring and retained seven completed homes that secure the remaining$2.5 million note balance which matures on March 31, 2010. Subject tocertain conditions, after all seven homes have been delivered, the guaranty ofthis debt by Hearthside Homes will be released and any remaining balance on the$2.5 million note will be cancelled. As of May 11, 2009, the subsidiaryhas entered into two sales contracts and five sales reservations for theremaining seven homes.

 

A subsidiary of Hearthside Homes, Inc. is continuing its effortsto negotiate a consensual resolution of the $2.4 million Lancaster loanwhich matured September 30, 2008. The loan is nonrecourse to us; however,it is guaranteed by Hearthside Homes which had a negative net worth of$49 million as of March 31, 2009. However, there can be no assurancethat the lender will agree to a consensual resolution of the loan.

 

On September 15, 2006 we entered into the $100 millionrevolving loan and the $125 million term loan with KeyBank National Association,as a lender and agent for several other lenders. These loans are described ingreater detail in Notes 5 and 6 to the Consolidated Financial Statements.On September 30, 2008, we amended the revolving and term loans to providegreater flexibility to repay the debt and finance construction based on mid2008 projections for home sales at Brightwater which reflected marketconditions at that time. In March 2009, we extended the maturity of therevolving 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** | ** ** |
|-------------------------|------------|---------------------------|------------|-------------------------------|------------|
| March 31, 2009     |       |                      |       | $                             | 87.0       |   |
| June 30, 2009      |       | $                         | —     |                          | 87.0       |   |
| September 30, 2009 |       | 7.0                       |       | 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** | ** ** |
|-------------------------|------------|---------------------------|------------|-------------------------------|------------|
| March 31, 2009     |       |                      |       | $                             | 105.6      |   |
| June 30, 2009      |       | $                         | —     |                          | 105.6      |   |
| September 30, 2009 |       | .6                        |       | 105.0                         |       |
| December 31, 2009  |       | 15.0                      |       | 90.0                          |       |
| March 31, 2010     |       | 15.0                      |       | 75.0                          |       |
| June 30, 2010      |       | 10.0                      |       | 65.0                          |       |
| September 30, 2010 |       | 15.0                      |       | 50.0                          |       |
| December 31, 2010  |       | 12.5                      |       | 37.5                          |       |
| March 31, 2011     |       | 12.5                      |       | 25.0                          |       |
| June 30, 2011      |       | 12.5                      |       | 12.5                          |       |
|                         |            |                           |            |                               |            |  |  |

 

As of March 31, 2009, the undrawn availability on our revolvingloan is $9.5 million. As of March 31, 2009 and December 31,2008, $77.5 million and $74.4 million, respectively, were outstandingunder the revolving loan. During the three months ended March 31, 2009, wemade mandatory repayments of $1.2 million and $1.8 million on therevolving and term loans, respectively, in connection with five 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. We currently expect to deliver 25 to 30 homes atBrightwater during the remaining nine months of 2009 (in addition to the fivehomes we delivered at Brightwater in the first quarter). This level of homesales would generate sufficient cash flow to meet the loan repaymentrequirements through December 31, 2009, as set forth above; however, therecan be no assurance that our sales projections will be realized or that we willotherwise generate cash flows sufficient to satisfy our obligations.

 

As a result of the debt repayments made in connection with the sale andleaseback transaction described above, as well as home deliveries and additionalborrowings through May 11, 2009, we have met our loan repaymentrequirements through September 30, 2009, excluding additional amounts thatmay be borrowed through September 30, 2009. We are currently in compliancewith our debt covenants and our current projections support our belief that wewill be able to satisfy our debt obligations and be in compliance with our debtcovenants throughout 2009. In the event of noncompliance due to continuingdeterioration in the homebuilding industry and related impact on our homeclosings, we believe that we will be able to obtain a covenant or defaultwaiver from the lender group, or will be able to successfully amend thecovenants to avoid any defaults through December 31, 2009. Therefore, tothe extent that we experience a shortfall in projected Brightwater homedeliveries, we do not expect any such shortfall to impair our liquidityposition until December 31, 2009, when $25.0 million of loanrepayments come due. In the event of a shortfall, there are a number of alternativeswe could pursue. Among these alternatives are scaling back construction inorder to reduce expenditures, negotiating further amendments to our creditagreements to defer a portion of the amortization payments due by December 31,2009, or raising additional debt or equity capital.

 

                Based on current projections ofBrightwater closings during the 12 months ending March 31, 2010, and dueto the additional $25 million in loan repayments due on March 31, 2010,there is substantial doubt that we will be able to meet our debt obligations onMarch 31, 2010 from cash generated by operations. In addition, we do notexpect to be able to repay the revolving loan by its maturity date of June 30,2010. Therefore, during the fourth quarter of 2009 or the first quarter of 2010we expect to negotiate revisions to our loan covenants and the timing ofcommitment reductions for our loans, and an extension of the maturity date ofthe revolving loan to accommodate the expected sales pace of the Brightwaterproject. In addition, we continue to examine financial and strategicalternatives to generate capital from a variety of sources, including, but notlimited to, further restructuring of our debt, equity offerings and issuancesof new debt. We cannot assure you that amended or future borrowings will beavailable to us in an amount sufficient to enable us to pay our indebtedness orto fund our other liquidity needs if we do not close escrow on enough homesduring the 12 months ending March 31, 2010.

 

As with many other homebuilders, we constantly evaluate potentialalternatives regarding our capital structure including, but not limited to,various strategies for restructuring our debt and raising additional capital.There can be no assurance that we will be successful in any of these endeavors,since the current national credit market crisis presents uncertainty as to ourability to secure additional financing, the terms of such financing ifavailable, and our ability to achieve positive cash flow from operationsrequired to satisfy our obligations.

 

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We will continue to pursue and evaluate various financing alternatives,including further amendments to the revolving and term loans. We do not believethat our cash, cash equivalents and future real estate sales proceeds will besufficient to meet anticipated operating and project development costs forBrightwater and general and administrative expenses for the next12 months, particularly those debt obligations due on March 31, 2010,unless we are successful in amending and extending the terms of our revolvingloan and term loan, or obtaining new financing.

 

We are subject to the usual obligations associated with entering intocontracts for the purchase of land and improved home sites. The purchase ofproperties under these contracts is generally contingent upon satisfaction ofcertain requirements by the sellers, including obtaining applicable propertyentitlements. We also utilize option contracts with third-party land sellersand financial entities as a method of acquiring land in staged takedowns andminimizing the use of funds from other corporate financing sources. Theseoption contracts also help to manage the financial and market risk associatedwith land holdings. Purchase and option contracts generally require the paymentof a non-refundable cash deposit of 5% to 15% of the purchase price for theright to acquire lots over a specified period of time (usually one to twoyears) at predetermined prices. We have the right at our discretion toterminate our obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As of March 31,2009, we have no land option deposits.

 

We may enter into land development and homebuilding joint ventures fromtime to time as a means of expanding our market opportunities, establishingstrategic alliances, managing our risk profile and leveraging our capital base.These joint ventures may obtain secured acquisition, development andconstruction financing, which minimize the use of funds from other corporatefinancing sources.

 

*March 31,2009 Compared with December 31, 2008*

 

Cash provided by operating activities of $5.5 million for thefirst quarter of 2009 primarily reflects net proceeds of $11.9 milliongenerated by five deliveries at Brightwater, which were partially offset byinvestments in Brightwater of $7.4 million, along with $400,000 of netcash flow generated by our inland projects ($600,000 generated from deliveriesof two homes less $200,000 of project investments).

 

Our primary sources of cash during the quarter were $12.5 million ofproceeds from sales of real estate inventories and $3.1 million of netborrowings from our revolving loan. Our primary uses of cash during the quarterinclude $7.4 million of investments in Brightwater and $1.8 million ofrepayments of our term loan.

 

The $7.7 million decrease in deferred tax assets primarily reflects theprovision for income taxes which is composed entirely of deferred taxes. Thereare no current taxes since we have a taxable loss for the quarter, primarilydue to the recognition of real estate losses for tax purposes that were previouslyrecorded for financial statement purposes.

 

The $27.2 million decrease in other project debt primarily reflects a$26.7 reduction in the Hearthside Lane note balance as a result of thedeed-in-lieu transaction completed during the quarter, as well as $500,000 ofproject debt repayments.

 

The $1.7 million decrease in restricted cash reflects the assignment ofrestricted cash related to the Hearthside Lane project to the investor thatholds the Hearthside Lane note in connection with the deed-in-lieu transaction.

 

**OffBalance Sheet Financing**

 

In the ordinary course of business, we enter into land option contractsin order to procure land for the construction of homes. The use of such optionagreements allows us to reduce the risks associated with land ownership anddevelopment; reduce our financial commitments, including interest and othercarrying costs; and minimize land inventories. Under such land optioncontracts, we will fund a specified option deposit or earnest money deposit inconsideration for the right to purchase land in the future, usually at apredetermined price. Our liability is generally limited to forfeiture of thenonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of March 31, 2009, we have no land option deposits and nothird party guarantees.

 

We also acquire land and conduct residential construction activitiesthrough participation in joint ventures in which we hold less than acontrolling interest. Through joint ventures, we reduce and share our risk andalso reduce the amount invested in land, while increasing our access topotential future home sites. The use of joint ventures also, in some instances,enables us to acquire land which we might not otherwise obtain or access on asfavorable terms, without the participation of a strategic partner. While weview the use of unconsolidated joint ventures as beneficial to our homebuildingactivities, we do not view them as essential to those activities.

 

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Under the requirements of FASB Interpretation No. 46(R), “*Consolidation of Variable Interest Entities*”(“FIN 46(R)”), certain of our land option contracts may create a variableinterest for us, with the land seller being identified as a VIE. In compliancewith FIN 46(R), we analyze our land option contracts and other contractualarrangements and consider whether we should consolidate the fair value of certainVIEs from which we are purchasing land under option contracts. As of March 31,2009, we had no deposits with VIEs.

 

**Impactof Inflation, Changing Prices and Economic Conditions**

 

Realestate and residential housing prices are affected by a number of factors, includingbut not limited to uncertainty by potential homebuyers in the stability of theUnited States and global economy, inflation or deflation, interest ratechanges, competition and the supply of new and existing homes to be purchased.Uncertainty in the stability of the national economy and significant volatilityin the banking system and financial markets can, and has, caused potentialhomebuyers to refrain from committing to make significant purchases, includingthe purchase of new homes. In the event the volatility in the banking systemand financial markets continues to remain high and the national economy doesnot stabilize in the near term, our ability to sell new homes to potentialhomebuyers can be impacted negatively.

 

The long-term impact of inflation may affect us through increased costsfor land, land development, construction and overhead, as well as in increasedsales prices of our homes. Our land acquisition costs are generally fixed,therefore, increases or decreases in the sales prices of homes will affect ourprofits. The sales price of each of our homes is fixed at the time a buyerenters into a contract to acquire a home. Therefore, if we sell our homesbefore we begin construction, any inflation of costs in excess of thoseanticipated may result in lower gross margins, unless these increased costs arerecovered through higher sales prices.

 

Also, deflation can cause the market value of our land and constructedhomes to decline which could negatively impact our results of operations. Ifinterest rates increase, construction and financing costs, as well as the costof borrowings, could also increase, which can result in lower gross margins onhome sales. Increases in home mortgage interest rates make it more difficultfor our customers to qualify for home mortgage loans, potentially decreasinghome sales revenue. Increases in interest rates also may affect adversely thevolume of mortgage loan originations. Increases in competition and the supplyof unsold new and existing homes have had an adverse effect on our ability togenerate new home orders and maintain home orders in backlog, and have had asignificant negative impact on our results of operations and gross margins onhome sales in our inland markets.

 

Interest rates, the length of time that land remains in inventory andthe proportion of inventory that is financed affect our interest costs. If weare unable to raise sales prices enough to compensate for higher costs, or ifmortgage interest rates increase significantly, affecting prospective buyers’ability to adequately finance home purchases, our revenues, gross margins andnet income would be adversely affected. Increases in sales prices, whether theresult of inflation or demand, may affect the ability of prospective buyers toafford new homes.

 

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

 

We utilize variable rate debt financing for acquisition, developmentand construction of homes. The interest rates on our debt approximate thecurrent rates available for secured real estate financing with similar termsand maturities, and as a result, their carrying amounts approximate fair value.While changes in interest rates generally may not impact the fair market valueof the debt instrument, they do affect our earnings and cash flows. Holding ourvariable rate debt balance constant as of March 31, 2009, each one pointpercentage increase in interest rates would result in an increase in variablerate interest incurred for the next 12 months of approximately$1.9 million.

 

We are exposed to market risks related to fluctuations in interestrates on our outstanding variable rate debt. We do not utilize swaps, forwardor option contracts on interest rates, or other types of derivative financialinstruments. We do not enter into or hold derivatives for trading orspeculative purposes.

 

You should be aware that many of the statements contained in thissection are forward looking and should be read in conjunction with ourdisclosures under the heading “Forward-Looking Statements.”

 

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**Item4.  Evaluation of Disclosure Controls andProcedures**

 

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

 

Our chief executive officer and chief financial officer, with theassistance of management, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended) as of the end of the periodcovered by this report (the “Evaluation Date”). Based on that evaluation, ourchief executive officer and chief financial officer concluded that, as of theEvaluation Date, our disclosure controls and procedures were effective toensure that information required to be disclosed in our reports under theExchange Act, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

 

However, no matter how well a control system is conceived and operated,it can provide only reasonable, not absolute, assurance that the objectives ofthe control system are met. In addition, the design of a control system mustreflect the fact that there are resource constraints and the benefits ofcontrols must be considered relative to costs. Therefore, no cost-effectivecontrol system and no evaluation of controls can provide absolute assurancethat all control issues and instances of misstatements due to error or fraud,if any, within our company have been detected.

 

*Changesin Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringthe three months ended March 31, 2009 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.   LegalProceedings.**

 

See Notes 6 and 9 to the consolidated financialstatements above, and “Item 1 - Business - Corporate Indemnification Matters”and “Item 3 - Legal Proceedings” in our Annual Report on Form 10-K for theyear ended December 31, 2008.

 

**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 notbeing filed for purposes of Section 18 of the Securities Exchange Act of1934, as amended, and are not to be incorporated by reference into any filingof the Company, whether made before or after the date hereof, regardless of anygeneral incorporation language in such filing.

 

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**SIGNATURE**

 

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

 
| Date: May 15, 2009 | CALIFORNIA COASTAL  COMMUNITIES, INC. |
|-------------------------|---------------------------------------|
|                    |                                  |
|                    |                                  |
|                    | By:**                                 | */s/ Sandra G. Sciutto* |
|                    |                                  | SANDRA G. SCIUTTO |
|                    |                                  | Senior Vice President  and |
|                    |                                  | Chief Financial Officer |

 

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