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** **

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

**(Mark One)**

| **x** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-------------------------------------------------------------------------------------------------------------|

** **

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

** **

**OR**

 

| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                       to                       **

 

**Commissionfile number: 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

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

 

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

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

 

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

**None**

 

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

 

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

 

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

 

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, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See definitionsof “large accelerated filer,” “accelerated filer,” and “smaller reportingcompany” 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 November 16, 2009 there were 10,995,902 shares of CommonStock, par value $.05 outstanding

 

 

 

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**CALIFORNIA COASTAL COMMUNITIES, INC.**

 

**FORM 10-Q**

 

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

 

**INDEX**

 
| Cautionary  Statement About Forward-Looking Statements | 3                      |
|--------------------------------------------------------|------------------------|
|                                                   |                   |   |   |
| Part I -                                          | Financial Information: | 5 |
|                                                   |                   |   |   |
|                                                   | Item 1.                | Financial Statements | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Balance  Sheets — September 30, 2009 (unaudited) and December 31, 2008 | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Statements of Operations — Three and Nine Months Ended September 30,  2009 and 2008 (unaudited) | 6 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated  Statements of Cash Flows — Three and Nine Months Ended September 30,  2009 and 2008 (unaudited) | 7 |
|                                                   |                   |   |   |
|                                                   |                   | Notes to  Consolidated Financial Statements | 8 |
|                                                   |                   |   |   |
|                                                   | Item 2.                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 25 |
|                                                   |                   |   |   |
|                                                   | Item 3.                | Quantitative  and Qualitative Disclosures About Market Risk | 44 |
|                                                   |                   |   |   |
|                                                   | Item 4.                | Evaluation of  Disclosure Controls and Procedures | 44 |
|                                                   |                   |   |   |
| Part II -                                         | Other Information:     | 44 |
|                                                   |                   |   |   |
|                                                   | Item 1.                | Legal Proceedings | 44 |
|                                                   |                   |   |   |
|                                                   | Item 1A.               | Risk Factors | 45 |
|                                                   |                   |   |   |
|                                                   | Item 6.                | Exhibits | 47 |
|                                                   |                   |   |   |
| SIGNATURE                                              | 48                     |

 

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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 (“SEC”) mayalso contain such forward-looking statements. Undue reliance should not beplaced on these statements which involve known and unknown risks, uncertaintiesand other factors which may cause our actual results, performance orachievements to be materially different from any future results, performancesor achievements expressed or implied by the forward-looking statements. In somecases, you can identify 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 comparableterminology.

 

These forward-looking statements include, but are not limited to:

 

·                  the impact, effect or eventual result of our recent voluntarybankruptcy filing under Chapter 11 of the Bankruptcy Code;

 

·                  our ability to create stockholder value;

 

·                  potential inability to comply with covenants in our debt agreements;

 

·                  our ability to successfully complete the restructuring of ourindebtedness;

 

·                  our future compliance with debt covenants and actions we may take withrespect thereto;

 

·                  economic changes nationally or in local markets, including changes inconsumer confidence, volatility of mortgage interest rates and inflation;

 

·                  continued or increased downturn in the homebuilding industry;

 

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

 

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

 

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

 

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

 

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

 

·                  our ability to deliver homes from backlog;

 

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

 

·                  our ability to secure materials andsubcontractors;

 

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

 

·                  our cost of and ability to access additionalcapital;

 

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

 

·                  our ability to continue relationships withcurrent or future partners;

 

·                  the effectiveness and adequacy of ourdisclosure and internal controls;

 

·                  the impact of recent accountingpronouncements; and

 

·                  stock market valuations.

 

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Any or all of the forward-looking statements included in this reportand in any other reports or public statements made by us are not guarantees offuture performance and may turn out to be inaccurate. This can occur as aresult of incorrect assumptions or as a consequence of known or unknown risksand uncertainties. These risks and uncertainties include the competitive environmentin which we operate; local, regional and national economic conditions; theeffects of the current national credit market crisis, inflation and therecession; our ability to comply with the covenants and amortization schedulescontained in our revolving and term loan agreements; the demand for homes;adverse market conditions that could result in additional inventoryimpairments, including an oversupply of unsold homes and declining home prices,among other things; declines in consumer confidence; increases in competition;fluctuations in interest rates and the availability of mortgage financing;mortgage foreclosure rates; the availability and cost of land for futuregrowth; the availability of capital, including access under our existing creditfacilities; uncertainties and fluctuations in capital and securities markets;changes in tax laws and their interpretation; legal proceedings; the ability ofcustomers to finance the purchase of homes or sell existing homes; theavailability and cost of labor and materials; the amount of our debt and theimpact of restrictive covenants in our loan agreements; adverse weatherconditions; domestic and international political events; geopolitical risks andthe uncertainties created by terrorist attacks; the effects of governmentalregulation, including regulations concerning development of land, the homebuilding industry, sales and customer financing processes, and the environment;and other risks discussed in our filings with the SEC. Many factors mentionedin this report or in other reports or public statements made by us, such asgovernment regulation and the competitive environment, will be important indetermining our future performance. Consequently, actual results may differmaterially from those that might be anticipated from our forward-lookingstatements. You should not place undue reliance on any of these forward-lookingstatements because they are based on current expectations or beliefs regardingfuture events or circumstances, which involve known and unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from any future results,performances or achievements expressed or implied by these forward-lookingstatements.

 

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, anyfurther disclosures made on related subjects in our subsequent reports on Forms10-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 SEC, including, withoutlimitation, the “Risk Factors” and the description of trends and other factorsin “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” set forth in this Form 10-Q and in our Form 10-K for theyear ended December 31, 2008. You should also read the following “ConsolidatedFinancial Statements” and the related notes.

 

Allforward-looking statements attributable to us or persons acting on our behalfapply only as of the date of this report and are expressly qualified in theirentirety by the cautionary statements included in this Form 10-Q. 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)

 
| ** **                                                                                                                                   | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                       | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                    |       | $                            | 3.7        |                        | $          | 2.3 |   |
| Restricted cash                                                                                                                              |       | 3.3                          |       | 5.4                         |       |
| Real estate inventories                                                                                                                      |       | 248.5                        |       | 260.7                       |       |
| Deferred tax assets                                                                                                                          |       | —                       |       | 37.1                        |       |
| Other assets, net                                                                                                                            |       | 4.2                          |       | 7.0                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 259.7      |                        | $          | 312.5 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                    | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                 |       |                         |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                     |       | $                            | 3.3        |                        | $          | 5.0 |   |
| Senior secured project revolver                                                                                                              |       | 81.7                         |       | 74.4                        |       |
| Senior secured term loan                                                                                                                     |       | 99.8                         |       | 107.4                       |       |
| Model home financing                                                                                                                         |       | 22.5                         |       | 22.5                        |       |
| Other project debt                                                                                                                           |       | 2.2                          |       | 38.9                        |       |
| Other liabilities                                                                                                                            |       | 8.9                          |       | 8.8                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Total liabilities                                                                                                                            |       | 218.4                        |       | 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                        |       |
| Accumulated deficit                                                                                                                          |       | (15.8                        | )          | (1.6                        | )          |
| Accumulated other comprehensive loss                                                                                                         |       | (2.8                         | )          | (2.8                        | )          |
| Total stockholders’ equity                                                                                                              |       | 41.3                         |       | 55.5                        |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 259.7      |                        | $          | 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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                     | ** ** | **2009**                                             | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | $                                                    | 9.6        |                                                | $          | 13.9 |   | $ | 32.9 |   | $ | 29.3 |   |
| Land                                           |       | 1.8                                                  |       | —                                              |       | 1.8 |   | — |   |
|                                           |       | 11.4                                                 |       | 13.9                                                |       | 34.7 |   | 29.3 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Costs of sales:                                |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | 8.0                                                  |       | 10.6                                                |       | 25.4 |   | 22.7 |   |
| Land                                           |       | 1.8                                                  |       | —                                              |       | 1.8 |   | — |   |
| Loss on impairment of real estate inventories  |       | —                                               |       | 29.1                                                |       | 3.2 |   | 34.1 |   |
|                                           |       | 9.8                                                  |       | 39.7                                                |       | 30.4 |   | 56.8 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Gross operating profit (loss)                  |       | 1.6                                                  |       | (25.8                                               | )          | 4.3 |   | (27.5 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative expenses   |       | 1.1                                                  |       | 1.5                                                 |       | 3.6 |   | 5.0 |   |
| Interest expense                               |       | —                                               |       | .6                                                  |       | .8 |   | .6 |   |
| Gains on debt restructuring and extinguishment |       | (4.1                                                 | )          | —                                              |       | (24.8 | ) | — |   |
| Income from unconsolidated joint ventures      |       | —                                               |       | (.1                                                 | )          | — |   | (.2 | ) |
| Other expense, net                             |       | 1.1                                                  |       | .3                                                  |       | 1.8 |   | 1.5 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) before income taxes              |       | 3.5                                                  |       | (28.1                                               | )          | 22.9 |   | (34.4 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax expense (benefit)                   |       | 21.6                                                 |       | (7.0                                                | )          | 37.1 |   | (9.5 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                       |       | $                                                    | (18.1      | )                                                   | $          | (21.1 | ) | $ | (14.2 | ) | $ | (24.9 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss per common share:                     |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted                              |       | $                                                    | (1.65      | )                                                   | $          | (1.94 | ) | $ | (1.29 | ) | $ | (2.28 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Common equivalent shares:                      |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted                              |       | 11.0                                                 |       | 10.9                                                |       | 11.0 |   | 10.9 |   |

 

See theaccompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

 

(unaudited)

 
| ** **                                                                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2009**                                            | ** ** | **2008** | ** ** |
|                                                                                   |       |                                                |       |   |   |
| Cash flows from operating activities:                                                  |       |                                                |       |   |   |
| Net loss                                                                               |       | $                                                   | (14.2      | ) | $ | (24.9 | ) |
| Adjustments to reconcile net loss to cash provided  by (used in) operating activities: |       |                                                |       |   |   |
| Gains on debt restructuring and extinguishment  (Note 8)                               |       | (24.8                                               | )          | — |   |
| Model homes depreciation                                                               |       | .2                                                  |       | .6 |   |
| Stock-based compensation expense                                                       |       | —                                              |       | .1 |   |
| Distributions from unconsolidated joint ventures                                       |       | —                                              |       | .1 |   |
| Equity in earnings of unconsolidated joint  ventures                                   |       | —                                              |       | (.2 | ) |
| Loss on change in fair value of derivative  instrument                                 |       | —                                              |       | (.2 | ) |
| Increase (decrease) in deferred tax assets                                             |       | 8.9                                                 |       | (14.0 | ) |
| Deferred tax asset valuation allowance                                                 |       | 28.2                                                |       | 4.5 |   |
| Gains on sales of real estate inventories                                              |       | (7.5                                                | )          | (6.6 | ) |
| Loss on impairment of real estate inventories                                          |       | 3.2                                                 |       | 34.1 |   |
| Proceeds from sale of real estate inventories, net                                     |       | 33.6                                                |       | 28.4 |   |
| Investments in real estate inventories                                                 |       | (21.8                                               | )          | (31.7 | ) |
| Changes in assets and liabilities:                                                     |       |                                                |       |   |   |
| (Increase) decrease in other assets                                                    |       | 1.3                                                 |       | (.3 | ) |
| Increase (decrease) in accounts payable, accrued  and other liabilities                |       | .3                                                  |       | (7.7 | ) |
|                                                                                   |       |                                                |       |   |   |
| Cash provided by (used in) operating activities                                        |       | 7.4                                                 |       | (17.8 | ) |
|                                                                                   |       |                                                |       |   |   |
| Cash flows from investing activities:                                                  |       |                                                |       |   |   |
| Investments in unconsolidated joint ventures                                           |       | —                                              |       | (.4 | ) |
| Change in restricted cash                                                              |       | .4                                                  |       | .1 |   |
|                                                                                   |       |                                                |       |   |   |
| Cash provided by (used in) investing activities:                                       |       | .4                                                  |       | (.3 | ) |
|                                                                                   |       |                                                |       |   |   |
| Cash flows from financing activities:                                                  |       |                                                |       |   |   |
| Borrowings of senior secured project revolver                                          |       | 26.5                                                |       | 40.7 |   |
| Repayments of senior secured project revolver                                          |       | (19.2                                               | )          | (22.8 | ) |
| Repayments of senior secured term loan                                                 |       | (7.6                                                | )          | (5.8 | ) |
| Borrowings of other project debt                                                       |       | —                                              |       | 1.1 |   |
| Repayments of other project debt                                                       |       | (5.9                                                | )          | (9.0 | ) |
| Deferred financing costs                                                               |       | (.2                                                 | )          | (3.4 | ) |
|                                                                                   |       |                                                |       |   |   |
| Cash provided by (used in) financing activities                                        |       | (6.4                                                | )          | .8 |   |
|                                                                                   |       |                                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                  |       | 1.4                                                 |       | (17.3 | ) |
|                                                                                   |       |                                                |       |   |   |
| Cash and cash equivalents - beginning of period                                        |       | 2.3                                                 |       | 24.3 |   |
|                                                                                   |       |                                                |       |   |   |
| Cash and cash equivalents - end of period                                              |       | $                                                   | 3.7        |   | $ | 7.0 |   |
|                                                                                   |       |                                                |       |   |   |
| Supplemental disclosures of cash flow information:                                     |       |                                                |       |   |   |
| Cash paid during the period for income taxes, net  of refunds received                 |       | $                                                   | .1         |   | $ | — |   |
|                                                                                   |       |                                                |       |   |   |
| Supplemental disclosures of non-cash investing and  financing activities:              |       |                                                |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories       |       | $                                                   | 1.7        |   | $ | .9 |   |
| Decrease in project debt and accrued liabilities  due to debt restructuring            |       | $                                                   | 32.8       |   | $ | — |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 –Basis of Presentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidatedsubsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes thatthese unaudited consolidated financial statements reflect all materialadjustments (consisting only of normal recurring adjustments) and disclosuresnecessary for the fair presentation of the results of operations and statementsof financial position when read in conjunction with the Consolidated FinancialStatements and Notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2008 and the current year’s previouslyissued Quarterly Reports on Form 10-Q. Intercompany accounts andtransactions 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.

 

*GoingConcern and Financial Reporting in Reorganization*

 

Whilethe Company is hopeful that it will be able to restructure its debt through theChapter 11 reorganization process described below in Note 2, there can be noassurance that the Company will be able to successfully execute such plan. Inthe event that the Company is not successful in that regard, substantial doubt wouldexist as to its ability to continue as a going concern. The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern and contemplate the realization of assets andthe satisfaction of liabilities in the normal course of business. As a resultof the Chapter 11 Cases, the realization of assets and the satisfaction ofliabilities are subject to uncertainty. While operating asdebtors-in-possession under Chapter 11, the Debtors may sell or otherwisedispose of or liquidate assets or settle liabilities, subject to the approvalof the Bankruptcy Court or as otherwise permitted in the ordinary course ofbusiness, in amounts other than those reflected in the accompanyingconsolidated financial statements. Further, a plan of reorganization couldmaterially change the amounts and classifications of assets and liabilities inthe historical consolidated financial statements. The accompanying consolidatedfinancial statements do not include any direct adjustments related to therecoverability and classification of assets or the amounts and classificationof liabilities or any other adjustments that might be necessary should theCompany be unable to continue as a going concern or as a consequence of theChapter 11 Cases.

 

**Note 2 –Chapter 11 Proceedings and Plans of Management**

 

*Commencementof Chapter 11 Bankruptcy Cases*

 

On October 27, 2009, the Company and certain ofits direct and indirect wholly-owned subsidiaries (collectively with theCompany, the “Debtors”) filed voluntary petitions (the “Chapter 11 Petitions”)for relief under chapter 11 of title 11 (“Chapter 11”) of the United StatesCode (the “Bankruptcy Code”) in the United States Bankruptcy Court for theCentral District of California (the “Bankruptcy Court”). The Chapter 11Petitions are being jointly administered under the caption *In reCalifornia Coastal Communities, Inc.*, Case No. 09-21712-TA(the “Chapter 11 Cases”). The Debtors continue to operate their businesses andmanage their properties as “debtors in possession” under the jurisdiction ofthe Bankruptcy Court and in accordance with the applicable provisions of theBankruptcy Code and orders of the Bankruptcy Court. The Debtors have obtainedthe Bankruptcy Court’s approval to, among other things, continue to paycritical vendors with lien rights, sell homes free and clear of all liens on aninterim basis, use cash collateral on an interim basis, honor homeownerwarranties on an interim basis, meet payroll obligations and provide employeebenefits. There can be no assurance that the Company and the other Debtors willbe able to successfully develop, execute, confirm and consummate one or moreplans of reorganization with respect to the Chapter 11 Cases that areacceptable to the Bankruptcy Court and the creditors and other parties ininterest.

 

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*LoanDefaults Preceding Chapter 11 Cases*

 

On September 28, 2009, the Company received anotice of an event of default from KeyBank National Association (“KeyBank”)with respect to the loan-to-value covenant of the senior secured revolvingcredit agreement (“Revolving Loan”) that would give KeyBank the right to accelerate theindebtedness under the Revolving Loan and senior secured term loan (“TermLoan”). As of September 30,2009, approximately $81.7 million and $99.8 million of principal wasoutstanding under the Revolving Loan and Term Loan, respectively. In addition,on October 1, 2009, the Company received a notice of an event of defaultfrom KeyBank with respect to the Company’s nonpayment of approximately $1.7million of principal that was due on September 30, 2009 under the terms ofthe Revolving Loan that would give KeyBank the right to accelerate theindebtedness under the Revolving Loan and the Term Loan.

 

On October 1, 2009, the Company entered into thesenior secured revolving loan forbearance agreement (“Revolving ForbearanceAgreement”) and senior secured term loan forbearance agreement (“TermForbearance Agreement”) with KeyBank, as a lender and as agent for the otherloan syndicate members under the Revolving Loan and the Term Loan. However, theCompany’s subsequent failure to make required interest payments aggregating$759,000 on October 14, 2009 for the Revolving Loan and Term Loanterminated the forbearance period provided under the Forbearance Agreements.Therefore, as a result of the Company’s nonpayment of $1.7 million of principal that was due on September 30,2009 and $759,000 of interest that was due on October 14, 2009, triggeringevents have occurred that could give rise to the immediate acceleration of thepayment of all outstanding principal and accrued interest under both the Termand Revolving Loans.

 

The filing of the Chapter 11 Cases also constitutedevents of default under the Revolving Loan and Term Loan that can triggeracceleration of the indebtedness. However, the filing of  theChapter 11 Petitions automatically stays most actions against the Company andthe other Debtors, including actions with respect to Revolving Loan and TermLoan.  As of October 27, 2009,approximately $82.3 million and $100.6 million of principal and accruedinterest is outstanding under the Revolving Loan and Term Loan, respectively.

 

*Plansof Management*

 

The Company is working with KeyBank and its lenders torestructure its debt obligations under the Revolving Loan and the Term Loanthrough the Chapter 11 reorganization process. Among other things, the Companyis seeking an extension of the maturity dates and changes to the repaymentschedules to provide full repayment by the end of the third quarter of 2013.However, there can be no assurance that the Company and the other Debtors willbe able to successfully develop, execute, confirm and consummate one or moreplans of reorganization with respect to the Chapter 11 Cases that areacceptable to the Bankruptcy Court and the creditors and other parties ininterest.

 

The Company and the other Debtors continue to operatetheir business as debtors-in-possession. The Company has incurred and willcontinue to incur significant costs associated with the reorganization whichare expected to significantly affect the Company’s results of operations.

 

An additional hearing is scheduled before the Bankruptcy Court on December 9,2009 to consider final orders for, among other things, continued use of cashcollateral, sellinghomes free and clear of liens, honoring homeowner warranties and continued useof the Company’s existing cash management system.

 

The Companyintends to maintain business operations through the reorganization process. TheCompany’s liquidity and capital resources, however, are significantly affectedby the Chapter 11 Cases, which have resulted in various restrictions on itsactivities, limitations on financing and a need to obtain Bankruptcy Courtapproval for various matters. In particular, the Debtors are not permitted tomake any payments on pre-petition liabilities without prior Bankruptcy Courtapproval. However, the Debtors have been granted relief in order to continuewage and salary payments and other employment benefits to employees as well asother related pre-petition obligations; to continue to construct and sell homesas well as certain related pre-petition customer obligations through December 9,2009; and to pay certain pre-petition trade claims held by critical vendorswith lien rights. Under the priority schedule established by the BankruptcyCode, certain post-petition and pre-petition liabilities need to be satisfiedbefore general unsecured creditors and equity holders are entitled to receiveany distribution. At this time, it is not possible to predict with certaintythe effect of the Chapter 11 Cases on the Company’s business or variouscreditors, or when the Company will emerge from these proceedings. Futureresults will depend upon the confirmation and successful implementation of aplan of reorganization. The continuation of the Chapter 11 Cases, particularlyif a plan of reorganization is not timely confirmed, could further adverselyaffect the Company’s operations.

 

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The Company depends on cash flows generated from operations andavailable borrowing capacity to fund its Brightwater development, and to meetits debt service and working capital requirements. However, the Company’sability to continue to generate sufficient cash flows has been and willcontinue to be adversely affected by continued difficulties in the homebuildingindustry and continued weakness in the California economy. During the lasteight months (March — October), the Company generated 31 net sales ordersat Brightwater, increased construction starts during the second and thirdquarters to keep pace with sales orders, and started construction of a limitednumber of speculative homes which are in greater demand in today’s market thancontract homes that are constructed over a five to nine month period. Whilesales of the Trails and Sands products, which are generally under $1.0 million,have increased during the first nine months of 2009, sales of the Company’slarger Cliffs and Breakers homes continue to be challenged by limitations onjumbo-mortgage financing and the downturn in the housing market, which havereduced demand for homes exceeding $1.0 million.

 

Due to cash requirements for on-going home construction and scheduleddebt amortization, the Company’s ability to meet future loan repaymentrequirements will depend on the results of negotiations with the Company’slenders and the Chapter 11 reorganization proceedings.  Based on Brightwater sales thus far in 2009,which have been primarily for the smallest Brightwater home product (TheTrails), the current product mix of home sales is not expected to generatesufficient cash flow to meet the Company’s future scheduled loan repayments forthe Revolving Loan and Term Loan as currently structured, as described ingreater detail in Notes 5 and 6.

 

Continuing negative conditions in the housing and credit markets giverise to uncertainty as to the Company’s present and future ability to meet itsprojected home sale closings and whether modified or new financings can beobtained in order for the Company to meet its debt obligations. The Company,like many other homebuilders, is constantly evaluating potential alternativesregarding its capital structure including, but not limited to, variousstrategies for restructuring existing debt financings and raising additionalcapital. There can be no assurance that the Company will be successful in anyof these endeavors. While the national credit markets appear to be improving,there is limited availability of financing for small businesses which presentsuncertainty as to the ability of the Company to secure new financing, ifneeded, and the terms of such financing if it is available. The current housingand mortgage markets also present uncertainty as to the Company’s ability toachieve sufficient positive cash flow from operations required to satisfy itsdebt obligations and meet financial covenant requirements. See Notes 5, 6and 8 for further discussion.

 

While the Company is hopeful that it will be able to restructure itsdebt through the Chapter 11 reorganization process, unless the Company issuccessful in amending and extending the terms of the Revolving Loan and TermLoan agreements, the Company does not believe that its cash, cash equivalentsand future real estate sales proceeds will be sufficient to meet its debtobligations or to meet anticipated operating and project development costs forBrightwater, and general and administrative expenses during the next12 months.

 

**Note 3 –Significant Accounting Policies**

 

*Basis of Consolidation*

 

The accompanying consolidated financial statements include the accountsof the Company and all majority-owned and controlled subsidiaries and joint ventures.Certain of the Company’s wholly-owned subsidiaries are members in jointventures 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.

 

*Consequencesof Chapter 11 Proceedings*

 

Financial Accounting Standards Board (“FASB”) Accounting StandardsCodification (“ASC”) 360-10-35, “*Reorganizations — OtherPresentation Matters*,” which is applicable to companies in Chapter11, generally does not change the manner in which financial statements areprepared. However, it does require that the financial statements for periodssubsequent to the filing of the Chapter 11 Cases distinguish transactions andevents that are directly associated with the reorganization from the ongoingoperations of the business. Amounts that can be directly associated with thereorganization and restructuring of the business must be reported separately asreorganization items in the statements of operations beginning in the quarterending December 31, 2009. The balance sheet must distinguish pre-petitionliabilities subject to 

 

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compromisefrom both those pre-petition liabilities that are not subject to compromise andfrom post-petition liabilities. Liabilities that may be affected by a plan ofreorganization must be reported at the amounts expected to be allowed, even ifthey may be settled for lesser amounts. In addition, cash provided byreorganization items must be disclosed separately in the statement of cashflows. The Company applied ASC 360-10-35 effective on October 27, 2009 andwill segregate those items as outlined above for all reporting periodssubsequent to such date.

 

*Subsequent Events*

 

The Company evaluated events through the filing date of this QuarterlyReport on Form 10-Q on November 12, 2009, including the October 27, 2009 commencement of theChapter 11 Cases. On October 28, 2009, the Company received a delistingdetermination letter from the NASDAQ Stock Market Listing Qualifications Staffindicating their decision to delist the Company’s common stock from the NASDAQStock Market pursuant to NASDAQ Marketplace Rules 5100, 5110(b) andIM-5101-1. The determination was made following the Company’s filing of avoluntary petition for relief under Chapter 11 of the United States BankruptcyCode (described above). On November 4, 2009, the Company requested ahearing before a NASDAQ Listing Qualifications Hearing Panel to appeal theproposed delisting. The hearing is currently scheduled to take place on December 3,2009. The Company’s common stock will remain listed on the NASDAQ Stock Marketpending the outcome of the hearing.

 

On November 6, 2009, theWorker, Homeownership and Business Assistance Act of 2009 (the “WHB Act”) waspassed and signed into law. The WHB Act allows businesses with net operatinglosses (“NOLs”) for 2008 and 2009 to carry back losses for up to five years andsuspends the 90% limitation on the use of any alternative tax NOL deductionattributable to carrybacks of the applicable NOL. Based upon the estimated taxloss for 2009, the Company anticipates filing refund claims approximating$900,000 for federal alternative minimum tax paid for years prior to 2009.

 

*Real Estate*

 

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

 

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 ASC 360-10-35, “*Impairment or Disposal of Long-Lived Assets,”*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. Impairment is evaluated by comparing an asset’s carryingvalue to the undiscounted estimated cash flows expected from the asset’soperations and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset is deemed to be the amount a willing buyer would paya willing seller for such asset in a current transaction. Additionally, asappropriate, the Company identifies alternative courses of action to recoverthe carrying value of its long-lived assets and evaluates all likelyalternatives under a probability-weighted approach as described in ASC360-10-35.

 

During the three and nine months ended September 30, 2009, theCompany recorded inland project impairment charges totaling zero and $3.2million, respectively. See Note 4 — Real Estate Inventories.

 

In accordance with ASC 360-10-35, 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’s assumptionsare based, 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 the Company builds and sells homes. These assumptions can significantlyaffect the Company’s estimates of future cash flows. For those communitiesdeemed to be impaired, the Company determines fair value based on discountedestimated future cash flows using estimated absorption rates for eachcommunity.

 

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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 ASC 820-10 *“FairValue Measurements and Disclosures,”* as it applies to financialassets and liabilities measured at fair value on a recurring basis on January 1,2008 and 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. Due to theChapter 11 Cases and current default status of the Company’s Revolving Loan andTerm Loan, the carrying amounts of the debt may not approximate fair value asof September 30, 2009. The Company has been notified that purchase/saletransactions involving the Revolving Loan and Term Loan have occurred or mayhave been negotiated between certain members of the loan syndicates and otherfinancial institutions. However, it is not practicable for the Company todetermine the fair value of the Revolving Loan and Term Loan as thetransactions are occurring in a private market. The carrying amounts of theproject debt approximate fair value given its current maturities.

 

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

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

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

 

During the three months ended March 31, 2009, real estateinventories with a carrying value of $6.2 million related to the Woodhavenproject in Beaumont, California were determined to be impaired and were writtendown to their estimated fair value of $3.0 million, resulting in an impairmentcharge of $3.2 million. See “*Impairment of Real EstateInventories*” above and Note 4 — Real Estate Inventories.

 

On September 30, 2009, a subsidiary of Hearthside Homes completeda sale of the 62 remaining finished lots at the Woodhaven project for $1.8million and sold the four remaining model homes for approximately $500,000,thereby disposing of all remaining assets of the project. See Note 8 foradditional discussion.

 

*Income Taxes*

 

The Company accounts for income taxes on the liability method, in accordancewith ASC 740-10, “*Income Taxes.*” Deferred incometaxes are determined based on the difference between the financial statementand tax bases of assets and liabilities, using enacted tax rates in effect inthe years in which these differences are expected to reverse. The liabilitymethod requires an evaluation of the probability of being able to realize thefuture benefits indicated by deferred tax assets. A valuation allowance isestablished against a deferred tax asset if, based on the available evidence,it is “more likely than not” that such asset will not be realized. Therealization of a deferred tax asset ultimately depends on the existence ofsufficient taxable income in either the carryback or carryforward periods undertax law. The Company evaluates on a quarterly basis, 

 

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whethera valuation allowance should be established based on its determination ofwhether it is “more likely than not” that some portion or all of the deferredtax assets will be realized. In the Company’s assessment, appropriateconsideration is given to all positive and negative evidence related to therealization of the deferred tax assets. This assessment considers, among othermatters, the nature, frequency and magnitude of current and cumulative incomeand losses, forecasts of future profitability, the duration of statutorycarryback or carryforward periods, the Company’s experience with operating lossand tax credit carryforwards not expiring unused, and tax planningalternatives.

 

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 taxableincome. If the Company’s results of operations are more or less than projectedand there is objectively verifiable evidence to support the realization of adifferent amount of its deferred tax assets, an adjustment to the Company’svaluation allowance may be required to reflect greater expected utilization.

 

*Homebuilding Revenues and Cost of Sales*

 

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

 

*Earnings Per Common Share*

 

Earnings per common share is accounted for in accordance with ASC260-10, “*Earnings Per Share*.” Basic earnings percommon share is computed using the weighted-average number of common sharesoutstanding for the period. Diluted earnings per common share is computed usingthe weighted-average number of common shares outstanding and the dilutiveeffect of potential common shares outstanding.

 

*New Accounting Pronouncements*

 

In August 2009, the FASB issued Accounting Standards Update (“ASU”)No. 2009-05 (“ASU 2009-05”), “*Fair Value Measurementsand Disclosures (Topic 820) — Measuring Liabilities at Fair Value*,”which provides guidance on measuring the fair value of liabilities under FASBASC 820. ASU 2009-05 is effective for interim and annual periods beginningafter August 28, 2009. The Company does not expect the adoption of ASU2009-05 to have a material effect on its consolidated financial statements.

 

In June 2009, the FASB issued SFAS No. 168, “*The FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles — a replacement of FASB Statement No. 162*”(“SFAS 168”, or ASC 105), which establishes the FASB ASC as the source ofauthoritative accounting principles recognized by the FASB to be applied bynongovernmental entities in the preparation of financial statements inconformity with generally accepted accounting principles in the United Statesof America. SFAS 168 is effective for interim and annual reporting periodsending after September 15, 2009. The Company adopted SFAS 168 for thereporting period ended September 30, 2009. The adoption of SFAS 168 didnot have a material effect on the Company’s consolidated financial statements.

 

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**Note 4 – Real Estate Inventories**

 

Real estate inventories primarily consist of homes under constructionand lots under development at Brightwater, along with a five-acre project beingplanned for 22 homes, in Huntington Beach in coastal Orange County and twoinland communities in Lancaster in Los Angeles County. As of September 30,2009, real estate inventories aggregated 430 lots and homes, including 17 modelhomes, five standing inventory homes completed and unsold, one home completedand in escrow, and 16 homes under construction and in escrow. Real estateinventories at September 30, 2009 included $242.0 million recordedfor 286 lots and homes under development and 17 model homes held under afinancing lease at the Brightwater community which is located on a 105-acreparcel on a mesa north of the Bolsa Chica wetlands in Huntington Beach,California and our adjacent five-acre parcel. An additional $6.5 millionin real estate inventories is recorded for 127 lots at the Company’s subsidiary’sinland projects in Lancaster, California. The Company capitalizes carryingcosts including interest and property taxes, as well as direct constructioncosts, to real estate inventories during the development and constructionperiod.

 

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 356 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.

 

On September 30, 2009, a subsidiary of Hearthside Homes completeda sale of the remaining 62 finished lots and four model homes at the Woodhaven projectin Beaumont, California for $2.3 million. See Note 8 for additional discussion.

 

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

 

The Company recorded inland project impairment charges totaling zeroand $3.2 million, respectively, during the three and nine months ended September 30,2009, compared with $29.1 million and $34.1 million, respectively, during thesame periods in 2008. The impairment charges recorded during the first quarterof 2009 relate to a subsidiary’s Woodhaven project in Beaumont, Californiawhich was sold on September 30, 2009 in a transaction which extinguishedthe related project debt for less than 100% of the principal balance.

 

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 ASC 360-10-35, 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 is allocated to real estateinventories when incurred and charged to cost of sales when the relatedproperty is delivered. Changes in capitalized interest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                             | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Capitalized interest, beginning of period |       | $                                                    | 37.5       |                                                | $          | 32.3 |   | $ | 37.3 |   | $ | 26.2 |   |
| Interest incurred and capitalized         |       | 5.0                                                  |       | 3.2                                                 |       | 12.2 |   | 10.7 |   |
| Charged to cost of sales                  |       | (2.9                                                 | )          | (1.2                                                | )          | (5.7 | ) | (2.6 | ) |
| Charged to gain on debt restructuring     |       | (2.8                                                 | )          | —                                              |       | (7.0 | ) | — |   |
| Capitalized interest, end of period       |       | $                                                    | 36.8       |                                                | $          | 34.3 |   | $ | 36.8 |   | $ | 34.3 |   |

 

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**Note 5 –Senior Secured Project Revolver**

 

See Note 2 for adetailed discussion of the Company’s default under the Revolving Loan and thestatus of the Chapter 11 Cases which commenced October 27, 2009.

 

As of September 30, 2009 and December 31, 2008, $81.7 millionand $74.4 million, respectively, was outstanding under the Revolving Loanat weighted average interest rates of 3.50% and 5.09%, respectively, based uponthe Company’s elected rates. The Company did not pay $1.7 million of principaldue on September 30, 2009, and received a notice of event of default fromKeyBank on October 1, 2009. As of September 30, 2009, one syndicatemember holding 12% of the loan was in default. The terms of the facilityprevent a defaulting member from receiving repayments.

 

Outstanding advances bearinterest based on the following loan-to-value grid:

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

 

Interest on the facility is calculated on the average, outstandingdaily balance and is paid monthly. Interest incurred on the Revolving Loan forthe three and nine months ended September 30, 2009 was $1.0 million and$3.2 million, respectively, at weighted-average interest rates of 3.54% and3.67%, respectively. Interest incurred on the Revolving Loan for the three andnine months ended September 30, 2008 was $1.1 million and $3.1million, respectively, at weighted-average interest rates of 4.49% and 4.90%,respectively. Following the Company’s default in paying $1.7 million ofprincipal when due, effective October 1, 2009, interest is incurred at thedefault rate stated in the loan.  As of November 2,2009, the Revolving Loan weighted average interest rate is 9% based on thePrime rate plus the default margin.

 

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 homes closed at theBrightwater project, and 40% of the $1 million release price per unitthereafter. As of September 30, 2009, the Company has delivered 70 homes.These mandatory repayments are applicable to the commitment reductions setforth below. The commitment amount under the Revolving Loan reduces to zero bythe final maturity as follows (in millions):

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

 

During the three and nine months ended September 30, 2009, theCompany delivered seven and 21 homes, respectively, at Brightwater and mademandatory repayments on the Revolving Loan of $1.7 million and $5.1 million,respectively. As of September 30, 2009, the Company has made cumulativemandatory repayments for the Revolving Loan of $16.8 million, reflecting70 homes delivered to date, including the 17 model homes included in thesale-leaseback transaction completed on December 31, 2008. In addition,the Company has made additional repayments of $1.5 million. Since the $100.0 millionRevolving Loan commitment was reduced to $80.0 million and the outstandingbalance at September 30, 2009 is $81.7 million, there is no availabilityunder the Revolving Loan.

 

As of September 30, 2009 and December 31, 2008, approximately$700,000 and $1.4 million, respectively, of deferred loan fees and closingcosts related to the Revolving Loan are included in other assets and amortizedover the life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories and charged tocost of sales when the related homes are delivered.

 

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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.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Revolver Loan debt outstanding to borrowingbase value from exceeding a maximum ratio, regarding which the Company has beennotified it is in default:

 
| **Reporting Period**                                 | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| 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 September 30, 2009, the Company’s consolidated totalliabilities are $218.4 million, tangible net worth after excluding the2008 Hearthside Lane and Las Colinas impairment charges and valuationallowances on deferred tax assets is $108.5 million and the leverage ratiois 2.01. The Company is in compliance with the leverage and net worthcovenants. However, the Company was notified on September 28, 2009 that itis not in compliance with the loan-to-value ratio covenant of the RevolvingLoan based on a recent appraisal obtained by the agent for the Revolving Loanand Term Loan.  The Company disputes thevalidity of that appraisal and has obtained its own appraisal.

 

While the sales pace at Brightwater is close to expectations at thebeginning of 2009, the mix is heavily weighted towards smaller homes which aregenerating less liquidity than the larger homes.  Therefore, the Company does not expect to beable to meet its mandatory principal repayments due on December 31, 2009,as well as March 31, 2010, or fully re-pay the Revolving Loan by itsmaturity date on June 30, 2010 from cash flow from operations.  The Company is currently negotiating with itslenders to restructure the Revolving Loan and Term Loan through the courtreorganization process to defer scheduled amortization payments in order toaccommodate the expected sales pace of the Brightwater project and providesufficient liquidity to fund construction and extend the maturity dates of theloans.  There can be no assurance thatthe Company will be successful in any of these endeavors. While the nationalcredit markets appear to be improving, there is limited availability offinancing for small businesses, which presents significant uncertainty as tothe ability of the Company to secure additional financing, and the terms ofsuch financing if available. The current housing and mortgage markets alsopresent uncertainty as to the ability of the Company to achieve sufficientpositive cash flow from operations required to satisfy its debt obligations.

 

**Note 6 –Senior Secured Term Loan**

 

See Note 2 fordetailed discussion of the Company’s default under the Revolving Loan and thestatus of the Chapter 11 Cases which commenced October 27, 2009.

 

On September 30, 2008, the Company entered into the thirdamendment to the five-year, $125 million Term Loan with KeyBank NationalAssociation, as a lender and as agent for the other loan syndicate members. TheTerm Loan is secured by a second trust deed on the Brightwater project, and ageneral pledge and assignment of the Company’s ownership interests in allmaterial subsidiaries. All existing material subsidiaries of the Company haveprovided full unconditional guarantees. The Term Loan includes financialcovenants which may limit the amount that may be outstanding.  In January 2009, a major shareholder ofthe Company purchased 6% of the Term Loan from certain members of the loansyndicate.

 

As of September 30, 2009 and December 31, 2008, $99.8 millionand $107.4 million, respectively, was outstanding under the Term Loan atinterest rates of 4.25% and 6.38%, respectively, based upon the Company’selected rates. The outstanding balance currently bears interest based on thefollowing loan-to-value grid:

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

 

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Interest on the facility is calculated on the average, outstandingdaily balance and is paid monthly. Interest incurred on the Term Loan for thethree and nine months ended September 30, 2009 was $1.4 million and$4.6 million, respectively, at weighted-average interest rates of 4.29%and 4.61%, respectively. Interest incurred on the Term Loan for the three andnine months ended September 30, 2008 was $1.7 million and $5.5 million,respectively, at weighted-average interest rates of 5.23% and 5.68%,respectively. Following the Company’s default in paying $1.7 million ofprincipal on the Revolving Loan when due, effective October 1, 2009,interest is incurred at the default rate stated in the loan.  As of November 2, 2009, the Term Loaninterest rate is 9.25% based on the Prime rate plus the default margin.

 

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

 

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

 
| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **End of Period  Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|-------------------------------|------------|
| September 30, 2009 |       | $                         | —     |                          | 99.8       |   |
| December 31, 2009  |       | 9.8                       |       | 90.0                          |       |
| March 31, 2010     |       | 15.0                      |       | 75.0                          |       |
| June 30, 2010      |       | 10.0                      |       | 65.0                          |       |
| September 30, 2010 |       | 15.0                      |       | 50.0                          |       |
| December 31, 2010  |       | 12.5                      |       | 37.5                          |       |
| March 31, 2011     |       | 12.5                      |       | 25.0                          |       |
| June 30, 2011      |       | 12.5                      |       | 12.5                          |       |
| September 15, 2011 |       | 12.5                      |       | —                        |       |
|                         |            |                           |            |                               |            |  |

 

During the three and nine months ended September 30, 2009, theCompany delivered seven and 21 homes, respectively, at Brightwater and mademandatory repayments on the Term Loan of $2.5 million and $7.6 million,respectively. As of September 30, 2009, the Company has made cumulativemandatory repayments for the Term Loan of $25.2 million, reflecting 70homes delivered to date, including the 17 model homes included in thesale-leaseback transaction completed on December 31, 2008. Availabilityunder the $125.0 million Term Loan has been reduced to $99.8 million.The Company has met the minimum debt repayments as of September 30, 2009,which limits the maximum outstanding under the Term Loan to $105.0 million.

 

As of September 30, 2009 and December 31, 2008, approximately$2.1 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 the HearthsideLane project in Corona and the Las Colinas project in Lancaster and valuationallowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Term Loan debt outstanding to borrowing basevalue from exceeding a maximum ratio, regarding which the Company has beennotified it is in default:

 
| **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                                | %          |

 

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

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

 

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

 

As of September 30, 2009, the Company’s consolidated totalliabilities are $218.4 million, tangible net worth after excluding the2008 Hearthside Lane and Las Colinas impairment charges and valuationallowances on deferred tax assets is $108.5 million and the leverage ratio is2.01. The Company is in compliance with the aforementioned covenants except forthe loan-to-value covenant. The Company was notified on September 28, 2009that it is not in compliance with the loan-to-value ratio covenant of the TermLoan based on a recent appraisal obtained by the agent for the Revolving Loanand Term Loan.  The Company disputes thevalidity of that appraisal and has obtained its own appraisal.

 

While the sales pace at Brightwater is close to expectations at thebeginning of 2009, the mix is heavily weighted towards smaller homes which aregenerating less liquidity than the larger homes.  Therefore, the Company does not expect to beable to make the mandatory repayments due on December 31, 2009, as well asMarch 31, 2010, under the Term Loan and the Revolving Loan.  The Company is currently negotiating with itslenders to restructure the Revolving Loan and Term Loan through the courtreorganization process to defer scheduled amortization payments in order toaccommodate the expected sales pace of the Brightwater project and providesufficient liquidity to fund construction and extend the maturity dates of theloans.  There can be no assurance thatthe Company will be successful in any of these endeavors. While the nationalcredit markets appear to be improving, there is limited availability offinancing for small business, which presents uncertainty as to the ability ofthe Company to secure additional financing, and the terms of such financing, ifavailable. The current housing and mortgage markets also present uncertainty asto the ability of the Company to achieve sufficient positive cash flow fromoperations required to satisfy its debt 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 hasnot been a significant decrease in the value of the model homes, and $500,000payable for conversion of the model homes for sale to homebuyers upontermination of the lease agreement. The Company has an option to repurchase themodel homes after at least 90% of the homes of the respective model type havesold, but no earlier than January 1, 2011. If the Company does notrepurchase the models, after the lessor receives a 16% internal rate of return,the Company is entitled to receive 75% of any profit resulting from the sale ofthe models at the end of the lease. Due to the Company’s repurchase option andprofit participation which constitute continuing interest, and in accordancewith ASC 840-40, “*Sale-Leaseback Transactions*,” theCompany accounted for the transaction as a financing transaction rather than asa sale and recorded model home financing debt of $22.5 million.

 

The Company utilized $10.2 million of the model home financingproceeds to make mandatory repayments under the Revolving Loan and the TermLoan, thereby reducing the payments that would have been due in 2009. TheCompany used an additional $10.7 million of the proceeds to reduce thebalance outstanding under the Revolving Loan. 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 subsidiary’s partner in the Oxnard joint venture, which is an affiliateof the investor who purchased the model homes. The $500,000 payment representsadditional capital contributions that become payable upon the dissolution ofthe joint venture.

 

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

 
| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2009     |       | $          | .8         |   |
| 2010     |       | 3.2        |       |
| 2011     |       | 3.3        |       |
| Total    |       | $          | 7.3        |   |

 

**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%. During the nine monthsended September 30, 2009, Hearthside Homes, Inc. and its subsidiariesdid not enter into any new loan facilities.

 

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

 
| ** **     | ** ** | ** **                   | ** ** | **Interest**          | ** ** | ** **               | ** **                                   | **Number**                 | ** ** | ** **         | ** ** | **Outstanding at**      | ** ** |
|----------------|------------|------------------------------|------------|-----------------------|------------|--------------------------|----------------------------------------------|----------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Rate   at 9/30/09** | ** ** | **Lender**               | ** **                                   | **of Lots  /  Homes** | ** ** | **Maturity  Date** | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|           |       |                         |       |                  |       |                     |                                         |                       |       |               |       |                         |       |   |   |
| Lancaster      |       | $                            | 14.0       |  (1)             | 10.25      | %              | IndyMac Federal Bank/  OneWest of California |                       | 54         |               | 9/30/08    |                         | $          | 2.2 |   | $ | 2.7 |   |
| Beaumont       |       | n/a                          |       | n/a                   |       | Comerica Bank            |                                         | —                     |       | n/a                |       | —                       |       | 7.0 |   |
| Corona-Hellman |       | n/a                          |       | n/a                   |       | Third party investor (2) |                                         | —                     |       | n/a                |       | —                       |       | 29.2 |   |
|           |       |                         |       |                  |       |                     |                                         |                       |       |               |       |                         |       |   |   |
|           |       |                         |       |                  |       |                     |                                         |                       |       |               |       | $                            |  2.2  |   | $ | 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 September 30, 2009 a subsidiary of Hearthside Homes completed asale of four model homes and the remaining 62 finished lots for its Woodhavenproject in Beaumont, California for $2.3 million. The lender for the loan securedby the project accepted the proceeds of the sale in full settlement of the loanwithout further recourse or obligation and the Company recognized a $4.1million gain on debt cancellation. The transaction was accounted for inaccordance with ASC 470-60, “*Troubled DebtRestructurings by Debtors*” and the gain was determined as follows(in millions):

 
| Land  sale proceeds                     |   | $   | 1.8    |   |
|-----------------------------------------|--------|-----|--------|--------|
| Model home sale proceeds                |   | .5  |   |
| Transaction costs                       |   | (.2 | )      |
| Net consideration                       |   | 2.1 |   |
| Debt balance at September 30, 2009 |   | 6.2 |   |
| Gain on debt restructuring              |   | $   | (4.1   | )      |

 

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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 Company recognized a pre-tax gain on debtrestructuring of $20.7 million. The transaction was accounted for in accordancewith ASC 470-60 and the gain 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 subsidiary conveyed the remaining 134 finished lots to the investorin exchange for a $28.7 million reduction in the note balance and retainedseven completed homes which secured the then remaining note balance of $2.5million. The subsidiary also assigned $1.7 million of restricted cash relatedto the project to the investor as part of the transaction.  During the three and nine months ended September 30,2009, the Company delivered six and seven homes, respectively, and the relateddebt has been paid in full.

 

In June 2009, a subsidiary of Hearthside Homes received a noticeof default relating to the loan facility which matured on September 30,2008 for development of the Las Colinas project in Lancaster. The currentbalance of the loan plus additional amounts due for delinquent interest andproperty tax advances is approximately $3 million. Unless the Company is ableto sell the property to a third party, the Company expects that the propertywill be sold to the lender in satisfaction of the loan upon approval of theBankruptcy Court. If the property is sold or transferred to the lender in fullsettlement of the loan without further recourse or obligation, the Companyexpects to recognize a modest gain as a result of sale or debtcancellation.  The loan is nonrecourse toCalifornia Coastal Communities, Inc.; however, the subsidiary’s parent,Hearthside Homes, Inc., guaranteed payment of the debt.

 

During the third quarter of 2008, in accordance with EITF 91-2 anda FASB staff interpretation thereof, the Company reduced the carrying value ofthe Las Colinas real estate project to its estimated fair value. During thenine months ended September 30, 2009, the Company delivered two homesat the Las Colinas project resulting in loan repayments of $424,000.

 

**Note 9 – Other Liabilities**

 

Otherliabilities were comprised of the following (in millions):

 
| ** **                                         | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                      |       | $                            | 5.8        |                        | $          | 5.9 |   |
| Home warranty reserves                             |       | 1.8                          |       | 1.7                         |       |
| Contingent indemnity and environmental obligations |       | 1.1                          |       | 1.1                         |       |
| Capital contribution due to joint venture          |       | .5                           |       | .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.

 

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*HomeWarranty Reserve*

 

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

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2009**                                             | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Balance at beginning of period       |       | $                                                    | 1.8        |                                                | $          | 2.0 |   | $ | 1.7 |   | $ | 2.3 |   |
| Provision                            |       | —                                               |       | .1                                                  |       | .1 |   | .1 |   |
| Adjustment due to change in estimate |       | —                                               |       | —                                              |       | — |   | (.1 | ) |
| Payments                             |       | —                                               |       | (.1                                                 | )          | — |   | (.3 | ) |
| Balance at end of period             |       | $                                                    | 1.8        |                                                | $          | 2.0 |   | $ | 1.8 |   | $ | 2.0 |   |

 

**Note 10 –Income Taxes**

 

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

 
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                                             | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Current taxes                               |       | $                                                    | —     |                                                | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes                              |       | 1.0                                                  |       | (7.0                                                | )          | 8.9 |   | (9.5 | ) |
| Valuation allowances on deferred tax assets |       | 20.6                                                 |       | —                                              |       | 28.2 |   | — |   |
| Income tax expense (benefit)                |       | $                                                    | 21.6       |                                                | $          | (7.0 | ) | $ | 37.1 |   | $ | (9.5 | ) |

 

On October 27, 2009, the Company filed Chapter 11 Petitions in theBankruptcy Court. Due to uncertainties regarding the resolution of the Chapter11 Cases and the Company’s ability to utilize its NOLs in the future, duringthe third quarter of 2009, a valuation allowance was recorded for the remainingamount of its net deferred tax assets of approximately $20.6 million. The net deferred tax balance at December 31,2008 is primarily composed of federal NOLs. During the second quarter of 2009, the Companyconcluded it was not “more likely than not” that the Company would be able togenerate sufficient taxable income in 2009, 2010 and 2011 to realize certainexpiring federal NOLs and recorded valuation allowances of $7.6 million.While the Company expects to report profitable operations before income taxesfor 2009, it expects to report a taxable loss due to tax losses recognized upondispositions of inland properties. These tax losses were previously recognizedfor financial statement purposes when impairment losses were recorded. TheCompany monitors the availability of real estate for development ateconomically viable prices, market conditions and other objectively verifiableeconomic factors affecting the Company’s operations, as well as other positiveand negative factors, as it assesses valuation allowances against its deferredtax assets. The Chapter 11 filing constitutes significant negative evidenceunder ASC 740-10 as it creates uncertainties related to future projectedtaxable income. The most critical uncertainties are whether the Company will beable to continue selling homes at its Brightwater project using currentlyprojected sales prices and absorption rates in light of the continuingdeterioration in the housing and credit markets, the Company’s recent Chapter11 filing, and the timing of dispositions of inland properties and the relatedrecognition of losses for tax reporting purposes.

 

The federal NOLs available as of September 30, 2009 wereapproximately $164 million. The amount of federal NOLs which expire if notutilized is $11 million in 2009, $49 million in 2010,$42 million in 2011, zero in 2012 and 2013, and $62 millionthereafter.

 

The Internal Revenue Code (the “Code”) generally limits theavailability of NOLs if an ownership change occurs within any three-year periodunder Section 382. If the Company were to experience an ownership changeof more than 50%, the use of all remaining NOLs would generally be subject toan annual limitation equal to the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate (4.48% as of October 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 16% as of November 2,2009, as computed in accordance with Section 382. A valuation allowance isrecorded against the net deferred tax assets, which are primarily composed offederal NOLs.  In the event of anownership change, the Company’s use of the NOLs may be limited and not fullyavailable for realization.

 

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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 $164 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.

 

Of the Company’s unrecognized tax benefits of $5.1 million at September 30,2009, no amount would affect the Company’s effective tax rate if recognized.The Company does not expect that its unrecognized tax benefits willsignificantly fluctuate or change within 12 months of the reporting date.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of September 30,2009, 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 2006through 2009 and the years 2005 through 2009 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.

 

Pursuant to ASC 718-740, “*Stock Compensation —Income Taxes*,” the Company has elected to recognize stock optiondeductions on the tax law ordering method, which maximizes the realization ofthe stock option deductions in the current year. While the Company realized themajority of its 2006 stock option deductions, approximately $400,000 ofunrealized tax benefits related to stock option deductions are not reflected inthe consolidated financial statements. Upon realization of the tax benefits,the Company would increase its additional paid-in capital.

 

**Note 11 –Commitments and Contingencies**

 

*Real Estate Matters*

 

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

 

*Legal Proceedings*

 

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

 

Chapter 11 Cases. On October 27, 2009 (the “Petition Date”), the Debtorscommenced the Chapter 11 Cases and they continue to operate their businesses asdebtors-in-possession under the jurisdiction of the Bankruptcy Court and inaccordance with applicable provisions of the Bankruptcy Code and the orders ofthe Bankruptcy Court. As debtors-in-possession, the Debtors are authorized tocontinue to operate as ongoing businesses, and may pay all debts and honor allobligations arising in the ordinary course of their businesses after thePetition Date. However, the Debtors may not pay creditors on account ofobligations arising before the Petition Date or engage in transactions outsidethe ordinary course of business without approval of the Bankruptcy Court, afternotice and an opportunity for a hearing.

 

Under theBankruptcy Code, actions to collect pre-petition indebtedness, as well as mostlitigation pending against the Debtors, are stayed. Other pre-petitioncontractual obligations against the Debtors generally may not be enforced.Absent an order of the Bankruptcy Court providing otherwise, substantially allpre-petition liabilities are subject to settlement under a plan ofreorganization to be voted upon by creditors and other stakeholders, andapproved by the Bankruptcy Court.

 

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The Debtors havereceived approval from the Bankruptcy Court of their “first day” motions, whichwere filed as part of the Chapter 11 Cases. Among other “first day” relief, theDebtors received approval to continue wage and salary payments and otherbenefits to employees as well as certain related pre-petition obligations; tocontinue to honor customer programs as well as certain related pre-petitioncustomer obligations; and to pay certain pre-petition trade claims held bycritical vendors with lien rights. Subject to receiving approval of finalorders from the court at a hearing scheduled for December 9, 2009, theDebtors intend to continue to pay their vendors and suppliers in the ordinarycourse of business for goods and services delivered post-petition.

 

Under the priorityscheme established by the Bankruptcy Code, certain post-petition and secured or“priority” pre-petition liabilities need to be satisfied before generalunsecured creditors and holders of the Debtors’ equity are entitled to receiveany distribution. No assurance can be given as to what values, if any, will beascribed in the bankruptcy proceedings to the claims and interests of each ofthese constituencies. Additionally, no assurance can be given as to whether,when or in what form unsecured creditors and holders of the Debtors’ equity mayreceive a distribution on such claims or interests.

 

Under theBankruptcy Code, the Debtors may assume, assume and assign, or reject certainexecutory contracts and unexpired leases, including, without limitation, leasesof real property and equipment, subject to the approval of the Bankruptcy Courtand certain other conditions. Any description of an executory contract orunexpired lease in this Form 10-Q, including where applicable our expresstermination rights or a quantification of Debtor obligations, must be read inconjunction with, and is qualified by, any overriding rejection rights theDebtors have under the Bankruptcy Code. As of the Petition Date, virtually allpending litigation against the Debtors is stayed as to the Debtors, and absentfurther order of the Bankruptcy Court, no party, subject to certain exceptions,may take any action, also subject to certain exceptions, to recover onpre-petition claims against the Debtors.

 

*California Department of Toxic Substances Control*

 

In October 2006, the California Department of Toxic Substances Control(“DTSC”) filed a civil complaint against the Company’s Hearthside ResidentialCorp. subsidiary (“HRC”) in the Federal District Court for the SouthernDivision of the Central District of California The DTSC’s complaint requeststhat HRC pay for approximately $1.0 million of costs incurred by the DTSC,together with interest on that amount, primarily in connection with theoversight and remediation of PCB contamination found on residential propertiesnever owned by HRC adjacent to a 43-acre site where HRC completed the removalof PCB contaminated soil during September 2005. HRC’s remediation processwas approved by the DTSC in December 2005 when it issued a finalacceptance of the remediation work. The complaint also seeks an order for HRCto pay any future costs which may be incurred in connection with furtherremediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has received invoices from DTSC seekingreimbursement for these costs; however, HRC contends, based upon advice of counsel,that it is not responsible for such costs because neither HRC nor any affiliateever developed or built the neighboring residential properties, neither HRC norany affiliate generated the contamination, the contamination did not emanatefrom the 43-acre site that HRC remediated, and, even if the contamination didemanate from the 43-acre site, it did not do so while HRC owned the site.Furthermore, HRC has also disputed such charges due to the fact that DTSCimproperly submitted its bill. The Company’s subsidiary is vigorously defendingitself in this matter. Therefore, the Company has not accrued for any of DTSC’sapproximately $1.0 million of claims related to these residentialproperties.

 

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

 

See Note 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 by indemnitiesfrom certain of the Company’s previously affiliated companies. The Companybelieves its consolidated balance sheet reflects adequate reserves for thesematters

 

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**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 threeindependent directors in 2009 and four independent directors in 2008, under theDirector Fee Program, which is a component of the 1993 Plan. These restrictedshares vest at a rate of 25% per quarter during 2008 and 2009, respectively. OnOctober 16, 2008, one of the Company’s independent directors resigned fromthe Board and forfeited 878 unvested restricted shares.

 

The Company did not grant any options during the nine months ended September 30,2009 and 2008. Pursuant to ASC 718-10, “*Compensation -**Stock Compensation*,” the Company recorded $53,000 and$78,000 of compensation expense during the nine months ended September 30,2009 and 2008, respectively, which is reflected in additional paid-in capital.

 

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

 
| ** **                                        | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                       |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                           |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                         |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, September 30                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.35 years |   |
|                                              |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at September 30 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 6.35 years |   |
|                                              |       |                        |       |                                  |       |                                  |       |
| Available for future grants at September 30  |       | 221,794                     |       |                                  |       |                                  |       |

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(a)          Adjusted for specialdividend of $12.50

 

As of September 30, 2009, there were 17,500 options outstandingwith a weighted-average exercise price of $21.58 (ranging from $13.35 to$25.99) and a weighted-average remaining life of 6.35 years. All outstandingstock options are fully vested. The aggregate intrinsic value of alloutstanding, fully-vested and exercisable stock options at September 30,2009 was zero. Following the January 2009 issuance of 125,000 shares ofrestricted stock under the Director Fee Program, there are 221,794 optionsavailable for future grants.

 

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 underlying stock,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. 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 September 30,2009, total stockholders’ equity is $41.3 million, reflecting beginningstockholders’ equity of $55.5 million and net loss of $14.2 million during thenine months ended September 30, 2009.

 

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

 

Thisitem contains forward-looking statements that involve risks and uncertaintiesas set forth in “Cautionary Statements About Forward-Looking Statements” at thebeginning of this Quarterly Report on Form 10-Q. Actual results may differmaterially from those indicated in the forward-looking statements set forthbelow. Factors that may cause such a difference include, but are not limitedto, those discussed in “Item 1A. Risk Factors” of both Part II of thisReport and in our Annual Report on Form 10-K for the year ended December 31,2008.

 

**Liquidityand Capital Resources**

 

*RecentChapter 11 Cases*

 

On October 27, 2009, we and certain of our directand indirect wholly-owned subsidiaries (collectively with the us, the “Debtors”)filed voluntary petitions (the “Chapter 11 Petitions”) for relief under chapter11 of title 11 (“Chapter 11”) of the United States Code (the “Bankruptcy Code”)in the United States Bankruptcy Court for the Central District of California(the “Bankruptcy Court”). The Chapter 11 Petitions are being jointlyadministered under the caption *In re California CoastalCommunities, Inc.*, Case No. 09-21712-TA (the “Chapter 11Cases”). We and the other Debtors continue to operate our businesses and manageour properties as “debtors in possession” under the jurisdiction of theBankruptcy Court and in accordance with the applicable provisions of theBankruptcy Code and orders of the Bankruptcy Court. We have obtained theBankruptcy Court’s approval to, among other things, continue to pay criticalvendors with lien rights, sell homes free and clear of all liens on an interimbasis, use cash collateral on an interim basis,, honor homeowner warranties onan interim basis, meet payroll obligations and provide employee benefits. Therecan be no assurance that we and the other Debtors will be able to successfullydevelop, execute, confirm and consummate one or more plans of reorganizationwith respect to the Chapter 11 Cases that are acceptable to the BankruptcyCourt and the creditors and other parties in interest.

 

We are continuing to work with KeyBank and our lendersto restructure our debt obligations under the Revolving Loan and the Term Loanthrough the Chapter 11 reorganization process. Among other things, we areseeking an extension of the maturity dates and changes to the repaymentschedules to provide full repayment by the end of the third quarter of 2013.However, there can be no assurance that we and the other Debtors will be ableto successfully develop, execute, confirm and consummate one or more plans ofreorganization with respect to the Chapter 11 Cases that are acceptable to theBankruptcy Court and the creditors and other parties in interest.

 

We continue to operate our businesses asdebtors-in-possession. We have incurred and will continue to incur significantcosts associated with the reorganization which are expected to significantlyaffect our results of operations.

 

An additional hearing is scheduled before the Bankruptcy Court on December 9,2009 to consider final orders for, among other things, continued use of cashcollateral, sellinghomes free and clear of liens, honoring homeowner warranties and continued useof our existing cash management system.

 

We intend tomaintain business operations through the reorganization process. Our liquidityand capital resources, however, are significantly affected by the Chapter 11Cases, which have resulted in various restrictions on our activities,limitations on financing and a need to obtain Bankruptcy Court approval forvarious matters. In particular, we and the other Debtors are not permitted tomake any payments on pre-petition liabilities without prior Bankruptcy Courtapproval. However, we have been granted relief in order to continue wage andsalary payments and other employment benefits to employees as well as otherrelated pre-petition obligations; to continue to construct and sell homes aswell as certain related pre-petition customer obligations through December 9,2009; and to pay certain pre-petition trade claims held by critical vendorswith lien rights. Under the priority schedule established by the BankruptcyCode, certain post-petition and pre-petition liabilities need to be satisfiedbefore general unsecured creditors and equity holders are entitled to receiveany distribution. At this time, it is not possible to predict with certaintythe effect of the Chapter 11 Cases on our business or various creditors, orwhen we and the other Debtors will emerge from these proceedings. Futureresults will depend upon the confirmation and successful implementation of aplan of reorganization. The continuation of the Chapter 11 Cases, particularlyif a plan of reorganization is not timely confirmed, could further adverselyaffect our operations.

 

We depend on cash flows generated from operations and availableborrowing capacity to fund our Brightwater development, and to meet our debtservice and working capital requirements. However, our ability to continue to generatesufficient cash flows has been and will continue to be adversely affected bycontinued difficulties in the homebuilding industry and continued weakness inthe California economy. During the last eight months (March — October), wegenerated 31 net sales orders at Brightwater, increased construction startsduring the second and third quarters to keep pace with sales orders, andstarted construction of a limited number of speculative homes which are ingreater demand in today’s market than 

 

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contracthomes that are constructed over a five to nine month period. While sales of theTrails and Sands products, which are generally under $1.0 million, haveincreased during the first nine months of 2009, sales of our larger Cliffs andBreakers homes continue to be challenged by limitations on jumbo-mortgagefinancing and the downturn in the housing market, which have reduced demand forhomes exceeding $1.0 million.

 

Due to cash requirements for on-going home construction and scheduleddebt amortization, our ability to meet future loan repayment requirements willdepend on the results of negotiations with our lenders and the Chapter 11reorganization proceedings.  Based onBrightwater sales thus far in 2009, which have been primarily for the smallestBrightwater home product (The Trails), the current product mix of home sales isnot expected to generate sufficient cash flow to meet our future scheduled loanrepayments for the Revolving Loan and Term Loan as currently structured.

 

Continuing negative conditions in the housing and credit markets giverise to uncertainty as to our present and future ability to meet our projectedhome sale closings and whether modified or new financings can be obtained inorder for us to meet our debt obligations. We, like many other homebuilders,are constantly evaluating potential alternatives regarding our capitalstructure including, but not limited to, various strategies for restructuringexisting debt financings and raising additional capital. There can be noassurance that we will be successful in any of these endeavors. While thenational credit markets appear to be improving, there is limited availabilityof financing for small businesses which presents uncertainty as to our abilityto secure new financing, if needed, and the terms of such financing if it isavailable. The current housing and mortgage markets also present uncertainty asto our ability to achieve sufficient positive cash flow from operationsrequired to satisfy our debt obligations and meet financial covenantrequirements.

 

While we are hopeful that we will be able to restructure our debtthrough the Chapter 11 reorganization process, unless we are successful inamending and extending the terms of the Revolving Loan and Term Loanagreements, we do not believe that our cash, cash equivalents and future realestate sales proceeds will be sufficient to meet our debt obligations or tomeet anticipated operating and project development costs for Brightwater, andgeneral and administrative expenses during the next 12 months.

 

*NasdaqDelisting Notice*

 

On October 28,2009, we received a letter from Nasdaq notifying us that it had determined todelist our common stock from trading as a result of our commencement of theChapter 11 Cases.  We are in the processof appealing the Nasdaq determination and a hearing is scheduled for December 3,2009; however, there can be no assurance that our appeal will besuccessful.  During the pendency of theappeal, our common stock will continue to be listed.  If we are not successful on appeal and ourcommon stock is delisted, negative implications may be associated with thedelisting, including potential loss in confidence in us by suppliers andcustomers and the loss of institutional investor interest in our common stock.

 

*General*

 

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

 
| ** **                                      | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2009**                        | ** ** | **2008** | ** ** |
| Cash and cash equivalents                       |       | $                               | 3.7        |   | $ | 7.0 |   |
| Cash provided by (used in) operating activities |       | 7.4                             |       | (17.8 | ) |
| Cash provided by (used in) investing activities |       | .4                              |       | (.3 | ) |
| Cash provided by (used in) financing activities |       | (6.4                            | )          | .8 |   |
|                                                 |            |                                 |            |  |  |  |  |

 

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 September 30,2009 aggregated $3.7 million provides our current liquidity. As of November 9,2009, our unrestricted cash and cash equivalents aggregated $1.5 million and weheld approximately $800,000 of cash from net real estate proceeds subject tothe Bankruptcy Court’s cash management order.

 

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On September 15, 2006 we entered into the $100 millionrevolving loan and the $125 million term loan with KeyBank NationalAssociation, as a lender and agent for several other lenders. These loans aredescribed in greater detail in Notes 5 and 6 to “Item 1. FinancialStatements” above. On September 30, 2008, we amended the revolving andterm loans to provide greater flexibility to repay the debt and financeconstruction based on mid-2008 projections for home sales at Brightwater whichreflected market conditions at that time. In March 2009, we extended thematurity of the revolving loan from September 15, 2009 to June 30,2010. The commitment reductions for the revolving and term loans are scheduledas follows (in millions):

 

**Senior Secured Revolving Loan**

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

 

**Senior Secured Term Loan**

 
| **Date**                | ** ** | **Commitment  Reduction** | ** ** | **End of  Period  Commitment** | ** ** |
|-------------------------|------------|---------------------------|------------|--------------------------------|------------|
| September 30, 2009 |       | $                         | —     |                           | 99.8       |   |
| December 31, 2009  |       | 9.8                       |       | 90.0                           |       |
| March 31, 2010     |       | 15.0                      |       | 75.0                           |       |
| June 30, 2010      |       | 10.0                      |       | 65.0                           |       |
| September 30, 2010 |       | 15.0                      |       | 50.0                           |       |
| December 31, 2010  |       | 12.5                      |       | 37.5                           |       |
| March 31, 2011     |       | 12.5                      |       | 25.0                           |       |
| June 30, 2011      |       | 12.5                      |       | 12.5                           |       |
|                         |            |                           |            |                                |            |  |

 

As of September 30, 2009 and December 31, 2008, $81.7 millionand $74.4 million, respectively, was outstanding under the revolving loan.During the nine months ended September 30, 2009, we made mandatoryrepayments of $5.1 million and $7.6 million on the revolving and termloans, respectively, in connection with 21 home deliveries at Brightwaterduring the period.

 

On September 28, 2009, we received a notice of anevent of default from KeyBank National Association with respect to the loan-to-valuecovenant of the revolving loan that would give KeyBank the right to accelerate theindebtedness under the revolving loan and term loan. As of September 30, 2009,approximately $81.7 million and $99.8 million of principal was outstandingunder the revolving loan and term loan, respectively. In addition, on October 1,2009, we received a notice of an event of default from KeyBank with respect toour nonpayment of approximately $1.7 million of principal that was due on September 30,2009 under the terms of the revolving loan that would give KeyBank the right toaccelerate the indebtedness under the revolving loan and term loan.

 

On October 1, 2009, we entered into the seniorsecured revolving loan forbearance agreement and senior secured term loanforbearance agreement with KeyBank, as a lender and as agent for the other loansyndicate members under the revolving loan and the term loan. However, oursubsequent failure to make required interest payments aggregating $759,000 on October 14,2009 for the revolving and term loans terminated the forbearance period underthe forbearance agreements. Therefore, as a result of our nonpayment of $1.7 million ofprincipal that was due on September 30, 2009 and $759,000 of interest thatwas due on October 14, 2009, triggering events have occurred that couldgive rise to the immediate acceleration of the payment of all outstandingprincipal and accrued interest under both the term and revolving loans.

 

The filing of the Chapter 11 Petitions on October 27,2009, also constituted events of default under the revolving loan and the termloan that can trigger acceleration of the indebtedness.  However, the filing of  the Chapter 11 Petitions automatically staysmost actions against us and the other Debtors, including actions with respectto revolving loan and term loan.  As of October 27,2009, approximately $82.3 million and $100.6 million of principal and accruedinterest is outstanding under the revolving loan and term loan, respectively.

 

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On September 30, 2009, a subsidiary of Hearthside Homes completeda sale of 62 finished lots and four models for $2.3 million, thereby disposingthe remaining assets of the Woodhaven project in Beaumont, California. Thelender for the loan secured by the project accepted the proceeds of the sale infull satisfaction of the outstanding debt and release of the related guaranty.As a result, we recognized a $4.1 million pre-tax gain on debt restructuringduring the third quarter of 2009.

 

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 secured the thenremaining $2.5 million note balance which matures on March 31, 2010.During the second and third quarters of 2009, the subsidiary delivered all ofthe remaining seven homes and repaid the loan in full.

 

A subsidiary of Hearthside Homes, Inc. is obligated on a loan witha principal amount of $2.2 million related to a Lancaster property thatmatured September 30, 2008. Additional amounts due under the loanagreement for delinquent interest and property tax advances aggregateapproximately $800,000. In June 2009, our subsidiary received a notice ofdefault. Unless we are able to sell the property to a third party, we expectthat the property will be sold to the lender in satisfaction of the loan uponapproval of the Bankruptcy Court. If the property is sold or transferred to thelender in full settlement of the loan without further recourse or obligation,we expect to recognize a modest gain as a result of sale or debt cancellation.The loan is nonrecourse to us; however, it is guaranteed by Hearthside Homes.

 

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

 

Cash provided by operating activities of $7.4 million for the firstnine months of 2009 primarily reflects net proceeds of $26.8 million generatedby 21 deliveries at Brightwater, which were partially offset by investments inBrightwater of $22.7 million, along with $6.8 million generated fromdeliveries of 18 inland homes and the sale of 62 finished lots.

 

Our primary sources of cash during the first nine months of 2009 were$33.6 million of proceeds from sales of real estate inventories and $7.3million of net borrowings from our revolving loan. Our primary uses of cashduring the first nine months of 2009 include $22.7 million of investments inBrightwater and $7.6 million of repayments of our term loan.

 

The $2.1 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 transactionand a $400,000 reduction in the interest reserve required under the term loan.

 

The $37.1 million decrease in deferred tax assets primarily reflectsnon-cash valuation allowances of $28.2 million recorded during the second andthird quarters of 2009, as well as the provision for income taxes which iscomposed entirely of deferred taxes. There are no current taxes since we have ataxable loss for the three and nine months ended September 30, 2009,primarily due to the recognition of real estate losses for tax purposes thatwere recorded in prior years for financial statement purposes.

 

The $2.8 million decrease in other assets primarily reflects theamortization of $1.6 million of prepaid rent related to our model homefinancing, as well as $1.7 million of prepaid loan fees amortized during thefirst nine months of 2009.

 

The $36.7 million decrease in other project debt primarily reflects a$26.7 million reduction in the Hearthside Lane note balance as a result of thedeed-in-lieu transaction completed during the first quarter of 2009 and a $4.1million reduction in the Woodhaven note balance in connection with the September 30,2009 short sale of the remaining four model homes and 62 finished lots at theproject. In addition, the decrease for the nine months ended September 30,2009 reflects project debt repayments of $5.9 million made from the proceeds ofhome deliveries and the Woodhaven transaction.

 

The $1.7 million decrease in accounts payable and accrued liabilitiesprimarily reflects a $1.0 million settlement of accrued seller profitparticipation related to two completed projects with the land seller whoaccepted the assignment from our subsidiary of a $700,000 receivable related toinfrastructure work.

 

*Availability of Additional Liquidity*

 

The availability of additional capital, whether from private capitalsources (including banks) or the public capital markets, fluctuates as marketconditions change. There may be times when the private capital markets and thepublic debt or equity markets lack sufficient liquidity or when our securitiescannot be sold at attractive prices, in which case we would not be able toaccess capital from these sources. Based on current market conditions and ourfinancial condition (including our recent Chapter 11 filing), our ability toeffectively access these liquidity sources is significantly limited. Inaddition, a further 

 

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weakeningof our financial condition or strength, including in particular a materialincrease in our leverage or a further decrease in our profitability or cashflows, could adversely affect our ability to obtain necessary funds, andotherwise increase our cost of borrowing.

 

**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 Lancaster in Los Angeles county. Our primary asset is a 356-home luxury coastalcommunity known as Brightwater in Huntington Beach, California. Our principalactivities include:

 

·                  obtaining zoning and otherentitlements for land we own or for third parties under consulting agreements;

 

·                  improving 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.

 

On September 30, 2009, a subsidiary of Hearthside Homes completeda sale of 62 finished lots and four model homes for $2.3 million, therebydisposing all remaining assets of the Woodhaven project in Beaumont,California. The lender for the loan secured by the project accepted theproceeds of the sale in full satisfaction of the outstanding debt. As a result,we recognized a $4.1 million pre-tax gain on debt restructuring during thethird quarter of 2009.

 

During the first quarter of 2009, our homebuilding subsidiary,Hearthside Homes, Inc., completed a deed-in-lieu transaction for theHearthside Lane project in Corona, California and recognized a pre-tax gain ondebt restructuring of $20.7 million. In exchange for a $28.7 million reductionin the loan balance secured by the project, the subsidiary conveyed theremaining 134 finished lots to the lender. The subsidiary retained sevencompleted homes which secured the remaining note balance of $2.5 million whichwas due in March 2010. As of September 30, 2009, the subsidiary hasdelivered all seven homes and the remaining note has been repaid in itsentirety.

 

In view of the continuing significant economic downturn in the housingmarket, during the remaining three months of 2009 and continuing into 2010our new home construction will be limited to our 356-home Brightwater projectlocated on the Bolsa Chica mesa in Huntington Beach, California; and ouroperations in other markets will focus on the resolution of the one remainingproject loan for 54 finished lots in Lancaster.

 

During the remaining three months of 2009, our primary goals will beto:

 

·                  continue constructing,selling and delivering homes at Brightwater;

 

·                  negotiate a consensualrestructuring of our existing debt secured by the Brightwater project with ourlending syndicates;

 

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

 

·                  dispose of a  nonperforming inland development project inLancaster, California that is in default through either a sale to a third partyor to the lender pursuant to a process approved by the Bankruptcy Court.

 

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 or opportunitiesthat we may pursue.

 

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 

 

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thecoast of Southern California and the absence of significant competition fromother homebuilders in the Huntington Beach market due to the lack of availableland for the development of new single family detached homes. We believe thatBrightwater is in a location that is difficult to replace and in a market whereapprovals are increasingly difficult to achieve. We also believe thatBrightwater has substantial embedded value that should not be sacrificed undercurrent depressed market conditions but, rather, should be realized over time.Finally, we believe that Brightwater’s demographics remain strong due to thecontinuing regulation-induced constraints on lot supplies and the significantnumber of affluent households along the coast of Southern California.Therefore, we remain optimistic about continuing sales at Brightwater.

 

Our total revenues for the three months ended September 30, 2009and 2008 were $11.4 million and $13.9 million, respectively, and $34.7million and $29.3 million for the nine months ended September 30, 2009 and2008, respectively. For the three months ended September 30, 2009 and 2008we delivered 20 and 17 homes, respectively, and for the nine months ended September 30,2009 and 2008 we delivered 39 and 40 homes, respectively. Our total assets asof September 30, 2009 and December 31, 2008 were $259.7 millionand $312.5 million, respectively, with Brightwater and our adjacentfive-acre parcel constituting $242.0 million (93% of total assets) and$238.5 million (76% of total assets), respectively. Our homebuildingsubsidiary, Hearthside Homes, Inc., has delivered 2,200 homes to familiesthroughout 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 debtfinancing, as described in Notes 5 and 6 to “Item 1. Financial Statements”above, which provided $100 million for Brightwater construction and$125 million to fund a $12.50 per share special dividend paid to ourstockholders in September 2006. As of September 30, 2009, we had$206.2 million of debt (including the model home financing) against$41.3 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.

 

**Homebuilding 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 nine months of 2009. Weakness in the homebuilding environmenthas continued as unemployment increased, the availability of jumbo-mortgagesremains limited and the economic recession continued. Specifically, the creditmarkets and the mortgage industry have been experiencing a period ofunparalleled turmoil and disruption characterized by bankruptcy, financialinstitution failure, consolidation and an unprecedented level of interventionby the United States federal government. While the ultimate outcome of theseevents cannot be predicted, it has made it more difficult for homebuyers toobtain acceptable financing. In addition, the supply of new and resale homes inthe marketplace remained excessive for the levels of consumer demand, furtherchallenged by an increased number of foreclosed homes offered at substantiallyreduced prices. These pressures in the marketplace resulted in the use ofincreased sales incentives and price reductions in an effort to generate salesand reduce inventory levels by us and 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 12.2% at the end of the thirdquarter of 2009 compared with 8.7% at the end of 2008, while the unemploymentrate in Orange County was 9.4% in September 2009 compared with 6.5% in December 2008.These adverse conditions have now persisted to varying degrees since thebeginning of 2006 and their impact is reflected in our results for the threeand nine months ended September 30, 2009 and 2008.  We believe that the weak demand we areexperiencing, particularly for homes over $1.0 million, reflects homebuyers’reluctance to make a purchasing decision until they are comfortable that homeprice declines are near bottom and that economic conditions have stabilized. Webelieve the current conditions could continue during the remaining three 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.

 

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Thus far during 2009, the homebuilding industry continues to faceadverse pressures. Weak buyer confidence and significantly tighter mortgagelending standards, coupled with an oversupply of new and existing homes forsale (boosted by foreclosures), continue to weigh on the housing market and maycause further deterioration in operating conditions and sales results. Whilesome positive signs are occurring, such as rising stock markets and reducednumber of new unemployment claims, it remains uncertain when the housing marketor the broader economy will experience a meaningful recovery. Actions taken orannounced by federal, state, and local governments to support housing maysoften, but are not expected to reverse, the impact of these pressures.

 

In addition, the California home-buyer tax credit enacted in early 2009(which does not contain income or first-time buyer restrictions and is limitedto new homes) appears to have boosted demand somewhat; however, the federalstimulus plan has not had much impact on sales at our Brightwater project dueto its income and first-time buyer restrictions. As of August 31, 2009,all of the $100 million in California tax credits had been issued. Key housingmetrics, including starts, new home sales and existing home sales may weaken orremain stagnant during the remaining three months of 2009.

 

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

 

While we have successfully sold all remaining standing inventory in ourinland markets as of September 30, 2009, the price reductions andadditional incentives have resulted in impairment reserves and significantlyreduced gross profits for our inland projects. In response to the ongoingcrisis in the housing market and national credit markets, during the first ninemonths of 2009 we have:

 

·                  terminated further inlandmarket construction activity until those markets improve;

 

·                  reduced sales prices andoffered incentives for all of our homes in order to eliminate our standinginventory in inland markets and reduce inventory at Brightwater;

 

·                  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;

 

·                  completed a short sale ofthe remaining Woodhaven project in Beaumont which resulted in a pre-tax gain ondebt restructuring of $4.1 million;

 

·                  continued negotiations withour lender in an attempt to reach a consensual resolution of our subsidiary’s$2.2 million principal loan default on the Las Colinas property in Lancaster;and

 

·                  filed voluntary petitionsfor relief under Chapter 11 in the Bankruptcy Court in order to restructureapproximately $182 million of indebtedness related to our Brightwater project.

 

We expect to continue to operate with fewer active communities until wesee reasonable signs of a housing market recovery. If market conditions declinefurther, we may need to take additional charges for inventory impairments infuture quarters. In addition, our results for the remaining three months of2009 will be adversely affected by the costs of restructuring our debt throughthe Chapter 11 reorganization process. Our results could also be adversely affected if general economicconditions do not improve or continue to deteriorate, if consumer confidenceremains weak or declines further, if job losses continue or accelerate, ifforeclosures or distressed sales increase, or if consumer mortgage lendingbecomes less available or more expensive, any or all of which would furtherdiminish the prospects for a recovery in housing markets.

 

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

 

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

 

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

 

·                  exercising tight controlover cash flows;

 

·                  changing sales and marketingefforts to generate additional traffic;

 

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

 

·                  ceasing construction andsales efforts at our inland projects until the housing market improves;

 

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

 

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

 

During the three and nine months ended September 30, 2009, wedelivered 20 and 39 homes (excluding the sale of 62 finished lots at ourBeaumont project), respectively, and as of November 11, 2009, twoadditional homes have been delivered and 14 additional homes are in escrow, asdiscussed further under “Our Current and Future Homesites” below.

 

Despite the challenges of the current California homebuilding market,we believe the potential for our Brightwater project remains high. Brightwaterhas not been immune to the effects of the unstable mortgage and housingmarkets; however, that impact appears less severe than the weakness we haveseen in our inland markets. Brightwater continues to have significant weeklytraffic, generating 15 net new sales orders during the third quarter of 2009compared with six in the comparable quarter of 2008 and 11 in the secondquarter of 2009. We believe that the reduced impact is a result of Brightwater’ssuperior coastal location, the extremely limited supply of new homes on thecoast of Southern California and the absence of significant competition fromother homebuilders in the Huntington Beach market due to the lack of availableland for the development of new single family detached homes. We believe thatBrightwater is in a location that is difficult to replace and in a market whereapprovals are increasingly difficult to achieve. We also believe thatBrightwater has substantial embedded value that should not be sacrificed undercurrent depressed market conditions but, rather, should be realized over time.Finally, we believe that Brightwater’s demographics remain strong due to thecontinuing regulation-induced constraints on lot supplies and the significantnumber of affluent households along the coast of Southern California.Therefore, we remain optimistic about continuing sales at Brightwater.

 

We currently believe that market conditions will continue to bechallenging throughout 2009 and into 2010, as unemployment rates are rising,foreclosure activity continues to be significant and consumer confidencecontinues to be eroded. Although substantially reduced home prices andrelatively low consumer mortgage interest rates for conforming loans haveimproved housing affordability, many potential homebuyers remain tepid aboutpurchasing a home in this unstable economic environment. This demand-sidedynamic, in conjunction with a high level of foreclosures, is sustaining theoversupply of unsold new and existing homes and competitive pricing pressuresthat have generated the extremely challenging conditions our industry hasexperienced since the beginning of 2006. We remain hopeful that the federalgovernment’s initiatives to stabilize the credit markets and restore confidencein the financial system and economy will be effective.

 

In view of the continuing significant economic downturn in the housingmarket, during the remaining three months of 2009 our new home constructionwill be limited to our 356-home Brightwater project located on the Bolsa Chicamesa in Huntington Beach, California. We expect that efforts in our inlandmarkets will focus on disposing of our subsidiaries’ Las Colinas (Lancaster)property. However, there can be no assurance that these strategies or anyalternatives will prove successful.

 

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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 three months of2009 could be adversely affected if housing, credit market, or general economicconditions deteriorate further, if job losses accelerate, if consumer mortgagelending becomes less available or more expensive, or if consumer confidencecontinues to fall, any or all of which would further diminish the prospects fora recovery in the housing market. We believe that there will not be ameaningful improvement in the housing market until there is a sustaineddecrease in inventory levels, price stabilization, reduced foreclosure rates,greater availability of mortgage financing, and the restoration of consumerconfidence that can support a decision to buy a home.

 

**Our Current and Future Homesites**

 

Our homebuilding operations include active projects in the HuntingtonBeach area of Southern California.  Wedelivered 20 homes during the three months ended September 30, 2009,compared with 17 deliveries during the comparable period of 2008. During thenine months ended September 30, 2009 and 2008, we delivered 39 and 40homes, respectively. We acquired no single-family residential lots during thethree and nine months ended September 30, 2009 and 2008 and we have nocontracts to acquire land or lots.

 

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

 
| **Project**                             | ** **                     | **Location**     | ** **                     | **Land  Acquisition** | ** **                     | **Commenced  Construction**                                                             | ** **                     | **Commenced********Sales**                                                              | ** **                     | **Models********(a)** | ** **                     | **Backlog** | ** **                     | **Standing  Inventory** | ** **                     | **Specs  Under Construction** | ** **                     | **Remaining  Lots** | ** **                     | **Total  Lot  Inventory** | ** **         |
|-----------------------------------------|--------------------------------|------------------|--------------------------------|-----------------------|--------------------------------|-----------------------------------------------------------------------------------------|--------------------------------|-----------------------------------------------------------------------------------------|--------------------------------|-----------------------|--------------------------------|-------------|--------------------------------|-------------------------|--------------------------------|-------------------------------|--------------------------------|---------------------|--------------------------------|---------------------------|--------------------|
| Brightwater  in Orange County:     |                           |             |                           |                  |                           |                                                                                    |                           |                                                                                    |                           |                  |                           |        |                           |                    |                           |                          |                           |                |                           |                      |               |
| The  Trails                             |                           | Huntington Beach |                           | 1970                  |                           | 2006                                                                                    |                           | 2007                                                                                    |                           | 4                     |                           | 9           |                           | —                  |                           | 2                             |                           | 25                  |                           | 40                        |               |
| The  Sands                              |                           | Huntington Beach |                           | 1970                  |                           | 2006                                                                                    |                           | 2007                                                                                    |                           | 4                     |                           | 2           |                           | 2                       |                           | 2                             |                           | 55                  |                           | 65                        |               |
| The  Cliffs                             |                           | Huntington Beach |                           | 1970                  |                           | 2006                                                                                    |                           | 2008                                                                                    |                           | 4                     |                           | 4           |                           | 2                       |                           | 1                             |                           | 90                  |                           | 101                       |               |
| The  Breakers                           |       | Huntington Beach |       | 1970                  |       | 2006                                                                                    |       | 2008                                                                                    |       | 5                     |       | 2           |       | 1                       |       | 2                             |       | 87                  |       | 97                        |     |
| *Subtotal—Orange County*           |                           |             |                           |                  |                           |                                                                                    |                           |                                                                                    |                           | 17                    |                           | 17          |                           | 5                       |                           | 7                             |                           | 257                 |                           | 303                       |               |
| Inland  Empire/Lancaster:               |                           |             |                           |                  |                           |                                                                                    |                           |                                                                                    |                           |                  |                           |        |                           |                    |                           |                          |                           |                |                           |                      |               |
| Las  Colinas                            |                           | Lancaster        |                           | 2005                  |                           | 2006                                                                                    |                           | 2006                                                                                    |                           | —                |                           | —      |                           | —                  |                           | —                        |                           | 54                  |                           | 54                        |               |
| Other  unimproved lots                  |                           | Lancaster        |                           | 2005                  |                           |               (b) |                           |               (b) |                           | —                |                           | —      |                           | —                  |                           | —                        |                           | 73                  |                           | 73                        |               |
| *Subtotal—Inland Empire/Lancaster* |                           |             |                           |                  |                           |                                                                                    |                           |                                                                                    |                           | —                |                           | —      |                           | —                  |                           | —                        |                           | 127                 |                           | 127                       |               |
| *Total—All Projects*               |                           |             |                           |                  |                           |                                                                                    |                           |                                                                                    |                           | 17                    |                           | 17          |                           | 5                       |                           | 7                             |                           | 384                 |                           | 430                       |               |

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(a)              While we sold our 17 Brightwater models toan independent third-party investor on December 31, 2008, the transactionis accounted for as a financing and therefore those homes are included in ourhome inventories.

(b)             To be determined subject to marketconditions.

 

As of September 30, 2009, we had standing inventory of five homesat Brightwater. During the third quarter of 2009, net new orders (excluding thesale of 62 finished lots and four model homes at the Woodhaven project)increased to 17 homes compared with 14 homes during the comparable period in2008 due to increased sales at Brightwater, offset by reduced activity due tofewer active communities at our inland projects. Cancellations as a percentageof new orders were 11.1% during the first nine months of 2009, compared withapproximately 25% during the comparable period in 2008. Backlog as of September 30,2009 decreased to 17 homes compared with 20 homes as of September 30, 2008primarily due to the initial orders in 2008 related to the grand opening at TheBreakers and The Cliffs and fewer active inland communities.

 

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*Brightwater at Bolsa Chica*

 

Brightwater is our coastal Orange County residential community, locatedon 105 acres of the Bolsa Chica mesa in the City of Huntington Beach,approximately 35 miles south of downtown Los Angeles. Brightwater was annexedinto the City of Huntington Beach in 2008. Brightwater offers a broad mix ofhome choices averaging 2,860 square feet and ranging in size from 1,710 squarefeet to 4,339 square feet. Located near Pacific Coast Highway and overlookingthe Pacific Ocean, Huntington Harbor and the recently restored 1,300-acre BolsaChica Wetlands, 63 of the 356 homes at Brightwater will have unobstructed oceanand/or wetlands views.

 

Brightwater is the largest property in our portfolio and, along with anadjacent five-acre parcel in the process of entitlement, representsapproximately 97% of our real estate inventories as of September 30, 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. During January 2008,we completed construction of nine additional model homes for The Cliffs and TheBreakers and in February 2008 began selling homes to buyers who previouslyregistered on our priority list. We held a grand opening for theseneighborhoods in March 2008. These homes are larger than The Trails andThe Sands, ranging from 2,724 to 4,339 square feet. We began delivering homesat The Cliffs and The Breakers during the third quarter of 2008. As of September 30,2009, we have delivered an aggregate of 53 homes (excluding the 17 model homes)at Brightwater, including 22, 14, eight, and nine homes at The Trails, TheSands, The Cliffs, and The Breakers, respectively.

 

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 63 homes atBrightwater which will have unobstructed views of the Pacific Ocean and/or theBolsa Chica wetlands, including 36 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 to five years and be completed in 2014.

 

·                  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 $140 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 7% to 28% due to our low carryingvalue in Brightwater. Gross margins for the larger homes at The Cliffs and TheBreakers are currently expected to approximate 21% to 28%, while gross marginsat The Trails and The Sands are currently expected to approximate 7% to 17%.The decrease in expected margins reflects price reductions required to be competitiveunder current market conditions, additional incentives to sell standinginventory and greater use of third-party real estate brokers.

 

The estimation process involved in the determination of value isinherently uncertain because it requires estimates as to future events andmarket conditions. This estimation process assumes our ability to completedevelopment and disposition of our real estate inventories in the ordinarycourse of business based on management’s present plans and intentions. Economic,market, and environmental conditions may affect our development and marketingplans. 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.

 

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In view of the continuing downturn in the housing market, we currentlyexpect that, during the remaining three months of 2009 and continuing into2010, our only new home construction will be at our 356-home Brightwaterproject in Huntington Beach; and that our operations in other markets willinvolve only the sale or transfer of 54 lots in Lancaster.

 

Deliveries for the three and nine months ended September 30, 2009and 2008 were as follows:

 
| ** **                      | ** ** | ** **        | ** ** | **Deliveries**         | ** ** |
|---------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                      | ** ** | ** **        | ** ** | **Three Months**       | ** ** | **Nine Months** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | **Ended**              | ** ** | **Ended** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                      | ** ** | **Location**      | ** ** | **2009**               | ** ** | **2008** | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                      | ** ** | ** **        | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater                     |       |              |       |                   |       |   |   |   |   |   |   |
| The Trails                      |       | Huntington  Beach |       | 7                      |       | 1 |   | 11 |   | 6 |   |
| The Sands                       |       | Huntington  Beach |       | —                 |       | 1 |   | 4 |   | 5 |   |
| The Cliffs                      |       | Huntington  Beach |       | —                 |       | 4 |   | 2 |   | 4 |   |
| The Breakers                    |       | Huntington  Beach |       | —                 |       | 1 |   | 4 |   | 1 |   |
|                            |       |              |       |                   |       |   |   |   |   |   |   |
| *Total Brightwater*             |       |              |       | 7                      |       | 7 |   | 21 |   | 16 |   |
| * *                        | * *   | * *          | * *   | * *               | * *   | * * | * * | * * | * * | * * | * * |
| Inland Empire/Lancaster         |       |              |       |                   |       |   |   |   |   |   |   |
| Completed Projects              |       | Various           |       | 6                      |       | 7 |   | 7 |   | 17 |   |
| Woodhaven                       |       | Beaumont          |       | 6                      | (a)        | 2 |   | 9 | (a) | 5 |   |
| Quartz Hill                     |       | Lancaster         |       | 1                      |       | 1 |   | 2 |   | 2 |   |
| Future Community                |       | Lancaster         |       | —                 |       | — |   | — |   | — |   |
|                            |       |              |       |                   |       |   |   |   |   |   |   |
| *Total Inland Empire/Lancaster* |       |              |       | 13                     |       | 10 |   | 18 |   | 24 |   |
| * *                        | * *   | * *          | * *   | * *               | * *   | * * | * * | * * | * * | * * | * * |
| *Total Deliveries*              |       |              |       | 20                     |       | 17 |   | 39 |   | 40 |   |

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(a)          Excluding the September 30, 2009 sale of 62 finished lots

 

*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 in February 2008. Wedelivered nine homes at an average price of $1.2 million, or $609 persquare foot during 2007 and 23 homes during 2008, at an average price of$1.4 million, or approximately $564 per square foot. We delivered 21 homesat an average price of $1.3 million (including three Breakers view homesaveraging $3.2 million) during the nine months ended September 30, 2009.As of November 11, 2009, 14 Brightwater homes (including three homes withwetland and ocean views) are in escrow at an average price of $1.3 million, orapproximately $530 per square foot, and 11 additional homes are completed orunder construction and have been released for sale.

 

*The Trails and The Sands*

 

We delivered seven and two homes at The Trails and The Sands during thethree months ended September 30, 2009 and 2008, respectively, and 15 and11 homes during the nine months ended September 30, 2009 and 2008,respectively. We generated $5.9 million and $1.8 million in revenue,respectively, during the three months ended September 30, 2009 and 2008and generated gross operating margins of 6.7% and 25.6%, respectively. Duringthe nine months ended September 30, 2009 and 2008, we generated $13.2million and $11.2 million in revenue, respectively, and generated grossoperating margins of 12.0% and 29.0%, respectively. The decrease in marginsreflects price reductions required to be competitive under current marketconditions, additional incentives to sell standing inventory and greater use ofthird-party real estate brokers. Homes at The Trails and The Sands are presentlybeing offered at prices ranging from $810,000 to $1.0 million. We delivered twoadditional homes at The Trails since September 30, 2009. As of November 11,2009, nine homes are in escrow at The Trails and The Sands.

 

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*The Cliffs and The Breakers*

 

We delivered no homes at The Cliffs and The Breakers during the threemonths ended September 30, 2009, and five during the three months ended September 30,2008 which generated revenue of $7.9 million and gross operating margins of34.9%. We delivered six and five homes during the nine months ended September 30,2009 and 2008, respectively. During the nine months ended September 30,2009 and 2008, we generated $14.5 million and $7.9 million in revenue,respectively, and generated gross operating margins of 31.2% and 34.9%,respectively. Homes at The Cliffs and The Breakers are presently being offeredat prices ranging from $1.4 million to $3.2 million for 2,724 to 4,339square foot homes. As of November 11, 2009, five homes are in escrow atThe Cliffs and The Breakers.

 

*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 secured the then remaining note balance of$2.5 million. During the second and third quarters of 2009, the subsidiarydelivered the remaining seven homes at an average price of $427,000 and fullyrepaid the remaining note balance.

 

*Beaumont.*  We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. We delivered 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 nine homes, including the remaining four model homes (aspart of a bulk sale), during the nine months ended September 30, 2009at an average price of $184,000. During the third quarter of 2009, we alsocompleted the sale of 62 finished lots for $1.8 million.

 

We recorded non-cash impairment charges of $3.2 million for ourWoodhaven project in Beaumont, California during the nine months ended September 30,2009, compared with $3.4 million of impairment charges during the comparableperiod in 2008.  The remainder of theproject (four model homes and 62 finished lots) was sold on September 30,2009 in a transaction which extinguished the related project debt and relatedguaranty for less than 100% of the principal balance.

 

*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 thenine months ended September 30, 2009, we delivered the final twoconstructed homes at an average price of $282,000, including the final modelhome. A subsidiary of Hearthside Homes, Inc. is obligated on a loan withprincipal amount of $2.2 million secured by this project that matured September 30,2008. In June 2009, our subsidiary received a notice of default. Unless weare able to sell the property to a third party, we expect that the propertywill be sold to the lender in satisfaction of the loan upon approval of theBankruptcy Court. The loan is non-recourse to California Coastal Communities, Inc.;however, the subsidiary’s parent, Hearthside Homes, Inc. guaranteedpayment of the debt.

 

**OxnardLand Development - Unconsolidated Joint Venture**

 

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

 

**Critical Accounting Policies and Estimates**

 

In the preparation of our consolidated financial statements, we appliedaccounting principles generally accepted in the United States of America. Theapplication of generally accepted accounting principles may require managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying results. Listed below are those policiesand estimates that we believe are critical and require the use of complexjudgment in their application. In particular, our critical accounting policiesand estimates include the evaluation of the impairment of long-lived assets andthe evaluation of the probability of being able to realize the future benefitsindicated by our significant federal tax net operating losses, as discussedfurther in Notes 3, 4 and 10 to “Item 1. Financial Statements” above.

 

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*Basis of Consolidation*

 

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 3 to “Item 1. Financial Statements” above. All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

*Impairment of Long-Lived Assets*

 

We recorded inland project impairment charges totaling zero and $3.2million during the three and nine months ended September 30, 2009,respectively, and impairment charges of $29.1 million and $34.1 million duringthe three and nine months ended September 30, 2008, respectively. Theimpairment charges recorded during the first and second quarters of 2009 relateto the Woodhaven project in Beaumont. The remainder of the project (four modelhomes and 62 finished lots) was sold on September 30, 2009 in atransaction which extinguished the related project debt for less than 100% ofthe principal balance and the release of the related guaranty.

 

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 ASC 360-10-35, 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 ASC 360-10-35 which requires thatlong-lived assets be reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.Impairment is evaluated by comparing an asset’s carrying value to theundiscounted estimated cash flows expected from the asset’s operations andeventual disposition. If the sum of the undiscounted estimated future cashflows is less than the carrying value of the asset, an impairment loss isrecognized based on the fair value of the asset. If impairment occurs, the fairvalue of an asset is deemed to be the amount a willing buyer would pay awilling 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 ASC 360-10-35.

 

In accordance with ASC 360-10-35, in developing estimated future cashflows for impairment testing for our real estate inventories, we incorporatedour own market assumptions including those regarding home prices, sales pace,sales and marketing costs, infrastructure and home-building costs, andfinancing costs regarding real estate inventories. Our assumptions are based,in part, on general economic conditions, the current state of the homebuildingindustry, expectations about the short- and long-term outlook for the housingmarket, and competition from other homebuilders in the areas in which we buildand sell homes. These assumptions can significantly affect our estimates offuture cash flows. For those communities deemed to be impaired, we determinefair value based on discounted estimated future cash flows using estimatedabsorption rates for each community.

 

We evaluated our Brightwater project for impairment as of December 31,2008, and determined that no impairment was indicated based on our projectionof the project’s future cash flows, including projected revenues, costs andgross margin.  We based our assumptionson our evaluation of projected prices while reflecting current marketingefforts, review of competitive home sales, characteristics of the HuntingtonBeach housing market, and current construction costs.  Our relatively lower book basis inBrightwater of $242.0 million as of September 30, 2009, is due in part toa fair 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.

 

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 

 

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reflectedthese price reductions in our projections which reduced projected gross marginsfor the project from approximately 30%-40% in 2007 to 25%-35% as of December 2008and 7%-28% as of September 2009. The decrease in expected margins also reflects greater use ofthird-party real estate brokers.

 

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

 

In our analysis, we noted that the Brightwater project in HuntingtonBeach is in a mature housing market with very limited new home construction anda low supply of comparable resale homes with views or competitivefeatures.  Further, Huntington Beach hasrecently ranked in the top 25% of housing performance in Orange County based onpricing, sales and foreclosures.  In 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 an increase in median home prices in 2010 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 theremainder of 2009 at levels relatively consistent with recent months and withreasonable expectations of price increases in future years given the limitedsupply of new homes along the coast of Southern California.

 

In our impairment analysis of the Brightwater project, we also considerprojected construction and related costs and the availability of mortgagefinancing for our potential homebuyers. Recent subcontracting efforts have resulted in price reductions fordirect costs of approximately 2% overall in the past year, a trend which isexpected to have a positive effect on margins during 2009 and possiblybeyond.  However, any savings experiencedin the near future would likely be diminished in future years if home pricesincrease.  While mortgage financing forour homes is still challenging, 30-year jumbo mortgage rates have decreasedfrom a national average high of 8.4% in October 2008 to approximately 6.0%currently.  With the conforming loanmaximum in Orange County continuing at $729,750, a significant portion of ourpotential homebuyers are able to finance a substantial portion of their home purchaseat historically low mortgage rates approximating 5.0%.

 

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 withASC 740-10, “*Income Taxes*.”Deferred income taxes are determined based on the difference between thefinancial statement and tax bases of assets and liabilities, using enacted taxrates in effect in the years in which these differences are expected toreverse. The liability method requires an evaluation of the probability ofbeing able to realize the future benefits indicated by deferred tax assets. Avaluation allowance is established against a deferred tax asset if, based onthe available evidence, it is “more likely than not” that such asset will notbe realized. 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 

 

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evidencerelated to the realization of the deferred tax assets. This assessmentconsiders, among other matters, the nature, frequency and magnitude of currentand cumulative income and losses, forecasts of future profitability, theduration of statutory carryback or carryforward periods, our experience withoperating loss and tax credit carryforwards not expiring unused, and tax planningalternatives.

 

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 partially offset by profits from home deliveries atour Brightwater project on the coast of 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 and nine months ended September 30, 2009, werecorded $4.1 million and $24.8 million, respectively, of pre-tax income fromcancellation of indebtedness related to our Corona and Beaumont projects.

 

While we expect to report profitable operations before income taxes for2009, we expect to report a taxable loss due to tax losses recognized uponinland property dispositions. These tax losses were previously recognized forfinancial statement purposes when impairment losses were recorded. The currentyear expected taxable loss includes the tax losses generated by the Coronaproperty deed-in-lieu transaction, the sale of the remaining four model homesand 62 lots at the Beaumont project, and the sale of the final seven homes atthe Corona project (which included approximately 83% of our cumulativepreviously unrecognized taxable losses on inland projects), as well as the lossexpected to be generated from the disposition or foreclosure of 54 inland lotsin the city of Lancaster.  In June 2009,a subsidiary of Hearthside Homes received a notice of default relating to theloan facility for development of the Las Colinas project in Lancaster. Weexpect that the lender will foreclose on the property secured by the loan inthe fourth quarter of 2009 unless we are able to sell the project to satisfythe loan. Therefore, we expect that the remaining expected taxable loss on ourinland projects will be included in our full year 2009 results.  The disposition of the inland assets during2009 is both an operational and tax strategy which we have completed except fordisposition of the 54 Lancaster lots. Therefore, we have reserved the approximately $3.8 million value of allof our NOL expiring in 2009.

 

Beginning in 2010, we do not expect recognized tax losses resultingfrom deliveries of inland lots or homes, leaving primarily Brightwater homedeliveries to generate our operating and taxable results. Therefore, in order toevaluate the recoverability of NOLs and other deferred tax assets in 2010 and2011 during the first two quarters of 2009, we projected our taxable incomereflecting actual and estimated 2009 levels of Brightwater home sales. Inaddition, we evaluated expected prices based on our current marketing, expectedproduct mix and gross margins, review of competitive home sales, marketconditions and other objectively verifiable economic factors affecting ouroperations, as well as other positive and negative factors. During the secondquarter of 2009 we reserved approximately $7.6 million for NOLs expiring in2010 and 2011.

 

On October 27, 2009, we filed Chapter 11 Petitions in theBankruptcy Court. Due to uncertainties regarding the resolution of our Chapter11 Cases and our ability to utilize our NOLs in the future, during the thirdquarter of 2009 we recorded a valuation allowance for the remaining amount ofour net deferred tax assets of approximately $20.6 million.

 

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.

 

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 (4.48% as of October 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 

 

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transactionsby stockholders who hold a 5% or greater interest in the company, we haveexperienced a three-year cumulative ownership shift of approximately 16% as of November 2,2009, as computed in accordance with Section 382. In the event of anownership change, our use of our NOLs may be limited.

 

*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 “Item 1. Financial Statements” above. We have reserved for costs expected tobe incurred with respect to these cases based upon information provided by ourlegal counsel. There can be no assurance that total litigation costs actuallyincurred will not exceed the amount of such reserve.

 

**Recent Accounting Pronouncements**

 

See discussion regarding Recent AccountingPronouncements in Note 3 to “Item 1. Financial Statements” above.

 

As a result of the Chapter 11 filing, we are nowrequired to periodically file various documents with, and provide certaininformation to the Bankruptcy Court, including statements of financial affairs,schedules of assets and liabilities, and monthly operating reports in formsprescribed by Chapter 11, as well as certain financial information on anunconsolidated basis. Such materials will be prepared according to requirementsof Chapter 11. While we believe that these documents and reports providethen-current information required under Chapter 11, they are prepared only forthe Debtors and, hence, certain operational entities are excluded. In addition,they are prepared in a format different from that used in our consolidatedfinancial statements filed under the securities laws and they are unaudited.Accordingly, we believe that the substance and format do not allow meaningfulcomparison with our regular publicly-disclosed consolidated financialstatements. Moreover, the materials filed with the Bankruptcy Court are notprepared for the purpose of providing a basis for an investment decisionrelating to our securities, or for comparison with other financial informationfiled with the SEC.

 

**Resultsof Operations**

 

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

 

**Backlog as of September 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2009**                       | ** ** | **2008**                                 | ** ** | **Change**                                                      | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 17                             |       | 20                                       |       | (15.0                                                           | )%         | $ | 21.4 |   | $ | 31.0 |   | (31.0 | )% | $ | 1,261 |   | $ | 1,549 |   | (18.6 | )% |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2009**                 | ** ** | **2008**                                 | ** ** | **Change**                                                      | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 20                       |       | 17                                       |       | 17.6                                                            | %          | $ | 9.6 |   | $ | 13.9 |   | (30.9 | )% | $ | 480 |   | $ | 818 |   | (41.3 | )% |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2009**                 | ** ** | **2008**                                 | ** ** | **Change**                                                      | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Change** | ** ** |
| 39                       |       | 40                                       |       | (2.5                                                            | )%         | $ | 32.9 |   | $ | 29.3 |   | 12.3 | % | $ | 844 |   | $ | 733 |   | 15.1 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*Three Months Ended September 30, 2009 Comparedwith the Three Months Ended September 30, 2008*

 

We reported revenues of $11.4 million and gross operating profitof $1.6 million for the third quarter of 2009, compared with $13.9 millionin revenues and gross operating loss of $25.8 million for the thirdquarter of 2008. Homebuilding revenues in the current period reflect deliveriesof 20 homes, including seven deliveries at Brightwater which generated revenuesof $5.8 million and gross operating profit of $400,000, and 13 homes atour inland projects which generated revenues of $3.8 million and grossoperating profit of approximately $200,000. Land sale revenues of $1.8 millionin the current period reflect the sale of 62 finished lots at our Woodhavenproject in Beaumont in connection with a short sale transaction we completed onSeptember 30, 2009. The comparable period of the prior year reflectsdeliveries of 17 homes, including seven homes at Brightwater and 10 inlandhomes, which generated gross profit of $3.3 million and was offset by non-cashimpairment charges of $29.1 million. Although we recorded no impairment chargesduring the third quarter of 2009, should market conditions further deterioratein the future or other events occur that indicate the carrying amount of ourreal estate inventories may not be recoverable, we will reevaluate our expectedcash flows from each project to determine whether any additional impairmentexists at any point in time.

 

Homebuilding gross operating profit before impairment charges decreasedfrom $3.3 million for the third quarter of 2008 to $1.6 million for the thirdquarter of 2009 primarily due to the absence of Cliffs and Breakers deliveriesand reduced margins. Seven Brightwater deliveries during the quarter generated a7% gross margin and gross operating profit of $400,000 while the delivery of 13homes at our inland projects generated a 3.6% gross margin and gross operatingprofit of $200,000. Gross operating profit for the three months ended September 30,2009 also includes gross operating profit of $1.0 million related to thesettlement of accrued seller profit participation related to two completedprojects as a result of a settlement with the land seller which is furtherdescribed below. Excluding impairment charges, homebuilding gross margin forthe third quarter of 2009 decreased to 16.7% compared with 23.7% in thecomparable period of 2008 due to increased incentives and third-party brokers’commissions that were necessary to move standing inventory at our communities.

 

Gain on debt restructuring and extinguishment of $4.1 million reflectsa pre-tax gain related to the short sale transaction at our Woodhaven projectin Beaumont. The lender for the note secured by the property accepted theproceeds of the sale in full settlement of the remaining balance on the noteand release of the related guaranty.

 

Selling, general and administrative expense for the third quarter of2009 decreased $400,000 compared with the third quarter of 2008 due to a$200,000 reduction in selling expenses primarily associated with communitieswhich were active during the first nine months of 2008 but had reduced or noactivity in the current year, as well as a $200,000 reduction in marketingcosts associated with our Brightwater project.

 

Other expense increased $800,000 in the third quarter of 2009 comparedwith the third quarter of 2008 primarily due to the assignment of a $700,000receivable to the land seller who sold lots to our subsidiary, in settlement ofan obligation for accrued seller profit participation aggregating $1.0 million.

 

Income before income taxes was $3.5 million for the three months ended September 30,2009 compared with a pre-tax loss of $28.1 million in the comparable quarter of2008, which reflected a $29.1 million impairment charge.

 

Income tax expense of $21.6 million for the three months ended September 30,2009 reflects a $20.6 million non-cash valuation allowance on deferred taxassets and a 40% tax rate.

 

*Nine Months Ended September 30, 2009 Comparedwith the Nine Months Ended September 30, 2008*

 

We reported revenues of $34.7 million and gross operating profit of$4.3 million for the nine months ended September 30, 2009, compared with$29.3 million in revenues and gross operating loss of $27.5 millionfor the comparable period of 2008. Revenues of $34.7 for the 2009 periodinclude $32.9 million generated from homebuilding activities, and land salerevenues of $1.8 million generated from the sale of 62 finished lots at ourWoodhaven project in Beaumont in 

 

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connectionwith a short sale transaction we completed on September 30, 2009.Homebuilding revenues in the current period reflect deliveries of 39 homes,including 21 deliveries at Brightwater which generated revenues of$27.7 million and gross operating profit of $6.0 million, and 18 homes atour inland projects which generated revenues of $5.2 million and gross operatingprofit of approximately $500,000. The comparable period of the prior yearreflects deliveries of 40 homes, including 16 homes at Brightwater and 24inland homes. Gross operating profit for the nine months ended September 30,2009 and 2008 includes non-cash impairment charges of $3.2 million and $34.1million, respectively. Impairment charges for the nine months ended September 30,2009 reflect fair value write-downs during the first quarter of 2009 for aninland project in Beaumont.  Theremainder of the Beaumont project (four model homes and 62 finished lots) wassold on September 30, 2009 in a transaction which extinguished the relatedproject debt for less than 100% of the principal balance and the release of therelated guaranty.  Should marketconditions further deteriorate in the future or other events occur thatindicate the carrying amount of our real estate inventories may not berecoverable, we will reevaluate our expected cash flows from each project todetermine whether any additional impairment exists at any point in time.

 

Homebuilding gross operating profit before impairment charges increased$900,000 from $6.6 million for the nine months ended September 30, 2008 to$7.5 million for the 2009 period. We delivered 21 Brightwater homes during thefirst nine months of 2009 which generated a 21.7% gross margin and grossoperating profit of $6.0 million along with the delivery of 18 inland homeswhich generated a 9.0% gross margin and gross operating profit of $500,000.Gross operating profit for the nine months ended September 30, 2009 alsoincludes gross operating profit of $1.0 million related to the settlement ofaccrued seller profit participation related to two completed projects for whichthe land seller accepted the assignment from our subsidiary of a $700,000receivable related to infrastructure work. Excluding impairment charges,homebuilding gross margin for the first nine months of 2009 was 22.7% comparedwith 22.5% in the comparable period of 2008.

 

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 and a $4.1 million pre-tax gain related to the shortsale transaction at our Woodhaven project in Beaumont that we completed on September 30,2009, pursuant to which the lender for the note secured by the propertyaccepted the proceeds of the sale in full settlement of the remaining balanceon the note and the release of the related guaranty. The Corona deed-in-lieutransaction resulted in a $28.7 million reduction in the note balance andrelated obligations secured by our Hearthside Lane project. In exchange, weconveyed the remaining 134 finished lots to the investor that purchased thenote from IndyMac Federal Bank.

 

Selling, general and administrative expenses decreased $1.4 million forthe first nine months of 2009 compared with the first nine months of 2008primarily reflecting a $1.0 million reduction in selling expenses associatedwith communities which were active during the first nine months of 2008 but hadreduced or no activity in the current year and a $300,000 decrease in sellingand marketing expenses for our Brightwater community, as well as reducedgeneral and administrative expenses resulting from headcount reductions.

 

The $200,000 increase in interest expense compared with the comparableperiod of 2008 primarily reflects interest incurred on projects which are nolonger under construction and, therefore, must be recorded as a period costrather than capitalized.

 

The $300,000 increase in other expense compared with 2008 reflects theassignment of a $700,000 receivable to the land seller who sold lots to oursubsidiary, in settlement of an obligation for accrued seller profitparticipation aggregating $1.0 million, and a $200,000 increase in pensionexpense due to lower investment returns. Other expense also reflects a $100,000increase in property tax expense during the nine months ended September 30,2009 compared with the comparable period of 2008 for projects which are no longerunder construction and, therefore, must be recorded as a period cost ratherthan capitalized.  These increases wereoffset by the absence in 2009 of $800,000 of other expense incurred during thenine months ended September 30, 2008 related to an interest rate swapagreement.

 

Income before income taxes was $22.9 million for the first nine monthsof 2009 compared with a pre-tax loss of $34.4 million in the first nine monthsof 2008, which reflected a $34.1 million impairment charge.

 

The effective income tax rate for the nine months ended September 30,2009 is 74%, which reflects a $28.2 million non-cash valuation allowance ondeferred tax assets and a tax rate of 41%.

 

*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 other accruedpensions, home warranty reserves and contingent indemnity 

 

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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 10 to “Item 1. FinancialStatements” above.

 

**Off BalanceSheet 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 September 30, 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.

 

Under the requirements of ASC 810-10, “*Consolidations,*”certain of our land option contracts may create a variable interest for us,with the land seller being identified as a variable interest entity (“VIE”). Weanalyze our land option contracts and other contractual arrangements andconsider whether we should consolidate the fair value of certain VIEs fromwhich we are purchasing land under option contracts. As of September 30,2009, 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,including but not limited to uncertainty by potential homebuyers in thestability of the United States and global economy, inflation or deflation,interest rate changes, competition and the supply of new and existing homes tobe purchased. Uncertainty in the stability of the national economy andsignificant volatility in the banking system and financial markets can, andhas, caused potential homebuyers to refrain from committing to make significantpurchases, including the purchase of new homes. In the event the volatility inthe banking system and financial markets continues to remain high and thenational economy does not stabilize in the near term, our ability to sell newhomes to potential homebuyers can be impacted negatively.

 

The long-term impact of inflation may 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.

 

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**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 September 30, 2009, each onepoint percentage increase in interest rates would result in an increase in variablerate interest incurred for the next 12 months of approximately$1.8 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.”

 

**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-effective controlsystem and no evaluation of controls can provide absolute assurance that allcontrol 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 September 30, 2009 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.   Legal Proceedings.**

 

See Notes 9 and 11 to “Item 1. Financial Statements”above, and “Item 1 - Business - Corporate Indemnification Matters” and “Item 3- Legal Proceedings” in our Annual Report on Form 10-K for the year ended December 31,2008.

 

On October 27, 2009, we and the other Debtorsfiled the Chapter 11 Cases. For a further discussion of these matters, see Note2 to “Item 1. Financial Statements” and “Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, which are incorporated hereinby reference. At this time, it is not possible to predict the outcome of theChapter 11 Cases or their effect on our business.

 

In general, all pending litigation involving us andthe other Debtors and was stayed upon the commencement of the Chapter 11 Cases.

 

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**Item 1A.   Risk Factors.**

 

In addition to other information set forth in thisreport, you should carefully consider the factors discussed in Part I,Item 1A. Risk Factors in our Annual Report on Form 10-K for the year endedDecember 31, 2008 which could materially impact our business, financialcondition or future results. Risks disclosed in our Annual Report on Form 10-Kare not the only risks facing us. Additional risks and uncertainties notcurrently known to us or that we currently deem immaterial may materiallyadversely impact our business, financial condition or operating results.

 

The information presented below updates, and should beread in conjunction with, the risk factors disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2008.

 

*RisksRelated to our Bankruptcy Filings.*

 

We and the other Debtors filed for protection underChapter 11 of the Bankruptcy Code on October 27, 2009. During the Chapter11 Cases, our operations, including our ability to execute our business plan,are subject to the risks and uncertainties associated with our bankruptcy.Risks and uncertainties associated with these proceedings include thefollowing:

 

·                  Actionsand decisions of our creditors and other third parties with interests in theproceedings, which may be inconsistent with our plans;

 

·                  Ourability to obtain court approval with respect to motions in the proceedingsmade from time to time;

 

·                  Ourability to develop, prosecute, confirm, and consummate a plan of reorganizationwith respect to the proceedings;

 

·                  Ourability to obtain and maintain commercially reasonable terms with vendors andservice providers;

 

·                  Ourability to maintain contracts that are critical to our operations;

 

·                  Ourability to retain management and other key individuals; and

 

·                  Risksassociated with third parties’ seeking and obtaining court approval toterminate or shorten the exclusivity period for us to propose and confirm aplan of reorganization, to appoint a trustee under Chapter 11, or to convertthe Chapter 11 Cases into liquidations under Chapter 7 of the Bankruptcy Code.

 

These risks and uncertainties could affect ourbusiness and operations in various ways. For example, negative events orpublicity associated with the proceedings could adversely affect our home salesand relationships with our customers, as well as with vendors and employees,which in turn could adversely affect our operations and financial condition,particularly if the proceedings are protracted. Also, transactions outside theordinary course of business are subject to the prior approval of the BankruptcyCourt, which may limit our ability to respond timely to certain events or takeadvantage of certain opportunities. In addition, in order to successfullyemerge from the proceedings, senior management will be required to spendsignificant amounts of time developing a comprehensive plan of reorganization,instead of concentrating exclusively on business operations. These proceedingsand the development of a plan of reorganization may result in the sale ordivestiture of assets, but there can be no assurance that we will be able tocomplete any sale or divestiture on acceptable terms or at all.

 

Because of the risks and uncertainties associated withthe proceedings, the ultimate impact that events that occur during theseproceedings will have on our business, financial condition and results ofoperations cannot be accurately predicted or quantified. There can be noassurance as to what values, if any, will be ascribed in the proceedings to ourvarious pre-petition assets, liabilities, common stock, and other securities.

 

*Ourliquidity position imposes significant challenges to our ability to continueoperations.*

 

As global economic conditions have deteriorated, wehave experienced significant pressure on our business, including our liquidityposition. The Chapter 11 Cases may increase this pressure. Because of thepublic disclosure of our liquidity constraints, our ability to maintain normalcredit terms with suppliers has become impaired. The terms of the trade creditreceived from suppliers has been reduced. If liquidity problems persist,suppliers could refuse to provide key products and services in the future. Ourfinancial condition and results of operations, in particular with regard to ourpotential failure to meet debt obligations, may lead some customers to becomereluctant to enter into home purchase agreements with us. In addition to thecash requirements necessary to fund continuing operations, it is anticipatedthat we will incur significant professional fees and other restructuring costsin connection with the Chapter 11 Cases.

 

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*During the pendency of the Chapter 11 Cases, our financial results maybe unstable and may not reflect historical trends.*

 

During the pendency of the Chapter 11 Cases, ourfinancial results may fluctuate as they reflect asset impairments, assetdispositions, restructuring activities, contract terminations and rejections,and claims assessments. As a result, our historical financial performance maynot be indicative of the financial performance following the commencement ofthe Chapter 11 Cases. Further, we may sell or otherwise dispose of assets orbusinesses and liquidate or settle liabilities, with court approval, foramounts other than those reflected in the Company’s historical financialstatements. Any such sale or disposition and any comprehensive restructuringplan could materially change the amounts and classifications reported in ourhistorical consolidated financial statements, which do not give effect to anyadjustments to the carrying value of assets or amounts of liabilities thatmight be necessary as a consequence of a comprehensive restructuring plan.

 

*We maynot be able to obtain confirmation of a Chapter 11 plan of reorganizationsubmitted for Bankruptcy Court approval.*

 

In order to successfully emerge from Chapter 11 as aviable entity, we believe that we must develop, and obtain requisite court andcreditor approval of a feasible Chapter 11 plan of reorganization. This processrequires us and the other Debtors to meet certain statutory requirements withrespect to adequacy of disclosure with respect to the plan of reorganization,soliciting and obtaining creditor acceptances of the plan, and fulfilling otherstatutory conditions for confirmation. We and the other Debtors may not receivethe requisite acceptances to confirm the plan. Even if the requisiteacceptances of the plan of reorganization are received, the Bankruptcy Courtmay not confirm the plan. A dissenting holder of a claim against the Debtorsmay challenge the balloting procedures and results as not being in compliancewith the Bankruptcy Code. Even if the Bankruptcy Court determined that theballoting procedures and results were appropriate, the Bankruptcy Court couldstill decline to confirm the plan of reorganization if it found that any of thestatutory requirements for confirmation had not been met, including that theterms of the plan are fair and equitable to non-accepting classes. Section 1129of the Bankruptcy Code sets forth the requirements for confirmation andrequires, among other things, a finding by the Bankruptcy Court that (i) theplan of reorganization “does not unfairly discriminate” and is “fair andequitable” with respect to any non-accepting classes, (ii) confirmation ofthe plan is not likely to be followed by a liquidation or a need for furtherfinancial reorganization and (iii) the value of distributions tonon-accepting holders of claims within a particular class under the plan willnot be less than the value of distributions such holders would receive if theDebtors were to be liquidated under Chapter 7 of the Bankruptcy Code.

 

The Bankruptcy Court may determine that the plan ofreorganization does not satisfy one or more of these requirements, in whichcase it would not be confirmable by the Bankruptcy Court. If the plan ofreorganization is not confirmed by the Bankruptcy Court, it is unclear whetherwe would be able to reorganize our businesses and what, if any, distributionsholders of claims against us would ultimately receive with respect to theirclaims. If an alternative reorganization could not be agreed upon, it ispossible that we would have to liquidate our assets, in which case it is likelythat holders of claims would receive substantially less favorable treatmentthan they would receive if we were to emerge as a viable, reorganized entity.

 

*A longperiod of operating under Chapter 11 may harm our business.*

 

A long period of operating under Chapter 11 couldadversely affect our business and operations. So long as the Chapter 11 Casescontinue, our senior management will be required to spend a significant amountof time and effort dealing with the Bankruptcy reorganization instead offocusing exclusively on business operations. A prolonged period of operatingunder Chapter 11 will also make it more difficult to attract and retainmanagement and other key personnel necessary to the success and growth of ourbusiness. In addition, the longer the Chapter 11 Cases continue, the morelikely it is that our customers and suppliers will lose confidence in ourability to successfully reorganize and seek to establish alternative commercialrelationships. Furthermore, so long as the Chapter 11 Cases continue, we willbe required to incur substantial costs for professional fees and other expensesassociated with the proceedings. A prolonged continuation of the Chapter 11Cases may also require us to seek additional financing. If we requireadditional financing during the Chapter 11 Cases and we are unable to obtainthe financing on favorable terms or at all, our chances of successfullyreorganizing our businesses may be seriously jeopardized.

 

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*The BankruptcyCourt may impose significant operating and financial restrictions on us,compliance or non-compliance with which could have a material adverse effect onour liquidity and operations.*

 

Restrictions imposed by the Bankruptcy Court couldadversely affect us by limiting our ability to plan for or react to marketconditions or to meet our capital needs. These restrictions might limit ourability, subject to certain exceptions, to, among other things:

 

·                  incuradditional indebtedness and issue stock;

 

·                  makeprepayments on or purchase indebtedness in whole or in part;

 

·                  paydividends and other distributions with respect to our capital stock orrepurchase our capital stock or make other restricted payments;

 

·                  makeinvestments;

 

·                  enterinto transactions with affiliates on other than arm’s-length terms;

 

·                  createor incur liens to secure debt;

 

·                  consolidateor merge with another entity, or allow one of our subsidiaries to do so;

 

·                  lease,transfer or sell assets and use proceeds of permitted asset leases, transfersor sales;

 

·                  incurdividend or other payment restrictions affecting subsidiaries;

 

·                  makecapital expenditures beyond specified limits;

 

·                  engagein specified business activities; and

 

·                  acquirefacilities or other businesses.

 

*NasdaqDelisting.*

 

On October 28,2009, we received a letter from Nasdaq notifying us that it had determined todelist our common stock from trading as a result of our commencement of theChapter 11 Cases.  We are in the processof appealing the Nasdaq determination; however, there can be no assurance thatour appeal will be successful.  Duringthe pendency of the appeal, our common stock will continue to be listed.  If we are not successful on appeal and ourcommon stock is delisted, negative implications may be associated with thedelisting, including potential loss in confidence in us by suppliers, customersand employees and the loss of institutional investor interest in our commonstock.

 

**Item6.   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:  November 16, 2009 | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|-------------------------------|---------------------------------------|
|                          |                                  |   |
|                          |                                  |   |
|                          | By:                                   | */s/  Sandra G. Sciutto* |
|                          |                                  | SANDRA  G. SCIUTTO |
|                          |                                  | Senior  Vice President and |
|                          |                                  | Chief  Financial Officer |

 

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