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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 June 30,  2008**                                                                                                                            |
| ** **                                                                                                                                                                        | ** ** | ** **                                                                                                   |
| **OR**                                                                                                                                                                            |
| ** **                                                                                                                                                                        | ** ** | ** **                                                                                                   |
| **o**                                                                                                                                                                             | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                        | ** ** | ** **                                                                                                   |
| **For the transition period  from                         to** |

 

**Commissionfile number: 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

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

 

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

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

 

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

**None**

 

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

 

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

 

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

 

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

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

 

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

 

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

 

As of August 4, 2008 there were 10,871,780 shares of Common Stock,par value $.05 outstanding.

 

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED JUNE 30, 2008

 

INDEX

 
| Cautionary  Statement About Forward-Looking Statements | 3                      |
|--------------------------------------------------------|------------------------|
|                                                   |                   |   |   |
| Part I -                                          | Financial Information: |   | 5 |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Consolidated Financial Statements | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Balance Sheets — June 30, 2008  (unaudited) and December 31, 2007 | 5 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of Operations — Three and Six  Months Ended June 30, 2008 and 2007 (unaudited) | 6 |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of Cash Flows -Six Months  Ended June 30, 2008 and 2007 (unaudited) | 7 |
|                                                   |                   |   |   |
|                                                   |                   | Notes to Consolidated Financial Statements | 8 |
|                                                   |                   |   |   |
|                                                   | Item 2 -               | Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 20 |
|                                                   |                   |   |   |
|                                                   | Item 3 -               | Quantitative and Qualitative Disclosures About Market  Risk | 34 |
|                                                   |                   |   |   |
|                                                   | Item 4 -               | Evaluation of Disclosure Controls and Procedures | 34 |
|                                                   |                   |   |   |
| Part II  -                                        | Other  Information:    |   | 35 |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Legal Proceedings | 35 |
|                                                   |                   |   |   |
|                                                   | Item  1A -             | Risk  Factors That May Affect Results of Operations and Financial Condition | 35 |
|                                                   |                   |   |   |
|                                                   | Item 2 -               | Not Applicable |   |
|                                                   |                   |   |   |
|                                                   | Item 3 -               | Defaults  Upon Senior Securities | 38 |
|                                                   |                   |   |   |
|                                                   | Item 4 -               | Submission of Matters to a Vote of Security Holders | 38 |
|                                                   |                   |   |   |
|                                                   | Item 5 -               | Not Applicable |   |
|                                                   |                   |   |   |
|                                                   | Item 6 -               | Exhibits | 38 |
|                                                   |                   |   |   |
| SIGNATURE                                              |                   | 39 |
|                                                        |                        |  |  |  |  |

 

 

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CAUTIONARY STATEMENT ABOUT FORWARD-LOOKINGSTATEMENTS

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 27A of the Securities Exchange Act of 1933 and Section 21Eof the Securities Exchange Act of 1934 that relate to future events or ourfuture financial performance. In addition, other statements we may make fromtime to time, such as press releases, oral statements made by our officials andother reports that we file with the Securities and Exchange Commission may alsocontain such forward-looking statements. Undue reliance should not be placed onthese statements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. In some cases, you canidentify forward-looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,”“continue,” or the negative of such terms or other comparable terminology.

 

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

 

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

 

·                  our ability to get unanimous approval fromthe 11-member bank syndicates with respect to modifications to our $95.7million senior secured revolving loan and our $118.5 million senior securedterm loan;

 

·                  information relating to anticipated operatingresults, financial resources, changes in revenues, changes in profitability,interest expense, growth and expansion, anticipated income to be realized fromour investments in unconsolidated entities;

 

·                  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;

 

·                  the 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 (including, but not limited to ongoing administrative proceedingsrelated to our joint venture near Oxnard, California);

 

·                  the ability to secure materials andsubcontractors;

 

·                  the ability to produce the liquidity andcapital necessary to expand and take advantage of opportunities in the future;

 

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

 

·                  our ability to continue relationships withcurrent or future partners;

 

·                  the effectiveness and adequacy of ourdisclosure and internal controls;

 

·                  the impact of recent accountingpronouncements; and

 

·                  stock market valuations.

 

Any or all of the forward-looking statements included in this reportand in any other reports or public statements made by us may turn out to beinaccurate. This can occur as a result of incorrect assumptions or as aconsequence of known or unknown risks and uncertainties. These risks anduncertainties include the competitive environment in which we operate; local,regional and national economic conditions; the effects of inflation or a recession;the demand for homes; fluctuations in interest rates and the availability ofmortgage financing; changes in home prices; the availability and cost of landfor future growth; the availability of capital; uncertainties and fluctuationsin capital and securities markets; changes in tax laws and theirinterpretation; legal proceedings; the ability of customers to finance thepurchase of homes or sell existing homes; the availability and cost of laborand materials; the amount of our debt and the impact of restrictive covenantsin our loan agreements; adverse weather conditions; domestic and internationalpolitical events; uncertainties created by terrorist attacks; the effects ofgovernmental regulation, including regulations concerning development of land,the home building industry, sales and customer financing processes, and theenvironment; and other risks discussed in our filings with the Securities andExchange Commission. Many factors mentioned in this report or in other reportsor public statements made by us, such as 

 

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governmentregulation and the competitive environment, will be important in determining ourfuture performance. Consequently, actual results may differ materially fromthose that might be anticipated from our forward-looking statements. You shouldnot place undue reliance on any of these forward-looking statements becausethey are based on current expectations or beliefs regarding future events orcircumstances, which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by these forward-looking statements.

 

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

 

Theseforward-looking statements should be considered in light of the informationincluded in this report and our other filings with the Securities and ExchangeCommission, including, without limitation, the “Risk Factors” set forth below,as well as the description of trends and other factors in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” setforth in our Form 10-K for the year ended December 31, 2007. Youshould also read the following “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in conjunction with theunaudited consolidated financial statements and the related notes that appearelsewhere in this report.

 

Weassume no, and hereby disclaim any, obligation to update any of the foregoingor any other forward-looking statements. We nonetheless reserve the right tomake such updates from time to time by press release, periodic report or othermethod of public 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**

 

**ITEM 1 —FINANCIAL STATEMENTS**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                  | ** ** | **June 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                   |       | $                       | 10.4       |                        | $          | 24.3 |   |
| Restricted cash                                                                                                                             |       | 5.9                     |       | 6.0                         |       |
| Real estate inventories                                                                                                                     |       | 291.5                   |       | 286.4                       |       |
| Deferred tax assets                                                                                                                         |       | 46.9                    |       | 44.4                        |       |
| Other assets, net                                                                                                                           |       | 6.8                     |       | 6.5                         |       |
|                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                        |       | $                       | 361.5      |                        | $          | 367.6 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               | ** ** | ** **              | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                |       |                    |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                    |       | $                       | 6.1        |                        | $          | 12.5 |   |
| Senior secured project revolver                                                                                                             |       | 88.0                    |       | 76.0                        |       |
| Senior secured term loan                                                                                                                    |       | 118.5                   |       | 121.8                       |       |
| Other project debt                                                                                                                          |       | 43.5                    |       | 48.8                        |       |
| Other liabilities                                                                                                                           |       | 7.6                     |       | 7.0                         |       |
|                                                                                                                                        |       |                    |       |                        |       |
| Total liabilities                                                                                                                           |       | 263.7                   |       | 266.1                       |       |
|                                                                                                                                        |       |                    |       |                        |       |
| Commitments and contingencies                                                                                                               |       |                    |       |                        |       |
|                                                                                                                                        |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                  |       |                    |       |                        |       |
| Common Stock—$.05 par value; 13,500,000 shares authorized; 10,871,780  and 10,852,708 shares issued and outstanding, respectively |       | .5                      |       | .5                          |       |
| Excess Stock—$.05 par value; 13,500,000 shares authorized; no shares  outstanding                                                      |       | —                  |       | —                      |       |
| Additional paid-in capital                                                                                                                  |       | 59.4                    |       | 59.3                        |       |
| Retained earnings                                                                                                                           |       | 39.3                    |       | 43.1                        |       |
| Accumulated other comprehensive loss                                                                                                        |       | (1.4                    | )          | (1.4                        | )          |
| Total stockholders’ equity                                                                                                             |       | 97.8                    |       | 101.5                       |       |
|                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                        |       | $                       | 361.5      |                        | $          | 367.6 |   |

 

See the accompanying notes to consolidated financial statements.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                    | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | $                                               | 10.4       |                                          | $          | 4.2 |   | $ | 15.4 |   | $ | 16.4 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Costs of sales:                               |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | 8.2                                             |       | 3.9                                           |       | 12.1 |   | 15.3 |   |
| Loss on impairment of real estate inventories |       | 5.0                                             |       | —                                        |       | 5.0 |   | 4.0 |   |
|                                          |       | 13.2                                            |       | 3.9                                           |       | 17.1 |   | 19.3 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Gross operating (loss) profit                 |       | (2.8                                            | )          | .3                                            |       | (1.7 | ) | (2.9 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general and administrative expenses  |       | 1.9                                             |       | 1.4                                           |       | 3.5 |   | 3.1 |   |
| Income from unconsolidated joint ventures     |       | (.1                                             | )          | (.4                                           | )          | (.1 | ) | (.4 | ) |
| Other expense, net                            |       | .6                                              |       | —                                        |       | 1.2 |   | .1 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Loss before income taxes                      |       | (5.2                                            | )          | (.7                                           | )          | (6.3 | ) | (5.7 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Benefit from income taxes                     |       | (2.1                                            | )          | (.3                                           | )          | (2.5 | ) | (2.3 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net loss                                      |       | $                                               | (3.1       | )                                             | $          | (.4 | ) | $ | (3.8 | ) | $ | (3.4 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net loss per common share:                    |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                         |       | $                                               | (.28       | )                                             | $          | (.04 | ) | $ | (.35 | ) | $ | (.32 | ) |
| Diluted                                       |       | $                                               | (.28       | )                                             | $          | (.04 | ) | $ | (.35 | ) | $ | (.32 | ) |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Common equivalent shares:                     |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                         |       | 10.9                                            |       | 10.9                                          |       | 10.9 |   | 10.9 |   |
| Diluted                                       |       | 10.9                                            |       | 10.9                                          |       | 10.9 |   | 10.9 |   |

 

See theaccompanying notes to consolidated financial statements.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                       | ** ** | **2008**                                      | ** ** | **2007** | ** ** |
|                                                                             |       |                                          |       |   |   |
| Cash flows from operating activities:                                            |       |                                          |       |   |   |
| Net loss                                                                         |       | $                                             | (3.8       | ) | $ | (3.4 | ) |
| Adjustments to reconcile net loss to cash used in operating  activities:         |       |                                          |       |   |   |
| Stock-based compensation expense                                                 |       | .1                                            |       | — |   |
| Distributions from unconsolidated joint ventures                                 |       | .1                                            |       | .1 |   |
| Equity in earnings of unconsolidated joint ventures                              |       | (.2                                           | )          | (.4 | ) |
| Model homes depreciation                                                         |       | .5                                            |       | — |   |
| Loss on change in fair value of derivative instrument                            |       | .2                                            |       | — |   |
| Deferred taxes                                                                   |       | (2.5                                          | )          | (2.3 | ) |
| Gains on sales of real estate inventories                                        |       | (3.3                                          | )          | (1.1 | ) |
| Loss on impairment of real estate inventories                                    |       | 5.0                                           |       | 4.0 |   |
| Proceeds from sale of real estate inventories, net                               |       | 14.9                                          |       | 15.7 |   |
| Investments in real estate inventories                                           |       | (21.7                                         | )          | (43.4 | ) |
| Changes in assets and liabilities:                                               |       |                                          |       |   |   |
| Decrease in other assets                                                         |       | —                                        |       | 1.6 |   |
| (Decrease) increase in accounts payable, accrued and other  liabilities          |       | (6.0                                          | )          | .7 |   |
|                                                                             |       |                                          |       |   |   |
| Cash used in operating activities                                                |       | (16.7                                         | )          | (28.5 | ) |
|                                                                             |       |                                          |       |   |   |
| Cash flows from investing activities:                                            |       |                                          |       |   |   |
| Sales of short-term investments                                                  |       | —                                        |       | .5 |   |
| Investments in unconsolidated joint ventures                                     |       | (.3                                           | )          | (.3 | ) |
| Change in restricted cash                                                        |       | .1                                            |       | .9 |   |
|                                                                             |       |                                          |       |   |   |
| Cash (used in) provided by investing activities:                                 |       | (.2                                           | )          | 1.1 |   |
|                                                                             |       |                                          |       |   |   |
| Cash flows from financing activities:                                            |       |                                          |       |   |   |
| Borrowings of senior secured project revolver                                    |       | 33.2                                          |       | 20.4 |   |
| Repayments of senior secured project revolver                                    |       | (21.2                                         | )          | — |   |
| Repayments of senior secured term loan                                           |       | (3.3                                          | )          | — |   |
| Borrowings of other project debt                                                 |       | 1.0                                           |       | 11.4 |   |
| Repayments of other project debt                                                 |       | (6.3                                          | )          | (9.1 | ) |
| Deferred financing costs                                                         |       | (.4                                           | )          | — |   |
|                                                                             |       |                                          |       |   |   |
| Cash provided by financing activities                                            |       | 3.0                                           |       | 22.7 |   |
|                                                                             |       |                                          |       |   |   |
| Net decrease in cash and cash equivalents                                        |       | (13.9                                         | )          | (4.7 | ) |
|                                                                             |       |                                          |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 24.3                                          |       | 10.6 |   |
|                                                                             |       |                                          |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                             | 10.4       |   | $ | 5.9 |   |
|                                                                             |       |                                          |       |   |   |
| Supplemental disclosures of cash flow information:                               |       |                                          |       |   |   |
| Cash paid during the period for income taxes, net of refunds received            |       | $                                             | —     |   | $ | .2 |   |
| Supplemental disclosures of non-cash investing and financing  activities:        |       |                                          |       |   |   |
| Amortization of deferred financing costs capitalized in real estate  inventories |       | $                                             | .5         |   | $ | — |   |

 

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, 2007 and the current year’s previouslyissued Quarterly Report on Form 10-Q. Intercompany accounts andtransactions have been eliminated.

 

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

 

**Note 2 -Significant Accounting Policies**

 

*Basis ofConsolidation*

 

Certainof the Company’s wholly-owned subsidiaries are members in joint venturesinvolved in the development and sale of residential projects and residentialloan production. The Company’s consolidated financial statements include theCompany’s accounts and all of its majority-owned and controlled subsidiariesand joint ventures. The financial statements of joint ventures in which theCompany 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 discussed in Note 4 tothe consolidated financial statements included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2007.

 

*CashFlows and Debt Compliance*

 

Negativeconditions in the current housing and credit markets give rise to uncertaintyas to the Company’s present and future ability to meet its projected home saleclosings and whether new or modified financings can be obtained, if needed. Given thenumber of homes currently under construction, the Company does not expect to beable to generate enough cash flow from operations at Brightwater during 2008 tomake the currently scheduled debt repayments. Therefore, during the secondquarter of 2008, the Company initiated discussions with its lenders regarding potentialamendments to the senior secured revolving loan and senior secured term loanthat would extend borrowing availability and extend the September 2009maturity date for the revolving loan. Amendments to the payment schedule andmaturity date will require the unanimous consent of the bank syndicates. Inaddition, the Company is seeking modification of certain covenants toaccommodate the slower projected pace of sales. In exchange for theseamendments, the Company has offered to pay modification fees and an increase inthe interest rates charged under the senior secured revolving loan and seniorsecured term loan. As of August 11, 2008, the Company’s negotiationsremained ongoing with the members of the bank syndicates and the Company isstriving to obtain final approval prior to September 30, 2008. TheCompany, like many other homebuilders, is constantly evaluating potentialalternatives regarding its capital structure including, but not limited to,various strategies for restructuring its debt and raising additional capital.There can be no assurance that the Company will be successful in any of theseendeavors, or that requested amendments to the senior secured revolving loanand senior secured term loan will be agreed to by the Company’s lenders. Currentcredit market conditions present uncertainty as to the ability of the Companyto secure additional financing, if needed, and the terms of such financing ifit is available, and as to the ability of the Company to achieve positive cashflow from operations required to satisfy its obligations. See Notes 4 and 5 for further discussion.

 

 

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*RealEstate*

 

Real estate inventories primarily consist of homesunder construction and lots under development and are carried at the lower ofcost or fair value less costs to sell. The estimation process involved in thedetermination 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.

 

Thecost of sales of multi-unit projects is computed using the relative sales valuemethod. Interest and other carrying costs are capitalized to real estateprojects during their development and construction period.

 

*Impairmentof Long-Lived Assets*

 

The Company recorded impairment charges of $5.0 million during thethree and six months ended June 30, 2008 consisting of $4.4 millionrelated to the Las Colinas project in Lancaster and $600,000 for the Alisalproject in Ontario. During the three and six months ended June 30, 2007,the Company recorded impairment charges of zero and $4.0 million, respectively,related to the Beaumont project. The impairment charges recorded during thefirst six months of 2008 and 2007 reflected the continuing slowdown in thehousing market and our expectations about the pace of sales and sales prices.To date, the Company has recorded impairment charges aggregating $37 millionrelated to five of its six active projects. The impairment charges werecalculated based on market conditions and assumptions made by management thatreflected current conditions at the time such impairment charges weredetermined, which may differ materially from actual results if marketconditions change. As required by SFAS 144, should market conditionsdeteriorate in the future or other events occur that indicate the carryingamount of the Company’s real estate inventories may not be recoverable, theCompany will reevaluate the expected cash flows from each project to determinewhether any additional impairment exists at any point in time.

 

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

 

In accordance with SFAS 144, in developing estimated future cashflows for impairment testing for its real estate inventories, the Company hasincorporated its own market assumptions including those regarding home prices,sales pace, sales and marketing costs, infrastructure and home-building costsand financing costs regarding real estate inventories. The Company’sassumptions are based, in part, on general economic conditions, the currentstate of the homebuilding industry, expectations about the short- and long-termoutlook for the housing market, and competition from other homebuilders in theareas in which the Company builds and sells homes. These assumptions cansignificantly affect the Company’s estimates of future cash flows. For thosecommunities deemed to be impaired, the Company determined fair value based ondiscounted estimated future cash flows using estimated absorption rates foreach community.

 

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

 

The Company believes that the accounting for the impairment oflong-lived assets is a critical accounting policy because the valuationanalysis involves a number of assumptions that may differ from actual resultsand the impact of recognizing impairment losses has been material to theCompany’s consolidated financial statements. The critical assumptions in theCompany’s evaluation of real estate inventories impairment included projectedsales prices, anticipated 

 

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salespace within each community, and applicable discount rates, any of which couldchange materially as economic conditions change.

 

*EarningsPer Common Share*

 

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

 

*RecentAccounting Pronouncements*

 

In March 2008, the FASB issued SFAS No. 161, *“Disclosures About Derivative Instruments and HedgingActivities — an amendment of FASB Statement No. 133”* (“SFAS 161”),which expands the disclosure requirements for derivative instruments andhedging activities required by Statement No. 133. SFAS 161 iseffective for financial statements issued for fiscal periods beginning after November 15,2008 (the Company’s fiscal year beginning January 1, 2009). The Company iscurrently evaluating the impact of adopting SFAS 161 on its consolidatedfinancial statements.

 

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

 

In February 2007, the FASB issued SFAS No. 159,*“The Fair Value Option for Financial Assets andFinancial Liabilities”* (“SFAS 159”), which expands the standardsunder SFAS 157 and provides entities a one-time election to measure financialinstruments and certain other items at fair value. The Company adopted SFAS 159 on January 1, 2008.The adoption of SFAS 159 did not have a material effect on the Company’sconsolidated financial statements.

 

In September 2006,the FASB issued SFAS No. 157, *“Fair Value Measurements”*(“SFAS 157”), which defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. The Company adopted SFAS 157 on January 1,2008. The adoption of SFAS 157 did not have a material effect on the Company’sconsolidated financial statements.

 

**Note 3 — Real Estate Inventories**

 

Real estate inventories primarily consist of homes under constructionand lots under development at Brightwater in coastal Orange County and fourcommunities in three additional Southern California counties. At June 30,2008, real estate inventories aggregated 697 lots and homes, including 19 homescompleted and unsold, eight homes completed and in escrow, and 15 homes underconstruction and in escrow. Real estate inventories at June 30, 2008included $233.9 million recorded for the Brightwater community which islocated on a 105-acre parcel on a mesa north of the Bolsa Chica wetlands (“UpperMesa”). In addition, real estate inventories include approximately 51 acresnearby which have been offered for dedication to the County of Orange forinclusion in the Harriet M. Weider Linear Park in conjunction with thedevelopment of Brightwater, and 51 additional acres which are subject to aconservation easement. The carrying value of these two properties is zero. TheCompany capitalizes carrying costs including interest and property taxes, aswell as direct construction costs, to real estate inventories during thedevelopment and construction period.

 

During the three months ended June 30, 2008, the Company recordedadditional impairment charges aggregating $5.0 million related to the LasColinas project in Lancaster and the Alisal project in Ontario. See additionaldiscussion in Note 2.

 

The Brightwater planned community offers a broad mix of home choices,averaging 2,860 square feet and ranging in size from 1,710 square feet to 4,339square feet. The community also has 37 acres of open space and conservationarea. With 349 homes permitted on 68 acres of the Upper Mesa, the resultinglow-density plan equates to approximately five homes per acre, consistent andcompatible with the neighboring Huntington Beach communities. In addition, theCompany owns land adjacent to the Brightwater development, on which it intendsto process permits to build seven additional homes which will be included inthe Brightwater community.

 

 

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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 productson March 15, 2008 and currently expects to begin delivering these homesduring the third quarter of 2008.

 

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

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| Capitalized interest, beginning of period |       | $                                               | 29.6       |                                          | $          | 13.7 |   | $ | 26.2 |   | $ | 10.2 |   |
| Interest incurred and capitalized         |       | 3.5                                             |       | 4.3                                           |       | 7.5 |   | 8.4 |   |
| Charged to cost of sales                  |       | (.8                                             | )          | (.2                                           | )          | (1.4 | ) | (.8 | ) |
| Capitalized interest, end of period       |       | $                                               | 32.3       |                                          | $          | 17.8 |   | $ | 32.3 |   | $ | 17.8 |   |

 

As of June 30,2008, real estate inventories includes $2.7 million of model home furnishings,net of related depreciation. Model home furnishings are depreciated using thestraight-line method over three to five years.

 

**Note 4 —Senior Secured Project Revolver**

 

On September 15, 2006, the Company entered into a three-year, $100 MillionSenior Secured Revolving Credit Agreement with KeyBank National Association, asa lender and agent for several other lenders (the “Revolving Loan”). TheRevolving Loan is secured by a first trust deed on the Brightwater project, andstock pledges of the Company’s material subsidiaries. The Revolving Loan willfund $100 million of development and construction costs for theproject.  As of June 30, 2008, theRevolving Loan commitment had been reduced to $95.7 million based on the numberof homes sold as of that date. Certain subsidiaries of the Company providedfull unconditional guarantees under the Revolving Loan.

 

As of June 30, 2008 and December 31, 2007, $88.0 millionand $76.0 million, respectively, was outstanding under the Revolving Loanat weighted average rates of 4.48% and 6.90%, respectively, based upon theCompany’s elected rates. Outstanding advances currently bear interest at theCompany’s option at either (i) the Alternate Base rate (“Prime”) minus 25basis points, or (ii) LIBOR plus 200 basis points. As of June 30,2008, the undrawn availability was $7.7 million. Interest on the facilityis calculated on the average, outstanding daily balance and is paid monthly.Interest incurred on the Revolving Loan for the three and six months ended June 30,2008 was $1.0 million and $1.9 million, respectively, at weighted-averageinterest rates of 4.79% and 5.18%, respectively. Interest incurred on theRevolving Loan for the three and six months ended June 30, 2007 was$700,000 and $1.2 million, respectively, at a weighted-average interest rate of7.32% for both periods. As of August 4, 2008, the Revolving Loan weightedaverage interest rate is 4.47%.

 

Given the number of homes currently under construction, the Companydoes not expect to be able to generate enough cash flow from operations atBrightwater during 2008 to make the currently scheduled debt repayments due onDecember 31, 2008. Therefore, during the second quarter of 2008, the Companyinitiated discussions with its lenders regarding potential amendments to theRevolving Loan that would extend borrowing availability and extend the September 2009maturity date. Amendments to the payment schedule and maturity date willrequire the unanimous consent of the Revolving Loan bank syndicate. In addition,the Company is seeking modification of certain covenants to accommodate theslower projected pace of sales. In exchange for these amendments, the Companyhas offered to pay a modification and extension fee, and an increase in theinterest rates charged under the Revolving Loan. As of August 11, 2008,the Company’s negotiations remained ongoing with the members of the RevolvingLoan bank syndicate and the term loan bank syndicate (as discussed below) and theCompany is striving to obtain final approval prior to September 30, 2008.The Company, like many other homebuilders, is constantly evaluating potentialalternatives regarding its capital structure including, but not limited to,various strategies for restructuring its debt and raising additional capital.There can be no assurance that the Company will be successful in any of theseendeavors, or that requested amendments to the Revolving Loan will be agreed toby the Company’s lenders. Current credit market conditions present uncertaintyas to the ability of the Company to secure additional financing, if needed, andthe terms of such financing if it is available, and as to the ability of theCompany to achieve positive cash flow from operations required to satisfy itsobligations.

 

If the Revolving Loan and the term loan are not amended, the Companywould be required to make $29.2 million in aggregate principalamortization payments by December 31, 2008, of which $20.7 millionwould be payable under the Revolving Loan (assuming the Company draws the remaining$7.7 million which is available as of June 30, 2008) and $8.5 millionwould be payable under the term loan.

 

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Beginning December 31, 2008 and at the end of each subsequentquarter, the commitment amount under the Revolving Loan is currently scheduledto decrease by $25.0 million until the commitment is reduced to zero bythe current maturity date on September 15, 2009. The Revolving Loan isalso subject to mandatory repayments and commitment reductions based on 40% ofthe $600,000 release price on the first 50 units closed at the Brightwaterproject, and 40% of the $1 million release price per unit thereafter.These mandatory repayments are applicable to the commitment reductions setforth above. During the three and six months ended June 30, 2008, theCompany delivered seven and nine homes, respectively, at Brightwater and mademandatory repayments of $1.7 million and $2.2 million, respectively. As of June 30,2008, the Company has delivered 18 homes at Brightwater and made cumulativemandatory repayments for the Revolving Loan of $4.3 million, or $240,000per home. Availability under the $100.0 million Revolving Loan has been reducedto $95.7 million after subtracting the $4.3 million cumulative mandatoryrepayments.

 

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

 

·                  a leverage covenant that prohibits theCompany’s ratio of consolidated total liabilities to consolidated tangible networth from exceeding the following:

 
| **Reporting Period**                           | ** ** | **Maximum  Leverage Ratio** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| March 31, 2008 through June 30, 2008 |       | 2.50  to 1.0                     |       |
| September 30, 2008 and thereafter         |       | 2.25  to 1.0                     |       |

 

·                  a minimum consolidated tangible net worthcovenant of $80 million.

 

As of June 30, 2008, the Company’s consolidated total liabilitiesare $263.7 million, tangible net worth is $97.8 million and leverageratio is 2.70. The Company has obtained a waiver through October 6, 2008of its leverage covenant for the period ended June 30, 2008 and is incompliance with all other covenants of the Revolving Loan as of June 30,2008.

 

As of June 30, 2008 and December 31, 2007, approximately$400,000 and $600,000, respectively, of deferred loan fees and closing costsrelated to the Revolving Loan are included in other assets and amortized overthe life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories when incurred,and charged to cost of sales when the related homes are delivered.

 

**Note 5 —Senior Secured Term Loan**

 

On September 15, 2006, the Company entered into a five-year,$125 Million Senior Secured Term Loan Agreement with KeyBank NationalAssociation, as a lender and agent for several other lenders (the “Term Loan”),and on September 15, 2006, the Company borrowed the maximum loan amount of$125 million. The proceeds were used to fund a “special dividend” of$12.50 per share, totaling $135.7 million, to common stockholders paid on September 28,2006. The Term Loan is secured by a second trust deed on the Brightwaterproject, and a general pledge and assignment of the Company’s ownershipinterests in all material subsidiaries. All existing material subsidiaries ofthe Company have provided full unconditional guarantees. The Term Loan includesfinancial covenants which may limit the amount that may be outstanding.

 

As of June 30, 2008 and December 31, 2007,$118.5 million and $121.8 million, respectively, was outstandingunder the Term Loan at rates of 5.24% and 7.5%, respectively, based upon theCompany’s elected rates. The outstanding balance currently bears interest atthe Company’s option at either (i) the prime interest rate plus 25 basispoints, or (ii) LIBOR plus 275 basis points. Interest on the Term Loan iscalculated on the average, outstanding daily balance and is paid monthly.Interest incurred on the Term Loan for the three and six months ended June 30,2008 was $1.8 million and $3.8 million, respectively, atweighted-average interest rates of 5.34% and 5.90%, respectively. Interestincurred on the Term Loan for the three and six months ended June 30, 2007was $2.6 million and $5.2 million, respectively, at aweighted-average interest rate of 8.07% for both periods. As of August 4,2008, the Term Loan interest rate is 5.22%.

 

Given the number of homes currently under construction, the Companydoes not expect to be able to generate enough cash flow from operations atBrightwater during 2008 to make the currently scheduled debt repayments due onDecember 31, 2008. Therefore, during the second quarter of 2008, the Companyinitiated discussions with its lenders regarding potential amendments to theTerm Loan that would extend borrowing availability. In addition, the Company isseeking modification of certain covenants to accommodate the slower projectedpace of sales. Amendments to the payment schedule will require the unanimousconsent 

 

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ofthe Term Loan bank syndicate. In exchange for these amendments, the Company hasoffered to pay a modification fee and an increase in the interest rates chargedunder the Term Loan. As of August 11, 2008, the Company’s negotiationsremained ongoing with the members of the Term Loan bank syndicate and theRevolving Loan bank syndicate (as discussed above) and the Company is strivingto obtain final approval prior to September 30, 2008. The Company, likemany other homebuilders, is constantly evaluating potential alternativesregarding its capital structure including, but not limited to, variousstrategies for restructuring its debt and raising additional capital. There canbe no assurance that the Company will be successful in any of these endeavors,or that requested amendments to the Term Loan will be agreed to by the Company’slenders. Current credit market conditions present uncertainty as to the abilityof the Company to secure additional financing, if needed, and the terms of suchfinancing if it is available, and as to the ability of the Company to achievepositive cash flow from operations required to satisfy its obligations.

 

On December 31, 2008, September 30, 2009 and September 30,2010, the commitment amount is currently scheduled to decrease by$15 million, $25 million, and $35 million, respectively.Thereafter, at the end of each subsequent quarter, the Term Loan commitmentamount will decrease in four equal installments of $12.5 million, untilthe commitment under the agreement is reduced to zero by the final maturitydate on September 15, 2011. The Term Loan is also subject to mandatoryrepayments based on 60% of the $600,000 release price on the first 50 unitsclosed at the Brightwater project, and 60% of the $1 million release priceper unit thereafter. These mandatory repayments are applicable to thecommitment reductions set forth above. During the three and six months ended June 30,2008, the Company delivered seven and nine homes, respectively, at Brightwaterand made mandatory repayments of $2.5 million and $3.3 million, respectively.As of June 30, 2008, the Company has delivered 18 homes at Brightwater andmade cumulative mandatory repayments of $6.5 million, or $360,000 perhome.

 

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 loan-to-valuecovenant which currently prohibits the combined debt outstanding under theRevolving Loan and the Term Loan from exceeding 65% of the borrowing basevalue.  As a result of the recent lenderappraisal of Brightwater as of June 1, 2008, the loan-to-value wasapproximately 68% as of June 30, 2008. The Company is negotiating with its lenders to increase this covenantfrom 65% to 70% and has obtained a waiver of the loan-to-value covenant throughOctober 6, 2008.

 

·                  a leverage covenant that prohibits theCompany’s ratio of consolidated total liabilities to consolidated tangible networth from exceeding the following:

 
| **Reporting Period**                           | ** ** | **Maximum  Leverage Ratio** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| March 31, 2008 through June 30, 2008 |       | 2.50  to 1.0                     |       |
| September 30, 2008 and thereafter         |       | 2.25  to 1.0                     |       |

 

·                  an interest coverage covenant that prohibitsthe Company’s ratio of EBITDA to interest incurred from being less than thefollowing:

 
| **Period**                                             | ** ** | **Minimum  Coverage Ratio** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| September 30, 2008 through December 30, 2008 |       | 1.0 to 1.0                       |       |
| December 31, 2008 through June 29, 2009      |       | 2.0 to 1.0                       |       |
| June 30, 2009 and thereafter                      |       | 2.5 to 1.0                       |       |

 

·                  a minimum consolidated tangible net worthcovenant of $80 million

 

As of June 30, 2008, the Company’s consolidated total liabilitiesare $263.7 million, tangible net worth is $97.8 million and leverageratio is 2.70 which exceeds the maximum allowed ratio of 2.50. The Company hasobtained a waiver of its leverage covenant through October 6, 2008.

 

As of June 30, 2008 and December 31, 2007, approximately$2.0 million and $1.9 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 whenincurred, and charged to cost of sales when the related homes are delivered.

 

Under the Term Loan agreement, the Company was required to enter into aswap agreement to hedge against risks associated with fluctuating interestrates related to $62.5 million of floating rate debt. On September 15,2006 the Company 

 

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enteredinto an interest rate swap transaction to effectively fix the interest rate on$62.5 million in floating rate debt at 8.015% per annum. The swaptransaction terminates September 15, 2008. The swap did not qualify forhedge accounting under SFAS No. 133, *“Accountingfor Derivative Instruments and Hedging Activities”*. The fair valueof the interest rate swap agreement represents the spread between the interestrate the Company would pay and the interest rate the Company would receive overthe remaining life of the agreement which are considered level 2 inputs underSFAS 157. As of June 30, 2008, the fair value of the swap agreement isapproximately $400,000. The non-cash change in fair value of the interest rateswap agreement during the three and six months ended June 30, 2008 was anapproximately $300,000 increase and $200,000 decrease, respectively, and wasincluded in other expense, net. In addition, the Company recorded $400,000 and$600,000 of expense for cash payments made under the terms of the interest rateswap agreement during the three and six months ended June 30, 2008,respectively, due to declining interest rates during the periods. Thecounterparties to the interest rate swap agreement are financial institutions.

 

**Note 6 —Other Project Debt**

 

In conjunction with the acquisition of single-family residential lots,the Company’s homebuilding subsidiary, Hearthside Homes, Inc. and itssubsidiaries, enter into construction loan agreements with commercial banks.These loan facilities finance a portion of the land acquisition and themajority of the construction of infrastructure and homes. Each loan facilityrequires a guaranty of project completion and an environmental indemnity byHearthside Homes, Inc. but these loans are nonrecourse to the Company. Theloans are secured by first trust deeds and bear an interest rate of prime plusone-half or prime plus three-fourths percent (5.5% to 5.75% at June 30,2008). The Lancaster and Hellman loan facilities have minimum interest rates of7.5% and 7.25%, respectively. During the six months ended June 30, 2008,Hearthside Homes, Inc. and its subsidiaries did not enter into any newloan facilities.

 

The following amounts were available and outstanding under these loanfacilities as of June 30, 2008 and December 31, 2007 ($ in millions):

 
| ** **     | ** ** | ** **                   | ** ** | ** **           | ** **    | ** **               | ** ** | ** **         | ** ** | **Outstanding at** | ** ** |
|----------------|------------|------------------------------|------------|----------------------|---------------|--------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Lender**           | ** **    | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **June 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|           |       |                         |       |                 |          |                     |       |               |       |                    |       |   |   |
| Ontario        |       | $                            | 11.7       |                 | Comerica Bank |                     | 4          |               | 7/19/08    |                    | $          | .2 |   | $ | 2.6 |   |
| Beaumont       |       | 17.9                         |       | Comerica Bank        |          | 74                       |       | 9/17/08            |       | 9.0                     |       | 9.9 |   |
| Lancaster      |       | 14.0                         |       | IndyMac Federal Bank |          | 61                       |       | 9/30/08            |       | 4.2                     |       | 4.2 |   |
| Corona-Hellman |       | 54.5                         |       | IndyMac Federal Bank |          | 143                      |       | 1/7/09             |       | 30.1                    |       | 32.1 |   |
|           |       |                         |       |                 |          |                     |       |               |       |                    |       |   |   |
|           |       |                         |       |                 |          |                     |       |               |       | $                       | 43.5       |   | $ | 48.8 |   |
|                |            |                              |            |                      |               |                          |            |                    |            |                         |            |  |  |  |  |  |

 

During July 2008, a subsidiary of Hearthside Homes repaid theOntario loan in full.

 

A subsidiary of Hearthside Homes has extended the Beaumont loan from June 17,2008 to September 17, 2008. During July 2008, this subsidiary maderepayments of $900,000, resulting in a loan balance of $8.1 million. HearthsideHomes has initiated discussions with its lender regarding an additionaltwelve-month extension; however, there can be no assurance that HearthsideHomes will succeed in obtaining this extension.

 

The Lancaster loan from IndyMac Bank required cumulative minimumrepayments of $3.0 million by July 1, 2008 which a subsidiary ofHearthside Homes has satisfied. Since IndyMac Bank has been taken over by theFDIC, this subsidiary is evaluating its alternatives with respect to theLancaster project debt, including but not limited to selling its three modelhomes and three remaining standing inventory to further reduce the $3.8 millionbalance outstanding as of August 4, 2008.

 

On June 13, 2008, Hearthside Homes and one of its subsidiariesreceived a notice of default related to the subsidiary’s Corona-Hellman loanfacility from IndyMac Bank (“Hellman Loan”) indicating that the subsidiary isnot in compliance with the absorption rate and home closings requirements ofthe loan. IndyMac Bank informed the subsidiary that it will not make anyfurther disbursements, including interest, under the Hellman Loan until thesubsidiary cures the default by closing nine homes at the Hellman project by August 12,2008. This subsidiary of Hearthside Homes has delivered three homes sincereceiving the notice and an additional home is in escrow as of August 4,2008. However, based on current market conditions and the lack of sufficientinventory of completed homes, the subsidiary does not expect to be able to curethe default. Hearthside Home’s subsidiary has made all required interestpayments and the principal balance of the Hellman Loan is not due until January 2009.Hearthside Homes’s subsidiary is evaluating its alternatives with respect tothe Hellman project. The Hellman loan is nonrecourse to the Company.

 

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**Note 7 - Other Liabilities**

 

Otherliabilities were comprised of the following (in millions):

 
| ** **                                         | ** ** | **June 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                      |       | $                       | 3.7        |                        | $          | 3.8 |   |
| Home warranty reserves                             |       | 2.0                     |       | 2.3                         |       |
| Contingent indemnity and environmental obligations |       | 1.1                     |       | 1.3                         |       |
| Deferred revenue                                   |       | 1.2                     |       | —                      |       |
| Unamortized discount                               |       | (.4                     | )          | (.4                         | )          |
|                                               |       | $                       | 7.6        |                        | $          | 7.0 |   |

 

Contingentindemnity and environmental obligations partially reflect reserves beforerelated discount (recorded pursuant to Fresh-Start Reporting in 1997) forcontingent indemnity obligations for businesses disposed of by formeraffiliates and unrelated to the Company’s current operations. Deferred revenuerepresents earnest money deposits held by the Company for home sales contractsin escrow, primarily related to the Brightwater project.

 

*HomeWarranty Reserve*

 

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

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| Balance at beginning of period       |       | $                                               | 2.1        |                                          | $          | 2.4 |   | $ | 2.3 |   | $ | 2.4 |   |
| Provision                            |       | —                                          |       | .1                                            |       | — |   | .2 |   |
| Adjustment due to change in estimate |       | —                                          |       | —                                        |       | (.1 | ) | — |   |
| Payments                             |       | (.1                                             | )          | (.1                                           | )          | (.2 | ) | (.2 | ) |
| Balance at end of period             |       | $                                               | 2.0        |                                          | $          | 2.4 |   | $ | 2.0 |   | $ | 2.4 |   |

 

**Note 8 -Income Taxes**

 

The following is a summary of thetax benefit:

 
| ** **                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| Current taxes             |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes            |       | (2.1                                            | )          | (.3                                           | )          | (2.5 | ) | (2.3 | ) |
| Benefit from income taxes |       | $                                               | (2.1       | )                                             | $          | (.3 | ) | $ | (2.5 | ) | $ | (2.3 | ) |

 

Thenet deferred tax balance at June 30, 2008 and December 31, 2007 isprimarily composed of federal net operating losses (“NOLs”). The Company hasconcluded that it is “more likely than not” that the Company will be able togenerate sufficient taxable income to realize such assets, therefore, theCompany has no valuation allowance related to the potential utilization of itsdeferred tax assets. The Company monitors the availability of real estate fordevelopment at economically viable prices, market conditions and other economicfactors affecting the Company’s operations, as well as other positive andnegative factors that may arise in the future, as it assesses the need for avaluation allowance against its deferred tax assets. The most critical uncertaintyis whether the Company will be able to continue selling homes at itsBrightwater project using currently projected sales prices and absorption ratesin light of the continuing deterioration in the housing and credit markets.

 

The federal NOLs available as of June 30, 2008 wereapproximately $138 million. The amount of federal NOLs which expire if notutilized is $3 million for 2008, $11 million, $49 million, $42 million, zero,and $33 million for 2009, 2010, 2011, 2012 and thereafter, respectively.

 

The Internal Revenue Code (the “Code”) generallylimits the availability of NOLs if an ownership change occurs within anythree-year period under Section 382. If the Company were to experience anownership change of more than 50%, the use of all remaining NOLs wouldgenerally be subject to an annual limitation equal to the value of the Company’sequity before the ownership change, multiplied by the long-term tax-exempt rate(4.65% as of August 2008) plus (ii) recognized 

 

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built-in-gains, defined as those gains recognized within five years ofthe ownership change subject to an overall limitation of the net unrealizedbuilt-in gains existing as of the ownership change date. The Company estimatesthat after giving effect to various transactions by stockholders who hold a 5%or greater interest in the Company, it has experienced a three-year cumulativeownership shift of approximately 31% as of August 4, 2008, as computed inaccordance with Section 382. In the event of an ownership change, theCompany’s use of its NOLs may be limited and the deferred tax assets recordedat June 30, 2008 may not be fully realizable.

 

On September 18, 2006, the Company’s Board ofDirectors suspended enforcement of the Company’s charter documents thatrestrict stockholders from acquiring more than 5% of the outstanding shares ofCommon Stock. The Board determined that such restrictions were not currentlyrequired to preserve the tax benefits of the Company’s $138 million of NOLs.While the Company remains subject to Code section 382, which limits theavailability of NOLs in the event of an ownership change, the Company wouldhave five years from the date of any such ownership change to recognize itsbuilt in gains and utilize its NOLs. However, the Board may reinstitute the 5%ownership limitation if required by currently unanticipated events.

 

Pursuantto SFAS 123(R), the Company has elected to recognize stock option deductions onthe tax law ordering method, which maximizes the realization of the stockoption deductions in the current year. While the Company realized the majorityof its 2006 stock option deductions, approximately $400,000 of unrealized taxbenefits related to stock option deductions are not reflected in theconsolidated financial statements. Upon realization of the tax benefits, theCompany will increase its additional paid-in capital.

 

*UncertainTax Positions*

 

TheCompany adopted the provisions of FASB Interpretation No. 48, *“Accounting for Uncertainty in Income Taxes”* (“FIN 48”),on January 1, 2007. As a result of the implementation of FIN 48, duringthe first quarter of 2007, the Company recorded a $5.1 million decrease indeferred tax assets for unrecognized tax benefits, which was offset by anincrease in deferred tax assets of $1.8 million for assets re-evaluated asrecognizable. The net change in deferred tax assets of $3.3 million wasrecorded as a cumulative effect of a change in accounting principle andresulted in a decrease to the January 1, 2007 retained earnings balance of$200,000 and a decrease to the additional paid in capital balance of $3.1million related to fresh-start accounting pursuant to a 1997 pre-packagedbankruptcy. There have been no changes to this amount during the three and sixmonths ended June 30, 2008. Of the Company’s unrecognized tax benefits of$5.1 million at June 30, 2008, $200,000 would decrease the Company’seffective tax rate if recognized. The Company does not expect that itsunrecognized tax benefits will significantly fluctuate or change within twelvemonths of the reporting date.

 

TheCompany recognizes interest expense and penalties related to uncertain taxpositions as interest or other expense. As of June 30, 2008, the Companyhas not recorded any interest or penalties related to unrecognized taxbenefits, 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 2004through 2007 and the years 2003 through 2007 remain open for Federal andCalifornia purposes, respectively, for which the Company utilized NOLsgenerated between 1990 and 1993 to offset taxable income. The Company expects toutilize Federal NOLs generated between 1993 and 1997 and in 1999, 2006 and 2007in future years. In addition, the Company expects to utilize California NOLgenerated in 2007 in future years.

 

**Note 9 -Commitments and Contingencies**

 

*RealEstate Matters*

 

The Company is subject to the usual obligations associated withentering into contracts for the purchase of land and improved home sites. Thepurchase of properties under these contracts is generally contingent uponsatisfaction of certain requirements by the sellers, including obtainingapplicable property entitlements. The Company also utilizes option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Option contracts generally requirethe payment of a non-refundable cash deposit of 5% to 15% of the purchase pricefor the right to acquire lots over a specified period of time (usually one totwo years) at predetermined prices. The Company has the right at its discretionto terminate its obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As of June 30,2008, the Company has no consolidated land option deposits.

 

The Company has outstanding performance and surety bonds, for thebenefit of city and county jurisdictions, related principally to its obligationsfor site improvements at various projects at June 30, 2008. The Companydoes not believe that 

 

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drawsupon these bonds, if any, will have a material effect on the Company’sfinancial position, results of operations or cash flows.

 

*Oxnard Land Development Joint Venture*

 

In February 2003, the Company entered into two option contracts toacquire land adjacent to the City of Oxnard in Ventura County, Californiaaggregating approximately 168 acres. The option contracts allow the Oxnardjoint venture to complete entitlement activities before purchasing the land.The option contracts currently expire in February 2009, and there arethree additional extensions available for each contract that, if exercised,would extend the outside closing date to December 31, 2011. The Company isdeveloping a land plan for the area, which also includes an additional 149acres owned by other landowners, with the intention of entitling the propertyfor residential development and annexing it into Oxnard. During October 2003,the Company entered into a limited liability company joint venture agreementwith a major financial partner to pursue the Oxnard development opportunity.The Company assigned the land purchase option contracts to the Oxnard LLC.Hearthside Homes, Inc., the Company’s homebuilding subsidiary, which isthe managing member of the Oxnard LLC.

 

As of June 30, 2008, the Company’s aggregate capital contributionswere $2.4 million and its total investment in the Oxnard LLC was$3.0 million. In addition, as of June 30, 2008, the Company hasincurred capitalized overhead costs of approximately $700,000 for the projectwhich are unreimbursed by the venture, bringing the Company’s total investmentin the project to $3.7 million. As of June 30, 2008, the non-managingmember’s aggregate capital contributions to the Oxnard LLC were$6.4 million. The members are currently funding capital requirements on a50/50 basis. The Company expects to make additional aggregate capitalcontributions of approximately $300,000 to the Oxnard LLC during theremaining six months of 2008, bringing the Company’s total expected investmentto $3.3 million and the Company’s total investment in the project to$4.0 million.

 

While the Company exerts a large degree of influence over the jointventure, the Company’s partner does have various substantive participatingrights such as approval rights with regard to the majority of businessdecisions, including approval of project budgets.

 

*LegalProceedings*

 

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

 

*CaliforniaDepartment of Toxic Substances Control*

 

In October 2006, the California Department of Toxic SubstancesControl (“DTSC”) filed a civil complaint against the Company’s HearthsideResidential Corp. subsidiary (“HRC”) in the Federal District Court for theSouthern Division of the Central District of California. A trial on this matteris currently scheduled to begin on October 7, 2008 and discovery in thecase is almost completed. The DTSC’s complaint requests that HRC pay forapproximately $1.0 million of costs incurred by the DTSC, together withinterest on that amount, primarily in connection with the oversight andremediation of PCB contamination found on residential properties adjacent to a43-acre site where HRC completed the removal of PCB contaminated soil during September 2005.HRC’s remediation process was approved by the DTSC in December 2005 whenit issued a final acceptance of the remediation work. The complaint also seeksan order for HRC to pay any future costs which may be incurred in connectionwith further remediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has received invoices from DTSC seeking reimbursementfor these costs; however, HRC contends, based upon advice of counsel, that itis not responsible for such costs because neither HRC nor any affiliate everdeveloped or built the neighboring residential properties, neither HRC nor anyaffiliate generated the contamination, the contamination did not emanate fromthe 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.

 

SeeNote 7 for a discussion of other contingencies.

 

*CorporateIndemnification Matters*

 

The Company and its former affiliates have, through avariety of transactions effected since 1986, disposed of several assets andbusinesses, many of which are unrelated to the Company’s current operations. Byoperation of law or contractual indemnity provisions, the Company may haveretained liabilities relating to certain of these assets and businesses. Thereis generally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities 

 

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is supported by insurance or by indemnities from certain of the Company’spreviously affiliated companies. The Company believes its consolidated balancesheet reflects adequate reserves for these matters.

 

**Note 10 —Stock Plan**

 

*1993Stock 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 2008, the Company issued a total of 15,817 shares ofits common stock to four independent directors under the Director Fee Program,which is a component of the 1993 Plan. These shares vest at the rate of 25% perquarter during 2008.

 

The Company did not grant any options during the six months ended June 30,2008 and 2007. Pursuant to SFAS 123(R), the Company recorded $53,000 and$71,000 of compensation expense during the six months ended June 30, 2008and 2007, respectively, which is reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993 plan for the six monthsended June 30, 2008 follows:

 
| ** **                                    | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** **  |
|-----------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|-------------|
| Outstanding,  January 1                  |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |        |   |
| Granted                                       |       | —                      |       | $                                     | —     |                                  |        |   |
| Exercised                                     |       | —                      |       | $                                     | —     |                                  |        |   |
| Outstanding, June 30                     |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 7.60  years |   |
|                                          |       |                        |       |                                  |       |                                  |        |
| Fully vested and  exercisable at June 30 |       | 15,000                      |       | $                                     | 19.97      | (a)                                   | 6.84  years |   |
| Available for future  grants at June 30  |       | 345,916                     |       |                                  |       |                                  |        |

 

(a)           Adjusted for specialdividend of $12.50

 

As of June 30, 2008, there were 17,500 options outstanding with a weighted-averageexercise price of $21.58 (ranging from $13.35 to $25.99) and a weighted-averageremaining life of 7.60 years. All outstanding unvested stock options areexpected to vest. The aggregate intrinsic value of all outstanding, fully-vestedand exercisable stock options at June 30, 2008 was zero.

 

The Company adopted SFAS 123(R) in the first quarter of 2006using the modified prospective method. Similar to SFAS 123, which theCompany adopted in 2003, SFAS 123(R) requires the cost of allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair valuesmeasured at the grant date, or the date of later modification, over therequisite service period. For tax purposes, the Company expects to be entitledto a tax deduction, subject to certain limitations, based on the fair value ofcertain equity awards when stock options are exercised. SFAS 123(R) requiresthat compensation cost be recognized in the financial statements based on thefair value measured at the grant date, or the date of later modification, overthe requisite service period. The cumulative compensation cost recognized forequity awards pursuant to SFAS 123(R) and amounts that ultimatelywill be deductible for tax purposes are temporary differences as prescribed bySFAS 109, ***“****Accounting for Income Taxes”*. The taxeffect of compensation deductions for tax purposes in excess of compensationcost recognized in the financial statements, if any, will be recorded as anincrease to additional paid-in capital when realized. A deferred tax assetrecorded for compensation cost recognized in the financial statements thatexceeds the amount that is ultimately realized on the tax return, if any, willbe charged to income tax expense when the restrictions lapse or stock optionsare exercised or expire unless the Company has an available additional paid-incapital pool (“APIC Pool”), as defined pursuant to SFAS 123(R). TheCompany is required to assess whether there is an available APIC Pool when thestock options are exercised or expire.

 

 

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

 

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

 

The Company estimates the fair value of its stock options using theBlack-Scholes option pricing model (the “Option Model”). The Option Modelrequires the use of subjective and complex assumptions, including the option’sexpected term and the estimated future price volatility of the 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 in accordancewith guidance provided in SFAS 123(R) and SAB 107. The risk-freeinterest rate used in the Option Model is based on the yield of U.S. Treasurieswith a maturity closest to the expected term of the Company’s stock options.

 

 

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MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Overviewof California Coastal Communities, Inc.**

 

We area residential land development and homebuilding company with properties ownedor controlled primarily in Orange County, California, and also in four otherSouthern California counties (Los Angeles, Riverside, San Bernardino andVentura). Our principal activities include:

 

·                  obtaining zoning and other entitlementsfor land we own or control through purchase options or joint ventures;

 

·                  improving the land for residentialdevelopment; and

 

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

 

Onceour residential land is entitled, we may build homes, sell unimproved land toother developers or homebuilders, sell improved land to homebuilders, orparticipate in joint ventures with other developers, investors or homebuildersto finance and construct infrastructure and homes. The majority of our homesare designed to appeal to move-up homebuyers and are generally offered for salein advance of their construction.

 

Duringthe remaining six months of 2008, our primary goals will be to:

 

·                  modify our existing credit agreements toaccommodate the ongoing downturn in the Southern California housing market;

 

·                  begin delivering homes in The Cliffs and TheBreakers neighborhoods at our Brightwater project during the third quarter of2008;

 

·                  continue selling and delivering homes in TheSands and The Trails neighborhoods at Brightwater;

 

·                  complete the entitlement process with theCity of Oxnard for a 168-acre joint venture project near Oxnard, California;and

 

·                  reduce standing inventories and thereforemaximize deliveries and revenues at our other homebuilding projects throughoutSouthern California.

 

Therecan be no assurance that we will accomplish, in whole or in part, all or any ofthese strategic goals or any other strategic goals or opportunities that we maypursue.

 

Ourtotal revenues for the three months ended June 30, 2008 and 2007 were$10.4 million and $4.2 million, respectively, and $15.4 million and $16.4million for the six months ended June 30, 2008 and 2007, respectively. Forthe three months ended June 30, 2008 and 2007, we delivered 15 and ninehomes, respectively, and for the six months ended June 30, 2008 and 2007,we delivered 23 and 24 homes, respectively. Our total assets as of June 30,2008 and December 31, 2007 were $361.5 million and $367.6 million,respectively, with Brightwater constituting $233.9 million (65% of totalassets) and $219.9 million (60% of total assets), respectively. Ourhomebuilding subsidiary, Hearthside Homes, Inc., has delivered over 2,100homes to families throughout Southern California since its formation in 1994.

 

Priorto obtaining the Coastal Development Permit for our Brightwater project in December 2005,we historically maintained a minimal amount of leverage. In September 2006,we obtained $225 million of debt financing as described in Notes 4 and 5 to theconsolidated financial statements in this Form 10-Q, which provided $100million for Brightwater construction and $125 million to fund the $12.50special dividend to our stockholders in September 2006, as described inNote 12 to the consolidated financial statements in our Annual Report on Form 10-Kfor the year ended December 31, 2007. As of June 30, 2008, we had$250.0 million of debt against $97.8 million of book equity.

 

Given the number of homes currently under construction, we do notexpect to be able to generate enough cash flow from operations at Brightwaterduring 2008 to make the currently scheduled debt repayments due on December 31,2008. Therefore, during the second quarter of 2008, we engaged in discussionswith our lenders regarding potential amendments to the revolving loan and termloan that would extend borrowing availability and extend the September 2009maturity date for the revolving loan. Amendments to the payment schedules andrevolving loan maturity date will require the unanimous consent of therespective bank syndicates. In addition, we are seeking modification of certaincovenants to accommodate the slower projected pace of sales. In exchange forthese amendments, we have offered to pay modification fees and an increase inthe interest rates charged under the senior secured revolving loan and seniorsecured term loan. As of August 11, 2008, our negotiations remainedongoing with the members of the bank syndicates and we are striving to obtainfinal approval prior to 

 

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September 30,2008. We have obtained waivers through October 6, 2008 from the banksyndicates with respect to the loan-to-value and leverage ratio covenantsdescribed in Notes 4 and 5 of Notes to the Financial Statements. We, like manyother homebuilders, are constantly evaluating potential alternatives regardingour capital structure including, but not limited to, various strategies forrestructuring our debt and raising additional capital. There can be noassurance that we will be successful in any of these endeavors, or thatrequested amendments to the revolving loan or term loan will be agreed to byour lenders. Current credit market conditions present uncertainty as to ourability to secure additional financing, if needed, and the terms of suchfinancing if it is available, and as to our ability to achieve positive cashflow from operations required to satisfy our obligations.

 

If the revolving loan and the term loan discussed in Notes 4 and 5 tothe Consolidated Financial Statements are not amended, we would be required tomake $29.2 million in aggregate principal payments by December 31,2008, of which $20.7 million would be payable under the revolving loan(assuming we draw the remaining $7.7 million available as of June 30,2008) and $8.5 million would be payable under the term loan.

 

Wewere formed in 1988 and our executive offices are located at 6 ExecutiveCircle, Suite 250, Irvine, California 92614. Our website address ishttp://www.californiacoastalcommunities.com and our telephone number is (949)250-7700. Through our website we make available our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, andamendments 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 we post current versions of our code of ethics, audit committee charterand nominating committee charter.

 

**Outlook**

 

During the second quarter of 2008, the homebuilding industry continuedto experience challenging business conditions created by eroding consumerconfidence due in part to a general downturn in economic activity and jobcreation; an oversupply of new and existing homes; increased foreclosures;intense competition for sales; ongoing turmoil in consumer mortgage lending andother credit markets; erosion of Wall Street and other capital markets;increased oil prices; and concerns about the affects of recession andinflation. Competition for home buyers remained intense with existing homeforeclosures and the continued limited availability of mortgage financingimpacting consumer confidence. As a result, we believe that home buyers remainreluctant to make purchasing decisions until they are comfortable that theprice declines are near bottom.  Theresult has been weakened demand for new homes, slower sales, higher than normalcancellation rates, and increased price discounts and other sales incentives toattract homebuyers. Additionally, the availability of certain mortgagefinancing products became more constrained starting in February 2007 whenthe mortgage industry began to more closely scrutinize sub-prime, Alt-A, andother non-prime mortgage products.

 

We currently believe that market conditions will continue to bechallenging for the remainder of 2008 and into 2009, with foreclosure activitycontinuing to rise, consumer mortgage lending and other credit marketscontinuing to be unsettled and consumer confidence continuing to decline.Although substantially reduced home prices and relatively low consumer mortgageinterest rates have improved housing affordability, many potential homebuyersremain reluctant to purchase homes for several reasons including: an inabilityto obtain adequate financing; an inability to sell their existing home at aperceived fair price or at a price that covers their existing mortgage; anxietyabout current economic conditions or employment prospects; or expectations thathome prices will fall further. This demand-side dynamic, in conjunction withrising foreclosures, is sustaining the oversupply of unsold new and existinghomes and competitive pricing pressures that have generated the extremelychallenging conditions our industry has experienced since 2006.

 

These adverse conditions have clearly impacted our results for thefirst half of 2008, particularly in our inland markets; however; despite thechallenges of the current homebuilding market, we believe the potential for ourBrightwater project remains high. While Brightwater has not been immune to theeffects of the unstable mortgage and housing markets, that impact appears lesssevere than the weakness we are seeing in our inland markets. We believe thatthe reduced impact is a result of Brightwater’s superior coastal location, theextremely limited supply of new homes on the coast of Southern California andthe absence of significant competition from other homebuilders in theHuntington Beach market due to the lack of available land for new single familydetached home development. We believe that Brightwater is in a location that isdifficult to replace and in a market where approvals are increasingly difficultto achieve. We also believe that Brightwater has substantial embedded valuethat will be realizable in the future and that this value should not besacrificed in the current soft market. Finally, we believe that Brightwater’sdemographics remain strong due to the continuing regulation-induced constraintson lot supplies and the growing number of affluent households along the coastof Southern California. Therefore, we remain optimistic about continuing salesat Brightwater.

 

Since February 2008, when sales commenced for larger homes at TheCliffs and The Breakers neighborhoods at Brightwater, the sales pace hasaccelerated project-wide. We have generated net sales orders at Brightwater for23 homes year-to-date and 32 homes from inception of sales in August 2007through August 4, 2008 (discussed below under “Our Current and FutureHomesites—Brightwater at Bolsa Chica”) and have delivered 18 homes at TheTrails and The Sands neighborhoods. As of August 4, 2008 we have 14 homesin escrow at Brightwater and five completed homes available for sale.

 

During the second quarter of 2008, we began to see a stabilization ofhome prices at our Woodhaven project in Beaumont. However, the remainder of ourInland Empire and Lancaster markets saw continued price depreciation and anexcess supply of homes available for sale. In addition, rising fuel costsappear to have further reduced demand for homes in our Lancaster market asprospective homebuyers seek to live closer to employment centers. Theseconditions resulted in both 

 

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loweroverall sales compared to the comparable period of 2007 and prior years anddownward pressure on our selling prices and margins, as limited demand andgreater competition for sales increased the need for sales incentives.

 

We do not expect the present business environment in our inland marketsor overall real estate market trends to improve markedly during 2008, and weexpect that the real estate market downturn will continue into 2009 and perhapsbeyond. Therefore, we have reduced selected sales prices and offered incentivesfor all of our homes in these inland markets in order to reduce our standinginventory and remain competitive during this continuing significant economicdownturn in the housing market. We have reduced standing inventory in ourinland markets from 33 homes at the end of 2007 to 14 homes as of June 30,2008. The price reductions and additional incentives have resulted insignificantly reduced gross profits for Inland Empire and Lancaster home sales.

 

In view of the continuing significant economic downturn in the housingmarket, we currently expect that during the remainder of 2008 and continuinginto 2009 our new home construction will be limited to our 356-home Brightwaterproject located on the Bolsa Chica mesa in Huntington Beach, California. Ourmanagement has concluded that this strategy is necessary under the prevailingmarket conditions and will allow us to market the properties at some futuretime when market conditions may have improved. We also expect that operationsin our other markets will focus on the sale of standing inventory, withlimited, if any, construction starts. In some inland markets, we may determineto sell existing model homes and re-open the projects when the marketdemonstrates improved sales levels. Finally, we intend to continue with ourentitlement efforts for our joint venture project near Oxnard.

 

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. Our operating strategyincludes:

 

·                  adjusting our cost structure to today’smarket conditions by reducing our headcount and overhead and rebiddingsubcontracts and materials in line with reduced demand;

 

·                  offering more incentives and price reductionsat our inland projects to reduce standing inventories and achieve acceptablelevels of sales volume and cash flow;

 

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

 

·                  limiting construction starts to better alignproduct available for sale with sales activity; and

 

·                  seeking to balance our short-term goal ofselling homes in a tough market and our long-term goal of maximizing the valueof our communities.

 

As of June 30, 2008, we had standing inventory of 19 homes,including five homes at Brightwater and 14 homes at our inland projects. Duringthe second quarter of 2008, net new orders increased to 26 homes compared with11 homes during the comparable period of 2007, primarily due to sales activityat our Brightwater community, which generated 11 sales orders during the secondquarter of 2008. Cancellations as a percentage of new orders were 19% duringthe second quarter of 2008 (15% at Brightwater and 21% at our inland projects),compared with approximately 35% during the comparable period of 2007. Backlogas of June 30, 2008 increased to 23 homes compared with 17 homes as of June 30,2007 primarily due to increased sales activity at Brightwater.

 

Finally, oursecond-half of 2008 and possibly our 2009 results could be adversely affectedif general economic conditions deteriorate, if job losses accelerate, ifconsumer mortgage lending becomes less available or more expensive, or ifconsumer confidence continues to fall, any or all of which would furtherdiminish the prospects for a recovery in housing markets. We believe that therewill not be a meaningful improvement in the housing market until there is asustained decrease in inventory levels, price stabilization, reducedforeclosure rates, and the restoration of consumer confidence that can supporta decision to buy a home. While it is difficult to predict when these eventswill occur, we believe we have responded with the right strategy to thedramatic reversal in the housing markets in the last few years.

 

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**OurCurrent and Future Homesites**

 

We currently have on-going Southern California homebuilding projectsin:

 

·                  Orange County in the Huntington Beach area;

 

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

 

·                  Northern Los Angeles County in the City ofLancaster.

 

Thefollowing chart describes our current projects, their location and our lot andstanding home inventories as of June 30, 2008:

 
| **Project**                             | ** ** | **Location**     | ** ** | **Models** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|-----------------------------------------|------------|------------------|------------|------------|------------|-------------|------------|-------------------------|------------|---------------------|------------|-------------------------------|------------|
| Brightwater in Orange County:           |       |             |       |       |       |        |       |                    |       |                |       |                          |       |
| The Trails                              |       | Huntington Beach |       | 4          |       | —      |       | 3                       |       | 45                  |       | 52                            |       |
| The Sands                               |       | Huntington Beach |       | 4          |       | —      |       | 2                       |       | 64                  |       | 70                            |       |
| The Cliffs                              |       | Huntington Beach |       | 4          |       | 5           |       | —                  |       | 98                  |       | 107                           |       |
| The Breakers                            |       | Huntington Beach |       | 5          |       | 8           |       | —                  |       | 96                  |       | 109                           |       |
|                                    |       |             |       |       |       |        |       |                    |       |                |       |                          |       |
| *Subtotal—Orange County*           |       |             |       | 17         |       | 13          |       | 5                       |       | 303                 |       | 338                           |       |
| * *                                | * *   | * *         | * *   | * *   | * *   | * *    | * *   | * *                | * *   | * *            | * *   | * *                      | * *   |
| Inland Empire/Lancaster:                |       |             |       |       |       |        |       |                    |       |                |       |                          |       |
| Hearthside Lane                         |       | Corona           |       | 5          |       | —      |       | 4                       |       | 134                 |       | 143                           |       |
| Woodhaven                               |       | Beaumont         |       | 4          |       | 2           |       | 6                       |       | 62                  |       | 74                            |       |
| Las Colinas                             |       | Lancaster        |       | 3          |       | 1           |       | 3                       |       | 54                  |       | 61                            |       |
| Other developments                      |       | Various          |       | —     |       | 7           |       | 1                       |       | —              |       | 8                             |       |
| Other unimproved lots                   |       | Lancaster        |       | —     |       | —      |       | —                  |       | 73                  |       | 73                            |       |
|                                    |       |             |       |       |       |        |       |                    |       |                |       |                          |       |
| *Subtotal—Inland Empire/Lancaster* |       |             |       | 12         |       | 10          |       | 14                      |       | 323                 |       | 359                           |       |
| * *                                | * *   | * *         | * *   | * *   | * *   | * *    | * *   | * *                | * *   | * *            | * *   | * *                      | * *   |
| *Total—All Projects*               |       |             |       | 29         |       | 23          |       | 19                      |       | 626                 |       | 697                           |       |

 

These homebuilding projects are currently expected to generate cashflows and gross operating margins through 2013. Up to approximately 554additional single-family lots could be available for homebuilding operations ifwe obtain entitlements for our Oxnard joint venture project; however, the exactnumber of homes will depend on the final outcome of the entitlement process.

 

*Brightwater at Bolsa Chica*

 

Brightwater is our Orange County residential community, located on the110-acre Bolsa Chica upper mesa adjacent to the City of Huntington Beach,approximately 35 miles south of downtown Los Angeles. Brightwater is beingannexed into the City of Huntington Beach as development progresses.Brightwater offers a broad mix of home choices averaging 2,860 square feet andranging in size from 1,710 square feet to 4,339 square feet. Located nearPacific Coast Highway and overlooking the Pacific Ocean and the recentlyrestored 1,200-acre Bolsa Chica Wetlands, 62 of the 356 homes at Brightwaterwill have unobstructed ocean and/or wetlands views. To date, over 3,600 peoplehave registered on our website requesting information about purchasing a homeat Brightwater; however, there can be no assurance that a significant number ofthese people will ultimately purchase a home.

 

Brightwater is the largest property in our portfolio, representingapproximately 80% of our real estate inventories as of June 30, 2008. Thisproject is located on one of the last large undeveloped coastal properties inSouthern 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 1,200-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, and we expect to submit a proposed site plan to the City ofHuntington Beach during 2008 to extend the Brightwater development onto a5-acre parcel that is currently zoned agricultural.

 

 

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In July 2007, we completed construction of eight model homes atThe Trails and The Sands neighborhoods and held a grand opening on August 11,2007 and delivered the first nine homes in December 2007. We deliveredseven and nine homes at The Trails and The Sands during the three and sixmonths ended June 30, 2008, respectively, and generated $7.2 and$9.4 million in revenue, respectively. We generated gross operatingmargins of 28.2% and 29.5% for the three and six months ended June 30,2008, respectively, due, in part, to our low cost basis in Brightwater. Homesat The Trails and The Sands are presently being offered at prices ranging from$900,000 to $1.2 million; however, home prices are inherently subject tochange. As of August 4, 2008, we have five completed homes available forsale.

 

During January 2008, we completed construction of nine additionalmodel homes for The Cliffs and The Breakers and in February 2008 beganselling homes to buyers who previously registered on our priority list. We helda grand opening for these neighborhoods on March 15, 2008. These homes arelarger than The Trails and The Sands, ranging from 2,724 to 4,339 square feet.As of August 4, 2008, we have 14 sales orders for The Cliffs and TheBreakers at prices ranging from $1.5 to $3.4 million for 2,724 to 4,100square foot homes. The first of these homes are currently expected to becompleted during the third quarter of 2008.

 

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

 

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

 

·                  There are 62 homes at Brightwater which will haveunobstructed views of the Pacific Ocean and/or the Bolsa Chica wetlands,including 35 homes at The Breakers, 25 homes at The Cliffs and two homes at TheSands.

 

·                  Build-out of production homes, which issubject to market conditions, is currently expected to take approximately fouryears and be completed in 2012.

 

·                  Costs to improve the lots from their rawcondition to finished lots, including County permits, City annexation fees andschool fees, approximate $200,000 per lot.

 

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

 

·                  Indirect costs are expected to approximate 6%of sales revenues.

 

·                  Based on current sales price projections, thevarious Brightwater products are currently expected to generate gross marginsof approximately 28% to 40% due to our low carrying value in Brightwater. Grossmargins for the larger homes at The Cliffs and The Breakers are currentlyexpected to approximate 35% to 40%, while gross margins at The Trails and TheSands are currently expected to approximate 28% to 35%.

 

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

 

*Oxnard Land Development - Unconsolidated JointVenture*

 

In February 2003, we entered into two option contracts to acquireapproximately 168 acres of land adjacent to the City of Oxnard in VenturaCounty, California. The option contracts allow the Oxnard joint venture tocomplete entitlement activities before purchasing the land. The optioncontracts currently expire in February 2009, and there are threeadditional extensions available for each contract that, if exercised, wouldextend the outside closing date to December 31, 2011. We are developing aland plan for the area, which also includes an additional 149 acres owned byother landowners, with the intention of entitling the property for residentialdevelopment and annexing it into Oxnard. During October 2003, we enteredinto a joint venture agreement with a major financial partner to pursue theOxnard development opportunity. We assigned the land purchase option contractsto the Oxnard joint venture. Hearthside Homes, Inc., our homebuildingsubsidiary, is the manager of the Oxnard joint venture.

 

A draft environmental impact report (“EIR”) for the proposed Oxnarddevelopment was circulated for public comments during the summer of 2007. As aresult of the public comments received, the City of Oxnard decided that the EIRneeded to be amended to address availability of water for the development andthe impact of such development on global 

 

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warming.During July 2008, the City recirculated a revised EIR for additionalpublic comments which are due by September 9, 2008. The Oxnard jointventure is attempting to obtain approval of its development plan from theOxnard City Council by the end of 2008 and approval of annexation into the Cityof Oxnard from the Local Agency Formation Commission during 2009; however,additional delays could be encountered. We do not expect to exercise our landpurchase options until housing market conditions demonstrate a clear andsignificant recovery.  Following any landpurchase, infrastructure construction is expected to take approximately oneyear, and build out of homes is expected to occur over the course of five tosix years, based on current expectations and assumptions.

 

We currently expect the residential development plan to includeapproximately 760 single-family detached lots and approximately 630 attachedresidential units (townhomes, condominiums and apartments); however, thesenumbers are subject to change during the course of the entitlement process.Approximately 554 of the single-family lots and approximately 347 of theattached units would be developed on the 168 acres of optioned land that theOxnard joint venture may purchase. The single-family detached product iscurrently expected to range from approximately 1,700 square feet to 3,400square feet and the attached units are currently expected to range fromapproximately 1,050 square feet to 1,575 square feet.

 

As of June 30, 2008, our aggregate capital contributions were$2.4 million and our total investment in the Oxnard joint venture was$3.0 million. In addition, as of June 30, 2008, we have incurredcapitalized overhead costs of approximately $700,000 for the project which areunreimbursed by the venture, bringing our total investment in the project to$3.7 million. As of June 30, 2008, the non-managing member’saggregate capital contributions to the joint venture were $6.4 million.The members are currently funding capital requirements on a 50/50 basis. Weexpect to make additional aggregate capital contributions of approximately$300,000 to the joint venture during the remaining six months of 2008, bringingour total expected investment in the venture to $3.3 million and our totalinvestment in the project to $4.0 million.

 

After payment of a preferred return of the greater of 10% or prime plus5% on invested capital to us and the non-managing member, the first$8 million of profits are allocated 75% to the non-managing member and 25%to us, and profits over $8 million and losses over $5 million aregenerally allocated on a 50/50 basis in accordance with the operating agreement.The first $5 million of losses are generally allocated 80% to thenon-managing member and 20% to us. While we are the managing member and exert alarge degree of influence over the joint venture, the non-managing member doeshave various substantive participating rights such as approval rights withregard to the majority of business decisions, including approval of projectbudgets.

 

*Homebuilding*

 

Our homebuilding operations include active projects in the HuntingtonBeach, Inland Empire (Corona and Beaumont), and Lancaster areas of SouthernCalifornia. We delivered 15 homes during the second quarter of 2008, comparedwith nine deliveries during the comparable period of 2007. During the sixmonths ended June 30, 2008 and 2007, we delivered 23 and 24 homes,respectively. We acquired no single-family residential lots during the threeand six months ended June 30, 2008 and 2007 and we have no contracts toacquire land or lots except through our Oxnard joint venture.

 

During the second quarter of 2008, we saw continued price depreciationin some but not all areas and an excess supply of homes available for sale inthe Inland Empire and Lancaster markets. Therefore, we have reduced selectedsales prices and offered incentives for all of our homes in these markets inorder to reduce our standing inventory and remain competitive during thiscontinuing significant economic downturn in the housing market. The pricereductions and additional incentives have resulted in significantly reducedgross profits for Inland Empire and Lancaster home sales.

 

We recorded asset impairment charges of $5.0 million during the firstsix months of 2008, compared with $4.0 million of asset impairment chargesrecorded during the first six months of 2007. The impairment charges reflectour expectations about home prices, sales pace, sales and marketing costs,infrastructure and homebuilding costs and financing costs for our inlandprojects. The impairment charges were calculated based on market conditions andassumptions made by management that reflected current conditions at the timesuch impairment charges were determined, which may differ materially fromactual results if market conditions change. As required by Statement ofFinancial Accounting Standards No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” (“SFAS 144”),we will reevaluate the expected cash flows from our homebuilding projects todetermine whether any additional impairment exists should events orcircumstances change.

 

In view of the continuing downturn in the housing market, we currentlyexpect that, during the next 12 months, our new home construction willprimarily be at our 356-home Brightwater project in Huntington Beach; and thatour operations in other markets will involve the sale of standing inventory, withlimited construction, if any, new construction. In some inland markets, we maydetermine to sell existing model homes and re-open the projects when the marketdemonstrates improved sales levels. Our management has concluded that thisstrategy is necessary under the prevailing market conditions and will allow usto market the properties at some future time when market conditions may haveimproved.

 

 

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Our homebuilding projects are described below:

 
| ** **               | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                      | ** ** | ** **          | ** ** | ** **    | ** ** | **Deliveries**    | ** ** |
|--------------------------|------------|------------------|------------|-----------------|------------|---------------------------------|------------|---------------------|------------|---------------|------------|-------------------|------------|
| ** **               | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                      | ** ** | ** **          | ** ** | ** **    | ** ** | **Three  Months** | ** ** | **Six  Months** | ** ** |
| ** **               | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                      | ** ** | ** **          | ** ** | ** **    | ** ** | **Ended**         | ** ** | **Ended** | ** ** |
| ** **               | ** ** | ** **       | ** ** | ** **      | ** ** | **Land**                        | ** ** | **Commenced**       | ** ** | **Commenced** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **               | ** ** | **Location**     | ** ** | **Acquisition** | ** ** | **Construction**                | ** ** | **Sales**           | ** ** | **2008**      | ** ** | **2007**          | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **               | ** ** | ** **       | ** ** | ** **      | ** ** | ** **                      | ** ** | **n/a**             | ** ** | ** **    | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater              |       |             |       |            |       |                            |       |                |       |          |       |              |       |   |   |   |   |
| The Trails               |       | Huntington Beach |       | 1970            |       | 2006                            |       | 2007                | (a)        | 4             |       | —            |       | 5 |   | — |   |
| The Sands                |       | Huntington Beach |       | 1970            |       | 2006                            |       | 2007                | (a)        | 3             |       | —            |       | 4 |   | — |   |
| The Cliffs               |       | Huntington Beach |       | 1970            |       | 2006                            |       | 2008                | (b)        | —        |       | —            |       | — |   | — |   |
| The Breakers             |       | Huntington Beach |       | 1970            |       | 2006                            |       | 2008                | (b)        | —        |       | —            |       | — |   | — |   |
|                     |       |             |       |            |       |                            |       |                |       |          |       |              |       |   |   |   |   |   |   |
| * *                 | * *   | * *         |       |            |       |                            |       | *Total Brightwater* |       | 7             |       | —            |       | 9 |   | — |   |
| * *                 | * *   | * *         | * *   | * *        | * *   | * *                        | * *   | * *            | * *   | * *      | * *   | * *          | * *   | * * | * * | * * | * * | * * | * * |
| Inland  Empire/Lancaster |       |             |       |            |       |                            |       |                |       |          |       |              |       |   |   |   |   |   |   |
| Completed  Projects      |       | Various          |       | n/a             |       | n/a                             |       | n/a                 |       | —        |       | —            |       | — |   | 6 |   |
| Chandler Ranch           |       | North Corona     |       | 2004            |       | 2005                            |       | 2005                |       | —        |       | 4                 |       | 1 |   | 7 |   |
| Alisal at Ontario        |       | Ontario          |       | 2005            |       | 2005                            |       | 2006                |       | 2             |       | —            |       | 4 |   | 2 |   |
| Woodhaven                |       | Beaumont         |       | 2005            |       | 2005                            |       | 2006                |       | 2             |       | 1                 |       | 3 |   | 1 |   |
| Hearthside Lane          |       | Corona           |       | 2005            |       | 2005                            |       | 2007                |       | 4             |       | —            |       | 5 |   | — |   |
| Alisal at  Lancaster     |       | Lancaster        |       | 2004            |       | 2004                            |       | 2005                |       | —        |       | 3                 |       | — |   | 5 |   |
| Las Colinas              |       | Lancaster        |       | 2005            |       | 2006                            |       | 2006                |       | —        |       | 1                 |       | 1 |   | 3 |   |
| Future Community         |       | Lancaster        |       | 2005            |       | —                          | (c)        | —              | (c)        | —        |       | —            |       | — |   | — |   |
|                     |       |             |       |            |       |                            |       |                |       |          |       |              |       |   |   |   |   |   |   |
| * *                 | * *   |             |       |            |       | *Total Inland Empire/Lancaster* |       | 8                   |       | 9             |       | 14                |       | 24 |   |
| * *                 | * *   | * *         | * *   | * *        | * *   | * *                        | * *   | * *            | * *   | * *      | * *   | * *          | * *   | * * | * * | * * | * * | * * | * * |
| * *                 | * *   | * *         |       |            |       |                            |       | *Total Deliveries*  |       | 15            |       | 9                 |       | 23 |   | 24 |   |
|                          |            |                  |            |                 |            |                                 |            |                     |            |               |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

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(a)                                  Commenced in August 2007.

 

(b)                                 Commenced in February 2008.

 

(c)                                  To bedetermined subject to market conditions.

 

*Huntington Beach.*  We completed construction of the first eightmodel homes for The Trails and The Sands products which range from 1,710 to2,160 square feet during July 2007 and opened for sales in August 2007.We completed construction of nine model homes for The Cliffs and The Breakersin January 2008 and began selling homes to homebuyers who previouslyregistered on our priority list in February 2008. We held a grand openingfor The Cliffs and The Breakers on March 15, 2008. We delivered nine homesat an average price of $1.2 million, or $609 per square foot during 2007and nine homes during the six months ended June 30, 2008, at an averageprice of $1.1 million, or approximately $563 per square foot. As of August 4,2008, 14 Brightwater homes are in escrow at an average price of$2.3 million, or approximately $640 per square foot.

 

*Corona.*  We acquired 83 lots in North Corona in May 2004.Following construction of infrastructure, during April 2005, we beganconstruction of homes averaging 3,160 square feet. We opened for sales duringthe third quarter of 2005 and delivered 58 homes during 2006 at an averageprice of $600,000. We delivered 21 homes during 2007 at an average price of$511,000 and one home during the six months ended June 30, 2008 at a priceof $450,000. As of August 4, 2008, the final three homes are in escrow atan average price of $438,000.

 

During April 2005, we acquired 151 additional lots in Corona.Following construction of infrastructure, construction of five model homesaveraging 3,600 square feet on lots of approximately 7,200 square feet beganduring the fourth quarter of 2006. These models were completed during April 2007,and we opened for sales during the second quarter of 2007. We delivered threehomes at an average price of $545,000 during 2007 and five homes at an averageprice of $456,000 during the first six months of 2008. As of August 4,2008, one home is completed and in escrow at a price of $450,000 and threehomes are completed and available for sale. We are evaluating our alternatives with respect to this project in lightof the FDIC takeover of IndyMac, which has been our lender on this project.

 

*Ontario.*  During April 2005, we acquired 26 lotsin the City of Ontario in Riverside County, California. This small community ofhomes, averaging 3,380 square feet, is an infill site. Construction of thefirst phase of 13 homes began during 

 

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thefourth quarter of 2005, and we opened for sales during March 2006. Wedelivered nine homes during 2006 at an average price of $675,000, nine homesduring 2007 at an average price of $613,000 and four homes during the first sixmonths of 2008 at an average price of $522,000. We delivered three of the finalfour homes during July 2008 at an average price of $472,000, and, as of August 4,2008, the final home is in escrow at a price of $470,000.

 

*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 three homes during the first six months of 2008at an average price of $270,000.  Wedelivered two additional homes during July 2008 at an average price of$298,000. As of August 4, 2008, six additional homes are completed andavailable for sale.

 

*Lancaster.*  In April 2005, we acquired 73 unentitledlots in the City of Lancaster in northern Los Angeles County. We have deferred theconstruction start for the 73-unit project, which has no recorded loan, untilsales activity in the market has improved. The tentative map for this projectis prepared, 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 will average 3,640 square feet. Construction ofmodels began in May 2006 and we opened for sales during July 2006. Wedelivered three homes at an average price of $537,000 during 2006 and 12 homesduring 2007 at an average price of $427,000. During the first six months of2008, we delivered one home at a price of $383,000. During July 2008, wedelivered one additional home at a price of $350,000. As of August 4,2008, one home is in escrow at a price of $280,000 and two additional homes arecompleted and available for sale. We are delaying the remainder of the projectuntil sales activity in the area improves. We are also evaluating our alternatives with respect to this project in lightof the FDIC takeover of IndyMac Bank, which has been our lender on thisproject.

 

**CriticalAccounting Policies**

 

In the preparation of the Consolidated Financial Statements, we appliedaccounting principles generally accepted in the United States of America. Theapplication of generally accepted accounting principles may require managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying results. Listed below are those policiesand estimates that we believe are critical and require the use of complexjudgment in their application. In particular, our critical accounting policiesand estimates include the evaluation of the impairment of long-lived assets andthe evaluation of the probability of being able to realize the future benefitsindicated by our significant federal tax net operating losses, as discussedfurther in Note 8 to the consolidated financial statements.

 

*Basis ofConsolidation*

 

Certain of our wholly-owned subsidiaries are members in joint venturesinvolved in the development and sale of residential projects and residentialloan production. Our consolidated financial statements include our accounts andall of our majority-owned and controlled subsidiaries and joint ventures. The financialstatements of joint ventures in which we generally have a controlling ormajority economic interest (and thus are controlled by us) are consolidatedwith our financial statements. Our investments in unconsolidated joint venturesare accounted for using the equity method when we do not have voting oreconomic control of the venture operations, as further discussed in Note 9to the consolidated financial statements.

 

*Impairmentof Long-Lived Assets*

 

We assess the impairment of real estate inventories and otherlong-lived assets in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” (“SFAS 144”) which requires that long-lived assets bereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. As provided bySFAS 144, impairment is evaluated by comparing an asset’s carrying valueto the undiscounted estimated cash flows expected from the asset’s operationand eventual 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 for purposes of SFAS 144 is deemed to be the amount awilling buyer would pay a willing seller for such asset in a currenttransaction. Additionally, as appropriate, we identify alternative courses ofaction to recover the carrying value of our long-lived assets and evaluate alllikely alternatives under a probability-weighted approach as described inSFAS 144.

 

In accordance with SFAS No. 144, in developing estimated futurecash flows for impairment testing for our real estate inventories, weincorporated our own market assumptions including those regarding home prices,sales pace, sales and marketing costs, infrastructure, home-building costs andfinancing costs regarding real estate inventories. Our assumptions 

 

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arebased, in part, on general economic conditions, the current state of thehomebuilding industry, expectations about the short- and long-term outlook forthe housing market, and competition from other homebuilders in the areas inwhich we build and sell homes. These assumptions can significantly affect ourestimates of future cash flows. For those communities deemed to be impaired, wedetermined fair value based on discounted estimated future cash flows usingestimated absorption rates for each community.

 

We recorded impairment charges of $5.0 million during the three and sixmonths ended June 30, 2008 consisting of $4.4 million related to the LasColinas project in Lancaster and $600,000 for the Alisal project in Ontario.During the three and six months ended June 30, 2007, we recordedimpairment charges of zero and $4.0 million related to the Beaumont project.The impairment charges recorded during the first six months of 2008 and 2007reflected the continuing slowdown in the housing market and our expectationsabout the pace of sales and sales prices. To date, we have recorded impairmentcharges aggregating $37.0 million for five of our active projects. Theimpairment charges were calculated based on market conditions and assumptionsmade by management that reflected current conditions at the time suchimpairment charges were determined, which may differ materially from actualresults if market conditions change. As required by SFAS 144, shouldmarket conditions deteriorate further in the future or other events occur thatindicate the carrying amount of our real estate inventories may not berecoverable, we will reevaluate the expected cash flows from each project todetermine whether any additional impairment exists at any point in time.

 

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.

 

*Income Taxe*s

 

We account for income taxes on the liability method. Deferred incometaxes are determined based on the difference between the financial statementand tax bases of assets and liabilities. The liability method requires anevaluation of the probability of being able to realize the future benefitsindicated by deferred tax assets, such as tax net operating losses. A valuationallowance related to the deferred tax asset is recorded when it is more likelythan not that some portion or all of the deferred tax asset will not berealized. Given the significance of our historical federal tax net operatinglosses, as discussed in Note 9 to the Consolidated Financial Statements,the application of our policy in evaluating the expected future benefit of netoperating losses is critical. In applying those policies, estimates andjudgments affect the amounts at which certain assets and liabilities arerecorded. We apply our accounting policies on a consistent basis. Ascircumstances change, they are considered in our estimates and judgments, andfuture changes in circumstances could result in changes in the amounts at whichassets and liabilities are recorded.

 

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 (4.65% as of August 2008)plus (ii) recognized built-in-gains, defined as those gains recognizedwithin five years of the ownership change subject to an overall limitation ofthe net unrealized built-in gains existing as of the ownership change date. Weestimate that as of August 4, 2008, we have experienced a three-yearcumulative ownership shift of approximately 31%, as computed in accordance withSection 382.

 

*HomebuildingRevenues and Cost of Sales*

 

Our homebuilding operation generates revenues from the sale of homes.The majority of these homes are designed to appeal to move-up homebuyers andthe homes 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 closing when title passes to the buyer, and the earnings process iscomplete. As a result, our revenue recognition process does not involvesignificant judgments or estimates. However, we do rely on certain projectionsand estimates to determine the related construction costs and resulting grossmargins associated with revenues recognized. The cost of sales is recordedbased upon total estimated costs within a subdivision and allocated using therelative sales value method. Our construction costs are comprised of direct andallocated costs, including estimated costs for future warranties andindemnities. Our estimates are based on historical results, adjusted forcurrent 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 Note 9 in ourconsolidated financial statements included in this quarterly report. We havereserved for costs expected to be incurred with respect to these 

 

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casesbased upon information provided by our legal counsel. There can be no assurancethat total litigation costs actually incurred will not exceed the amount ofsuch reserve.

 

**RecentAccounting Pronouncements**

 

See discussion regarding Recent Accounting Pronouncementsin Note 2 to the consolidated financial statements.

 

**Resultsof Operations**

 

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

 

**Backlog as of June 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                       | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 23                             |       | 17                                       |       | 35.3                                                            | %          | $ | 32.3 |   | $ | 9.7 |   | 233.0 | % | $ | 1,403 |   | $ | 569 |   | 146.6 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 
| **Homes****Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**               | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 15                     |       | 9                                        |       | 66.7                                                            | %          | $ | 10.4 |   | $ | 4.2 |   | 147.6 | % | $ | 696 |   | $ | 467 |   | 49.0 | % |
|                        |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **
| **Homes****Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**               | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 23                     |       | 24                                       |       | (4.2                                                            | )%         | $ | 15.4 |   | $ | 16.4 |   | (6.1 | )% | $ | 670 |   | $ | 683 |   | (1.9 | )% |
|                        |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Three Months Ended June 30, 2008 Compared withthe Three Months Ended June 30, 2007*

 

We generated $2.8 million of gross operating loss for the secondquarter of 2008, reflecting $5.0 million of impairment charges partially offsetby gross operating profit of $2.2 million, compared with $300,000 of grossoperating profit in the second quarter of 2007, during which there were noimpairment charges. We also reported revenues of $10.4 million and grossoperating loss of $2.8 million for the second quarter of 2008, comparedwith $4.2 million in revenues and gross operating profit of $300,000 forthe second quarter of 2007. Revenues in the current period reflect deliveriesof 15 homes, including seven deliveries at Brightwater which generated revenuesof $7.2 million and gross operating profit of $2.0 million, and eighthomes at our inland projects which generated revenues of $3.2 million andgross operating profit of $200,000. The comparable period of the prior yearreflects deliveries of nine homes, including four homes at the Chandler Ranchproject, three homes at our Alisal project in Lancaster, one home each at ourLas Colinas project in Lancaster and our Woodhaven project in Beaumont.

 

Gross operating loss for the second quarter of 2008 includes impairmentcharges of $5.0 million related to our Las Colinas project in Lancasterand the remaining four homes at our Alisal project in Ontario, which were allin escrow as of June 30, 2008. These impairment charges reflect ourcurrent expectations about selling prices, gross margins, and sales pace forthe projects. As required by SFAS 144, should market conditions furtherdeteriorate in the future or other events occur that indicate the carryingamount of our real estate inventories may not be recoverable, we willreevaluate our expected cash flows from each project to determine whether anyadditional impairment exists at any point in time.

 

We generated $1.9 million more in gross operating profit beforeimpairment charges from home sales during the second quarter of 2008 comparedwith the second quarter of 2007 primarily as a result of delivering seven homesat Brightwater which generated a 28.2% gross margin and gross operating profitof $2.0 million. This profit margin percentage was partially offset by 4.9%margins at our inland projects due to the prolonged real estate slowdown whichhas resulted in lower selling prices and greater incentives in order to remaincompetitive and move standing inventories in this difficult market.Homebuilding gross margin before impairment charges increased to 21.2% for thesecond quarter of 2008 compared with 7.1% in the comparable period of 2007 dueto the higher gross margin at Brightwater.

 

 

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The $600,000 increase in other expense, net during the second quarterof 2008 compared with the comparable period of 2007 primarily reflects a$200,000 increase in real estate holding costs due to our inability tocapitalize property taxes for inland projects no longer under construction, a$100,000 loss on our interest rate swap agreement, and a $100,000 decrease ininvestment income for the second quarter of 2008.

 

*Six Months Ended June 30, 2008 Compared withthe Six Months Ended June 30, 2007*

 

We reported revenues of $15.4 million and gross operating loss of$1.7 million for the six months ended June 30, 2008, compared with$16.4 million in revenues and gross operating loss of $2.9 millionfor the comparable period of 2007. We generated $3.3 million of gross operatingprofit before impairment charges for the six months ended June 30, 2008,compared with $1.1 million of gross operating profit in the comparable periodof 2007. Revenues in the current period reflect deliveries of 23 homes,including nine deliveries at Brightwater which generated revenues of$9.4 million and gross operating profit of $2.8 million, and 14 homes atour inland projects which generated revenues of $6.0 million and grossoperating profit of $500,000. The comparable period of the prior year reflectsdeliveries of 24 homes, including the final six homes at the Rancho Santa Feproject, seven homes at the Chandler Ranch project, five homes at our Alisalproject in Lancaster, three homes at our Las Colinas project in Lancaster, twohomes at our Alisal project in Ontario, and one home at our Woodhaven projectin Beaumont.

 

Gross operating loss for the six months ended June 30, 2008 and2007 includes impairment charges of $5.0 million and $4.0 million,respectively. The impairment charges recorded during 2008 reflect a $4.4million impairment for our Las Colinas project in Lancaster and a $600,000impairment for our Alisal project in Ontario, where the final four homes werein escrow as of June 30, 2008. The impairment charge recorded during thefirst six months of 2007 relates to the remaining homes at our Beaumontproject. These impairment charges reflect our expectations about sellingprices, gross margins, and sales pace for the projects. As required bySFAS 144, should market conditions further deteriorate in the future orother events occur that indicate the carrying amount of our real estateinventories may not be recoverable, we will reevaluate our expected cash flowsfrom each project to determine whether any additional impairment exists at anypoint in time.

 

We generated $2.2 million more in gross operating profit beforeimpairment charges from home sales during the six months ended June 30,2008 compared with comparable period of 2007 primarily as a result ofdelivering nine homes at Brightwater which generated a 29.5% gross margin andgross operating profit of $2.8 million and was partially offset by reducedmargins at our inland projects due to the prolonged real estate slowdown which hasresulted in lower selling prices and greater incentives in order to remaincompetitive and move standing inventories in this difficult market.Homebuilding gross margin before impairment charges increased to 21.4% for thesix months ended June 30, 2008 compared with 6.7% in the comparable periodof 2007 due to the higher gross margin at Brightwater.

 

The $1.1 million increase in other expense, net during the six monthsended June 30, 2008 compared with the comparable period of 2007 primarilyreflects an $800,000 loss on our interest rate swap agreement which included a$100,000 non-cash fair value adjustment and $700,000 of cash payments madeunder the terms of the agreement, as well as a $200,000 decrease in investmentincome.

 

 

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*PaymentsUnder Contractual Obligations*

 

We have entered into certain contractual obligations to make futurepayments for items such as loans, project debt, and lease agreements. A summaryof the payments due under specified contractual obligations, aggregated bycategory of contractual obligation, for specified time periods is presentedbelow as of June 30, 2008 (in millions):

 
| ** **                                    | ** ** | **Payments due by period** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **Total**                                 | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More  than  5 years** | ** ** |
| Revolving loan(a)                             |       | $                                         | 91.4       |   | $ | 66.2 |   | $ | 25.2 |   | $ | — |   | $ | — |   |
| Term loan(a)                                  |       | 129.1                                     |       | 22.1 |   | 107.0 |   | — |   | — |   |
| Other project debt(a)                         |       | 44.9                                      |       | 44.9 |   | — |   | — |   | — |   |
| Defined benefit retirement plan contributions |       | 1.5                                       |       | .2 |   | .4 |   | .4 |   | .5 |   |
| Operating leases                              |       | 1.2                                       |       | .3 |   | .7 |   | .2 |   | — |   |
| Total                                         |       | $                                         | 268.1      |   | $ | 133.7 |   | $ | 133.3 |   | $ | .6 |   | $ | .5 |   |

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(a)                                  Amounts includeestimated interest expense which is calculated based on forecasted debtbalances and the applicable interest rate at June 30, 2008.

 

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

 

**Liquidityand Capital Resources**

 

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

 

| ** **                                      | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30,**              | ** ** |
| ** **                                      | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| Cash and cash equivalents                       |       | $                              | 10.4       |   | $ | 5.9 |   |
| Cash used in operating activities               |       | (16.7                          | )          | (28.5 | ) |
| Cash (used in) provided by investing activities |       | (.2                            | )          | 1.1 |   |
| Cash provided by financing activities           |       | 3.0                            |       | 22.7 |   |
|                                                 |            |                                |            |  |  |  |  |

 

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 and availableinternal funds. Our unrestricted cash and cash equivalents as of June 30,2008 aggregated $10.4 million. At June 30, 2008, we had $7.7 millionof immediately available borrowing capacity as further described below.

 

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 4 and 5 to the consolidated financialstatements.

 

We obtained the revolving loan as a construction facility to financeinfrastructure and homebuilding activities at Brightwater. This loan is fundinga revolving $100 million of development and construction costs for theBrightwater project as reduced by mandatory repayments. The revolving loanincludes other financial covenants which may limit the amount that may beborrowed.  We have obtained a waiverthrough October 6, 2008 from the bank syndicates with respect to theloan-to-value and leverage ratio covenants described in Notes 4 and 5 of Notesto the Consolidated Financial Statements.

 

As of June 30, 2008, based on construction in place, theimmediately available borrowing capacity on our revolving loan is$7.7 million. As of June 30, 2008 and December 31, 2007,$88.0 million and $76.0 million, respectively, was outstanding underthe revolving loan. During the first six months of 2008, we made mandatoryrepayments of $2.2 million 

 

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and$3.3 million on the revolving and term loans, respectively, in connection withnine home deliveries at Brightwater during the period. Outstanding advances onthe revolving loan bear interest at our option at either (i) the AlternateBase rate (“Prime”) minus 25 basis points or (ii) LIBOR plus200 basis points. Outstanding advances on the term loan bear interest atour option at either (i) the prime interest rate plus 25 basis points, or (ii) LIBORplus 275 basis points.

 

Given the number of homes currently under construction, we do notexpect to be able to generate enough cash flow from operations at Brightwaterduring 2008 to make the currently scheduled debt repayments due on December 31,2008. Therefore, during the second quarter of 2008, we engaged in discussionswith our lenders regarding potential amendments to the revolving loan and termloan that would extend borrowing availability and extend the September 2009maturity date for the revolving loan. Amendments to the payment schedules andmaturity date of the revolving loan will require the unanimous consent of therespective bank syndicates. In addition, we are seeking modification of certaincovenants to accommodate the slower projected pace of sales. In exchange forthese amendments, we have offered to pay modification fees and an increase inthe interest rates charged under the revolving loan and term loan. As of August 11,2008, our negotiations remained ongoing with the members of the bank syndicatesand we are striving to obtain final approval prior to September 30, 2008.We, like many other homebuilders, are constantly evaluating potentialalternatives regarding our capital structure including, but not limited to,various strategies for restructuring our debt and raising additional capital.There can be no assurance that we will be successful in any of these endeavors,or that requested amendments to the revolving loan or term loan will be agreedto by our lenders. Current credit market conditions present uncertainty as toour ability to secure additional financing, if needed, and the terms of suchfinancing if it is available, and as to our ability to achieve positive cashflow from operations required to satisfy our obligations.

 

If the revolving loan and term loan discussed in Notes 4 and 5 of theConsolidated Financial Statements are not amended, we would be required to make$29.2 million in aggregate principal payments by December 31, 2008,of which $20.7 million would be payable under the revolving loan (assumingwe draw the remaining $7.7 million available as of June 30, 2008) and$8.5 million would be payable under the term loan.

 

Our other project debt, which is secured by various inland projects,has current maturity dates through January 2009. During July 2008, werepaid the Ontario loan in full. We have extended the Beaumont loan from June 17,2008 to September 17, 2008 and have initiated discussions with ComericaBank regarding an additional 12-month extension. The maturity dates for ourLancaster and Corona-Hellman loans are September 30, 2008 and January 7,2009, respectively. These loans are held by IndyMac Federal Bank and we areevaluating our alternatives with respect to these projects in light of the FDIC’srecent takeover of IndyMac.

 

On June 13, 2008, Hearthside Homes and one of its subsidiariesreceived a notice of default related to the subsidiary’s Corona-Hellman loanfacility indicating that the subsidiary is not in compliance with theabsorption rate and home closings requirements of the loan. IndyMac Bank informedour subsidiary that it will not make any further disbursements, includinginterest, under the loan facility until our subsidiary cures the default byclosing nine homes at the Hellman project by August 12, 2008. We havedelivered three homes since receiving the notice and an additional home is inescrow as of August 4, 2008. However, based on current market conditionsand the lack of sufficient inventory of completed homes, our subsidiary doesnot expect to be able to cure the default. Our subsidiary has made all requiredinterest payments and the principal balance of the loan facility is not dueuntil January 2009. Our subsidiary is evaluating its alternatives withrespect to the Hellman project. The loan facility is nonrecourse to us.

 

We are utilizing internally generated cash and joint venturecontributions to fund the Oxnard land development project. During the threemonths ended June 30, 2008, we made aggregate additional capital contributionsof approximately $135,000 to the Oxnard joint venture, bringing our totalinvestment in the venture to $3.0 million (see Note 9 to theconsolidated financial statements). In addition, as of June 30, 2008, wehave incurred capitalized overhead costs of approximately $700,000 for theproject which are unreimbursed by the venture, bringing our total investment inthe project to $3.7 million. During the remaining six months of 2008, weexpect to make additional aggregate capital contributions of approximately$300,000.

 

As discussed above, we are pursuing and evaluating various financingalternatives, including on going negotiations to amend our revolving loan andterm loan. We believe that if we are successful in reaching agreements with ourrevolving loan and term loan syndicates, that funds available under our currentcredit agreements, in addition to our cash and cash equivalents and future realestate sales proceeds will be sufficient to meet anticipated operating andcapital investment requirements and project development costs for Brightwater,the Oxnard land development project, and general and administrative expenses,for at least the next 12 months.

 

We are subject to the usual obligations associated with entering intocontracts for the purchase of land and improved homesites. The purchase ofproperties under these contracts is generally contingent upon satisfaction ofcertain requirements 

 

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bythe sellers, including obtaining applicable property entitlements. We alsoutilize option contracts with third-party land sellers and financial entitiesas a method of acquiring land in staged takedowns and minimizing the use offunds from other corporate financing sources. These option contracts also helpto manage the financial and market risk associated with land holdings. Purchaseand option contracts generally require the payment of a non-refundable cashdeposit of 5% to 15% of the purchase price for the right to acquire lots over aspecified period of time (usually one to two years) at predetermined prices. Wehave the right at our discretion to terminate our obligations under these landpurchase and option agreements by forfeiting the cash deposit with no furtherfinancial responsibility. As of June 30, 2008, we have no consolidatedland option deposits. However, our unconsolidated Oxnard joint venture doeshave land deposits of $2.5 million.

 

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

 

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

 

Cash used in operating activities of $16.7 million for the firstnine months of 2008 primarily reflects investments in Brightwater of$20.0 million, which were partially offset by net proceeds of$9.1 million generated by nine deliveries at Brightwater and $4.1 millionof net cash flow generated by our inland projects ($5.8 million generatedfrom deliveries of 14 homes less $1.7 million of project investments).

 

Our primary sources of cash during the first six months of 2008 were$14.9 million of proceeds from sales of real estate inventories and $12.0million of net borrowings from our revolving loan. Our primary uses of cashduring the first six months of 2008 include $20.0 million of investments inBrightwater, $5.3 million of net repayments of other project debt and$3.3 million of net repayments of our term loan.

 

The $2.5 million increase in deferred tax assets reflects a $2.5million tax benefit for additional net operating losses generated during thefirst six months of 2008.

 

The $6.0 million decrease in accounts payable and accrued liabilitiesprimarily reflects reductions in accounts payable related to payments ofproject construction costs due to the declining level of construction activityat our inland projects and the substantial completion of land development andmodel home construction at Brightwater.

 

**OffBalance Sheet Financing**

 

In the ordinary course of business, we enter into land option contractsin order to procure land for the construction of homes. The use of such optionagreements allows us to reduce the risks associated with land ownership anddevelopment; reduce our financial commitments, including interest and othercarrying costs; and minimize land inventories. Under such land optioncontracts, we will fund a specified option deposit or earnest money deposit inconsideration for the right to purchase land in the future, usually at apredetermined price. Our liability is generally limited to forfeiture of thenonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of June 30, 2008, we have no consolidated land optiondeposits and no third 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.

 

Our investment in unconsolidated joint ventures totaled$3.1 million and $2.7 million at June 30, 2008 and December 31,2007. These joint ventures had total assets of $9.0 million and$9.7 million as of June 30, 2008 and December 31, 2007,respectively, which included land deposits of $2.5 million for bothperiods. In certain instances, we may provide varying levels of guarantees ondebt of unconsolidated joint ventures. As of June 30, 2008, we provide noguarantees on debt of unconsolidated joint ventures.

 

Under the requirements of FASB Interpretation No. 46(R), “*Consolidation of Variable Interest Entities*”(“FIN 46(R)”), certain of our land option contracts may create a variableinterest for us, with the land seller being identified as a VIE. In compliancewith FIN 46(R), we analyze our land option contracts and other contractualarrangements and consider whether we should consolidate the fair value ofcertain VIEs from which we are purchasing land under option contracts. As of June 30,2008, we had no consolidated deposits with VIEs.

 

 

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**Inflation**

 

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, since we generally contract to sell our homes before we beginconstruction, any inflation of costs in excess of those anticipated may resultin lower gross margins.

 

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

 

ITEM 3- QUANTITATIVE AND QUALITATIVE DISCLOSURES 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 do 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 June 30, 2008, each one pointpercentage increase in interest rates would result in an increase in variablerate interest incurred for the next 12 months of approximately$1.9 million.

 

We are exposed to market risks related to fluctuations in interestrates on our outstanding variable rate debt. Other than an interest rate swapused to manage our exposure to changes in interest rates on $62.5 millionof our variable rate-based Term Loan, we did not utilize swaps, forward oroption contracts on interest rates, or other types of derivative financialinstruments as of or during the three months ended June 30, 2008. We donot enter into or hold derivatives for trading or speculative purposes.

 

Under the Term Loan agreement, we were required to enter into a swapagreement to hedge against risks associated with fluctuating interest ratesrelated to $62.5 million of floating rate debt. On September 15, 2006we entered into an interest rate swap transaction to effectively fix theinterest rate on $62.5 million in floating rate debt at 8.015% per annumfor two years. The swap transaction terminates September 15, 2008. Theswap did not qualify for hedge accounting under SFAS No. 133. The fairvalue of the interest rate swap agreement represents the spread between theinterest rate we would pay and the interest rate we would receive over theremaining life of the agreement which are considered level 2 inputs under SFAS157. As of June 30, 2008, the fair value of the swap agreement isapproximately $400,000. The non-cash change in fair value of the interest rateswap agreement during the three and six months ended June 30, 2008 was anapproximately $300,000 increase and $200,000 decrease, respectively, and wasincluded in other expense, net in our consolidated statement of operations andin accounts payable and accrued liabilities in our consolidated balance sheet.In addition, we recorded $400,000 and $600,000 of expense for cash paymentsmade under the interest rate swap agreement during the three and six monthsended June 30, 2008, respectively, due to declining interest rates duringthe quarter. The counterparties to the interest rate swap agreement arefinancial institutions.

 

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.”

 

ITEM 4- EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

 

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

 

Ourchief executive officer and chief financial officer, with the assistance ofmanagement, evaluated the effectiveness of our disclosure controls andprocedures (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 provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. In addition, the design of a control system must reflect thefact that there are resource constraints and the benefits of controls must beconsidered relative to costs. Therefore, no cost-effective control system andno evaluation of controls can provide absolute assurance that all control issuesand instances of misstatements due to error or fraud, if any, within ourcompany have been detected.

 

*Changesin Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringthe three months ended June 30, 2008 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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PART II - OTHER INFORMATION

 

ITEM 1-                LEGAL PROCEEDINGS

 

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

 

ITEM1A -             RISK FACTORS

 

In addition to the 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 yearended December 31, 2007, which could materially affect our business,financial condition or future results. The risks described below and in ourAnnual Report on Form 10-K are not the only risks that we face. Additionalrisks and uncertainties not currently known to us or that we currently deem tobe immaterial also may materially adversely affect our business, financialcondition and/or operating results.

 

***Unlessamended, we do not expect to be able to make required principal payments underour existing debt instruments, or to maintain compliance with the covenants ormeet certain financial ratios that must be satisfied as conditions to incurringadditional indebtedness. .***

 

Given the number of homes currently under construction, we do notexpect to be able to generate enough cash flow from operations during 2008 tomake the currently scheduled debt repayments due on December 31, 2008.Therefore, during the second quarter of 2008, we commenced discussions with ourlenders regarding potential amendments to our Brightwater revolving loan andterm loan that would extend borrowing availability and extend the September 2009maturity date for the revolving loan. Amendments to the payment schedules andmaturity date of the revolving loan will require the unanimous consent of therespective bank syndicates. If the revolving loan and term loan are notamended, we would be required to make $29.2 million in aggregate principalpayments by December 31, 2008, of which $20.7 million would bepayable under the revolving loan (assuming we draw the remaining $7.7 millionavailable as of June 30, 2008) and $8.5 million would be payableunder the term loan.

 

We are currentlyout of compliance with certain financial covenants contained in our revolvingloan and term loan and are operating under a waiver which expires on October 6,2008. Therefore, we are seeking modification of these covenants toaccommodate the slower projected pace of sales. In exchange for theseamendments, we have offered to pay modification fees and an increase in theinterest rates charged under the revolving loan and term loan. As of August 11,2008, our negotiations remained ongoing with the members of the banksyndicates. There can be no assurance that the requested amendments to therevolving loan or term loan will be agreed to by our lenders. Current creditmarket conditions present uncertainty as to our ability to secure additionalfinancing, if needed, and the terms of such financing if it is available, andas to our ability to achieve positive cash flow from operations required tosatisfy our obligations.

 

If wereceive the requested loan amendments, there can be no assurance that we willbe able to meet the amended covenants, payment schedule or our otherrequirements in our revolving loan and term loan credit facilities if slowingmarket conditions worsen. If we are unable to comply with or meet any one ormore of our obligations under these loans, we could be precluded from incurringadditional borrowings and, in the event of default, our obligation to repayindebtedness outstanding under these loans could be accelerated in full. We cangive no assurance that in such an event, we would have, or be able to obtain,sufficient funds to pay all debt we are required to repay.

 

***Availability of Additional Liquidity***

 

The availability of additional capital, whether fromprivate capital sources (including banks) or the public capital markets,fluctuates as market conditions change. There may be times when the privatecapital markets and the public debt or equity markets lack sufficient liquidityor when our securities cannot be sold at attractive prices, in which case wewould not be able to access capital from these sources. Based on current marketconditions, our ability to effectively access these liquidity sources issignificantly limited. In addition, a further weakening of our financialcondition, including in particular a material decrease in our profitability orcash flows, could adversely affect our ability to obtain necessary funds orotherwise increase our cost of borrowing.

 

***The significant downturn in the homebuildingindustry is expected to continue throughout 2008 and into 2009 or beyond; thisdownturn has had a material adverse effect on our business and results ofoperations and is expected to continue.***

 

The housing industry downturn which began in 2006continues to have a material adverse effect on our business and results ofoperations, and this significant downturn will continue during the foreseeablefuture. We believe the principal factors that have caused this downturn includeeach of the following, the 

 

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impactof which varies between our inland and coastal projects:

 

·  decreased affordability of housing as a result of significant priceappreciation in the years preceding the downturn and tightened credit standardsfor homebuyers,

 

·  declining homebuyer demand due to lower consumer confidence in theresidential real estate market and an inability of many homebuyers to selltheir existing homes,

 

·  increased inventory of new and existing homes for sale, including theimpact of increases in residential foreclosures,

 

·  reduced availability and increased cost of mortgage financing due to thesignificant mortgage market disruptions, and

 

·  pricing pressures resulting from a variety of factors, including thedecision of homebuilders to offer significant discounts and sales incentives toliquidate unsold inventories in order to generate cash, and the need for homeprices to fall within mortgage qualification limits.

 

These conditions have led to, among other things,significant decreases in our homebuilding revenues and substantial land-relatedimpairments. As a result, our homebuilding operations incurred substantiallosses and may continue to do so. Any worsening in market conditions in thehomebuilding industry could have a further material adverse effect on ourbusiness and results of operations.

 

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

 

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

 

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

 

The government-sponsored enterprises, principallyFNMA and FHLMC, play a significant role in buying home mortgages and creatinginvestment securities that they either sell to investors or hold in theirportfolios. These organizations provide liquidity to the secondary mortgagemarket. FNMA and FHLMC have recently experienced financial difficulties. Anynew federal laws or regulations that restrict or curtail their activities, orany other events or conditions that prevent or restrict these enterprises fromcontinuing their historic businesses, could affect the ability of our customersto obtain the mortgage loans or could increase mortgage interest rates orcredit standards, which could reduce demand for our homes and/or the loans thatwe originate and adversely affect our results of operations.

 

In addition, the Housing and Economic Recovery Actof 2008 prohibits, as of October 15, 2008, seller funded downpaymentassistance programs. As a result of these trends, the ability and willingnessof prospective buyers to finance home purchases or to sell their existing homeshas been adversely affected, which has adversely affected our operatingresults. These conditions may continue or worsen.

 

***We may be unable to obtain suitable bonding for thedevelopment of our communities.***

 

We provide bonds to governmental authorities andothers to ensure the completion of our projects. If we are unable to providerequired surety bonds for our projects, our business operations and revenuescould be adversely affected. As a result of the recent deterioration in marketconditions, surety bond capacity has decreased and providers have becomeincreasingly reluctant to issue new bonds and some 

 

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providersare requesting credit enhancements in order to maintain existing bonds or toissue new bonds. If we are unable to obtain required bonds in the future, orare required to provide credit enhancements with respect to our current orfuture bonds, our liquidity could be negatively impacted.

 

***The homebuilding industry is highly competitiveand, with more limited resources than many of our competitors, we may not beable to compete effectively.***

 

The homebuilding industry is highly competitive. Wecompete with numerous other residential construction firms, including largenational and regional firms, for customers, land, financing, raw materials,skilled labor and employees. We compete for customers primarily on the basis ofthe location, design, quality and price of our homes and the availability ofmortgage financing. Some of our competitors have substantially largeroperations and greater financial resources than we do and as a result may havelower costs of capital, labor and materials than us, and may be able to competemore effectively.

 

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

 

***Our controlling stockholders are able to exercisesignificant influence over us.***

 

Five (5) of our stockholders have over 50% ofthe outstanding shares of our common stock. Their combined stock ownershipenables them to exert significant control over us, including power to controlthe election of our Board of Directors and to approve matters presented to ourstockholders. This concentration of ownership may also make some transactions,including mergers or other changes in control, more difficult or impossiblewithout their support. Also, because of their combined voting power,circumstances may occur in which their interests could be in conflict with theinterests of other stockholders.

 

***Our net operating loss carryforwards could be substantially limited ifwe experience an ownership change as defined in the Internal Revenue Code.***

 

Wecurrently have a substantial amount of net operating loss carryforwards. Section 382of the Internal Revenue Code contains rules that limit the ability of acompany that undergoes an ownership change, which is generally any change inownership of more than 50% of its stock over a three-year period, to utilizeits net operating loss carryforwards and certain built in losses recognized inyears after the ownership change. These rules generally operate byfocusing on ownership changes among stockholders owning directly or indirectly5% or more of the stock of a company or any change in ownership arising from anew issuance of stock by a company.

 

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

 

***We are subject to current credit market risks.***

 

Current credit market conditions present uncertaintyas to our ability to secure additional financing, if needed, and the terms ofsuch financing if it is available, or as to our ability to achieve positivecash flow from operations to satisfy our obligations.

 

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ITEM 3-                 DEFAULTS UPON SENIOR SECURITIES

 

Twoof our subsidiaries received a notice of financial covenant default fromIndyMac Bank relating to the $30.1 million outstanding under a $54.5 millionloan facility for the Hellman-Corona inland development project.  The default relates to the failure to meetspecified absorption rate and home closing requirements. As a consequence of thesedefaults, IndyMac Bank informed our subsidiaries that no further borrowingsunder the loan facility would be permitted until the defaults are cured.  There are no payment defaults with respect tothis loan facility.  The loan facility isnonrecourse to the Company.

 

 

ITEM 4 -                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Our Annual Meeting of stockholders was held on June 24,2008. A quorum of common stock was present in person or by proxy. The followingproposals were approved by the requisite vote of our stockholders entitled tovote, as follows:

 

**Proposal No. 1**:  *The Director Proposal*.  The director proposal recommended election offive directors to a one-year term. Set forth below is a table of how the voteswere cast for each nominee, which constituted the affirmative votes for allnominees, by the holders of at least 90.1% of the outstanding common stockrepresented in person or by proxy at the Annual Meeting.

 
| **Name**                  | ** ** | **Votes Cast “For Nominee”** | ** ** | **Votes “Withheld”** |
|---------------------------|------------|-------------------------------------------------------|------------|-------------------------------------|
|                      |       |                                                  |       |                                |
| Geoffrey W. Arens         |       | 9,728,373                                             |       | 60,132                              |
| Phillip R. Burnaman II    |       | 9,728,358                                             |       | 60,147                              |
| Marti P. Murray           |       | 9,729,473                                             |       | 59,032                              |
| Raymond J. Pacini         |       | 9,730,538                                             |       | 57,967                              |
| Thomas W. Sabin, Jr. |       | 9,730,343                                             |       | 58,162                              |

 

**Proposal No. 2**:     *The Auditor Proposal*.   The holders of common stock cast 9,773,743votes “for” and 12,407 votes “against” the proposal to ratify the appointmentof Deloitte & Touche, LLP as our independent registered publicaccounting firm for the fiscal year ending December 31, 2008. Such votesconstituted the affirmative vote “for” the Auditor Proposal by the holders ofapproximately 99.9% of the outstanding common stock represented in person or byproxy at the Annual Meeting. There were 2,355 abstentions and no brokernon-votes by the holders of shares of common stock with respect to the AuditorProposal.

 

ITEM 6-                EXHIBITS

 
| 31.1 |   | Section 302 Certificate of Raymond J. Pacini,  Chief Executive Officer of California Coastal Communities, Inc.                                                  |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Section 302 Certificate of Sandra G. Sciutto,  Chief Financial Officer of California Coastal Communities, Inc.                                                  |
| 32.1 |   | Section 906 Certificate of Raymond J. Pacini,  Chief Executive Officer and Sandra G. Sciutto, Chief Financial Officer of  California Coastal Communities, Inc.* |

 

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*              These certifications are being furnished solely toaccompany this report pursuant to 18 U.S.C. Section 1350, and are notbeing filed for purposes of Section 18 of the Securities Exchange Act of1934, as amended, and are not to be incorporated by reference into any filingof the Company, whether made before or after the date hereof, regardless of anygeneral incorporation language in such filing.

 

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Table of Contents

 

**SIGNATURE**

 

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

 
| Date: August 11, 2008 | CALIFORNIA COASTAL COMMUNITIES, INC. |
|----------------------------|--------------------------------------|
|                       |                                 |   |
|                       |                                 |   |
|                       | By:                                  | /s/ Sandra G. Sciutto |
|                       |                                 | SANDRA G. SCIUTTO |
|                       |                                 | Senior Vice President and |
|                       |                                 | Chief Financial Officer |
|                            |                                      |  |  |

 

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