** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| **(Mark  One)**                                                                                                                                                                           | ** ** | ** **                                                                                              |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                     | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                                                      |       |                                                                                                    |
| **For the quarterly period ended September  30, 2007**                                                                                                                                    |
|                                                                                                                                                                                      |       |                                                                                                    |
| **OR**                                                                                                                                                                                    |
|                                                                                                                                                                                      |       |                                                                                                    |
| **o**                                                                                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                      |       |                                                                                                    |
| **For the transition period from               to              ** |
|                                                                                                                                                                                      |       |                                                                                                    |
| **Commission file number: 0-17189**                                                                                                                                                       |

 

**CALIFORNIA COASTALCOMMUNITIES, INC.**

**(Exact name of registrant as specified 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)                            |

 

**(949) 250-7700**

(Registrant’s telephone number, including area code)

 

**Not applicable**

(Former name, former address and former fiscal year, if changed fromlast report)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES x  NO o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 
| **Large accelerated filer  ****o** | **Accelerated filer ****x** | **Non-accelerated filer ****o** |
|-----------------------------------------|----------------------------------|--------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct). YES o  NO x

 

Indicate the number of sharesoutstanding of each of the Issuer’s classes of common stock, as of the latestpracticable date:

 

As of October 29, 2007,10,855,963 shares of Common Stock par value $.05 per share were outstanding.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER30, 2007

 

I N D E X

 
| Cautionary Statement About Forward-Looking  Statements |                   |
|--------------------------------------------------------|------------------------|
|                                                   |                   |   |   |
| Part I -                                          | Financial Information: |   |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Consolidated Financial Statements |   |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Balance Sheets -  September 30, 2007 (unaudited) and December 31, 2006 |   |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of  Operations -  Three and Nine Months Ended September 30, 2007 and 2006 (unaudited) |   |
|                                                   |                   |   |   |
|                                                   |                   | Consolidated Statements of  Cash Flows -  Nine Months Ended September 30, 2007 and 2006 (unaudited) |   |
|                                                   |                   |   |   |
|                                                   |                   | Notes to Consolidated Financial  Statements |   |
|                                                   |                   |   |   |
|                                                   | Item  2 -              | Management’s  Discussion and Analysis of Financial   Condition and Results of Operations |   |
|                                                   |                   |   |   |
|                                                   | Item 3 -               | Quantitative and Qualitative  Disclosures About Market Risk |   |
|                                                   |                   |   |   |
|                                                   | Item 4 -               | Evaluation of Disclosure  Controls and Procedures |   |
|                                                   |                   |   |   |
| Part II -                                         | Other Information:     |   |
|                                                   |                   |   |   |
|                                                   | Item 1 -               | Legal Proceedings |   |
|                                                   |                   |   |   |
|                                                   | Item 1A -              | Risk Factors That May Affect  Results of Operations and Financial Condition |   |
|                                                   |                   |   |   |
|                                                   | Item 6 -               | Exhibits |   |
|                                                   |                   |   |   |
| SIGNATURE                                              |                   |

 

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CAUTIONARY STATEMENT ABOUTFORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statementswithin the meaning of Section 27A of the Securities Exchange Act of 1933 andSection 21E of the Securities Exchange Act of 1934 that relate to future eventsor our future financial performance. In addition, other statements we may makefrom time to time, such as press releases, oral statements made by ourofficials and other reports that we file with the Securities and ExchangeCommission may also contain such forward-looking statements. Undue relianceshould not be placed on these statements which involve known and unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from any future results,performances or achievements expressed or implied by the forward-lookingstatements. In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“believes,” “estimates,” “predicts,” “potential,” “continue,” or the negativeof such terms or other comparable terminology.

 

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

 

•                  statements aboutour strategies, plans, objectives, goals, expectations and intentions,including our platform for continued growth;

•                  informationrelating to anticipated operating results, financial resources, changes inrevenues, changes in profitability, interest expense, growth and expansion,anticipated income to be realized from our investments in unconsolidatedentities;

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

•                  housing marketconditions in the geographic markets in which we operate, including therelative impact of interest rates, jobs, land constraints, demographic trends,and the availability of mortgage financing;

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

•                  the ability todeliver homes from backlog;

•                  our strategicfocus on growing in existing markets and our focus on generating strongfinancial returns and conservatively managing our balance sheet;

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

•                  the ability tosecure materials and subcontractors;

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

•                  our expectedhomebuilding gross margin percentage, anticipated buyer demand, and expectedjoint venture income and deliveries;

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

•                  our ability tocontinue relationships with current or future partners;

•                  theeffectiveness and adequacy of our disclosure and internal controls;

•                  the impact ofrecent accounting pronouncements; and

•                  stock marketvaluations.

 

Any or all of the forward-looking 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, including consumer confidence,employment rates, interest rates, the cost and availability of mortgagefinancing, and stock market, home and land valuations; the demand for homes;fluctuations in interest rates and the availability of mortgage financing;changes in home prices; the availability and cost of land for future growth;the availability of capital; the cost and availability of construction financing;uncertainties and fluctuations in capital and securities markets; the cyclicaland competitive nature of our business; changes in tax laws and theirinterpretation; legal proceedings; the ability of customers to finance thepurchase of homes or sell existing homes; cancellations of purchase contractsby homebuyers; the availability and cost of labor and materials; delays in theland entitlement process, development, construction, or the opening of new homecommunities; the significant amount of our debt and the impact of restrictivecovenants in our loan agreements; adverse weather conditions; natural disasterssuch as earthquakes, wildfires and floods; domestic and international politicalevents; the impact on economic conditions of terrorist attacks or the outbreakor escalation of armed conflict involving the United States; litigation andwarranty claims; the effects of governmental regulation, including regulationsconcerning development of land, the home building industry, sales and customerfinancing processes, and the environment; future business decisions and ourability to successfully implement our operational, growth and other strategies;and other risks discussed in our filings with the Securities and ExchangeCommission.  Many factors

 

3

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mentioned in this report or in other reports or public statements madeby us, such as government regulation and the competitive environment, will beimportant in determining our future performance. Consequently, actual resultsmay differ materially from those that might be anticipated from ourforward-looking statements. You should not place undue reliance on any of theseforward-looking statements because they are based on current expectations orbeliefs regarding future events or circumstances, which involve known andunknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from any futureresults, performances or achievements expressed or implied by theseforward-looking statements.

 

Although we believe that our strategies, plans, objectives, goals,expectations and intentions reflected in, or suggested by these forward-lookingstatements are reasonable given current information available to us, we cangive no assurance that any of them will be achieved. Forward-looking statementsspeak only as of the date they are made. We undertake no obligation to publiclyupdate any forward-looking statements, whether as a result of new information,future events or otherwise. However, any further disclosures made on relatedsubjects in our subsequent reports on Forms 10-K, 10-Q and 8-K should beconsulted.

 

These forward-looking statements should be considered in light of theinformation included in this report and our other filings with the Securitiesand Exchange Commission, including, without limitation, the “Risk Factors” setforth 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, 2006. You should alsoread the following “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” in conjunction with the unaudited consolidatedfinancial statements and the related notes that appear elsewhere in thisreport.

 

We assume no, and hereby disclaim any, obligation to update any of theforegoing or any other forward-looking statements. We nonetheless reserve theright to make such updates from time to time by press release, periodic reportor other method of public disclosure without the need for specific reference tothis Form 10-Q or any other report filed by us. No such update shall be deemedto indicate that other statements not addressed by such update remain corrector create an obligation to provide any other updates.

 

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**PART I. FINANCIALINFORMATION**

 

**ITEM 1 – FINANCIAL STATEMENTS**

 

CALIFORNIA COASTAL COMMUNITIES,INC.

 

CONSOLIDATEDBALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                   | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                    |       | $                            | 5.2        |                        | $          | 10.6 |   |
| Short-term investments                                                                                                                       |       | —                       |       | .5                          |       |
| Restricted cash                                                                                                                              |       | 13.6                         |       | 14.6                        |       |
| Real estate inventories                                                                                                                      |       | 284.0                        |       | 264.8                       |       |
| Deferred tax assets                                                                                                                          |       | 45.7                         |       | 34.7                        |       |
| Other assets                                                                                                                                 |       | 7.0                          |       | 7.1                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 355.5      |                        | $          | 332.3 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                 |       |                         |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                     |       | $                            | 12.3       |                        | $          | 13.1 |   |
| Senior secured project revolver                                                                                                              |       | 61.7                         |       | 18.3                        |       |
| Senior secured term loan                                                                                                                     |       | 125.0                        |       | 125.0                       |       |
| Other project debt                                                                                                                           |       | 50.1                         |       | 44.9                        |       |
| Other liabilities                                                                                                                            |       | 7.0                          |       | 7.5                         |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Total liabilities                                                                                                                            |       | 256.1                        |       | 208.8                       |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Commitments and contingencies                                                                                                                |       |                         |       |                        |       |
|                                                                                                                                         |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                   |       |                         |       |                        |       |
| Common Stock—$.05 par value; 13,500,000  shares authorized; 10,855,963 and 10,852,708 shares issued and  outstanding, respectively |       | .5                           |       | .5                          |       |
| Excess Stock—$.05 par value; 13,500,000  shares authorized; no shares outstanding                                                       |       | —                       |       | —                      |       |
| Additional paid-in capital                                                                                                                   |       | 59.3                         |       | 62.3                        |       |
| Retained earnings                                                                                                                            |       | 41.1                         |       | 62.2                        |       |
| Accumulated other comprehensive loss                                                                                                         |       | (1.5                         | )          | (1.5                        | )          |
| Total stockholders’ equity                                                                                                              |       | 99.4                         |       | 123.5                       |       |
|                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                         |       | $                            | 355.5      |                        | $          | 332.3 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

5

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CALIFORNIA COASTAL COMMUNITIES,INC.

 

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 

(in millions, except per shareamounts)

 

(unaudited)

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                     | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | $                                                    | 5.2        |                                                | $          | 24.8 |   | $ | 21.6 |   | $ | 71.5 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Costs of sales:                                |       |                                                 |       |                                                |       |   |   |   |   |
| Homebuilding                                   |       | 5.0                                                  |       | 21.4                                                |       | 20.3 |   | 60.2 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Loss on impairment of real estate  inventories |       | 28.0                                                 |       | —                                              |       | 32.0 |   | — |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Gross operating (loss) profit                  |       | (27.8                                                | )          | 3.4                                                 |       | (30.7 | ) | 11.3 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative  expenses  |       | 1.7                                                  |       | 1.6                                                 |       | 4.8 |   | 4.7 |   |
| Interest expense                               |       | .1                                                   |       | —                                              |       | .1 |   | — |   |
| Income from unconsolidated joint ventures      |       | (.1                                                  | )          | (.1                                                 | )          | (.5 | ) | (.1 | ) |
| Other (income) expense, net                    |       | —                                               |       | (.3                                                 | )          | .1 |   | (.8 | ) |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| (Loss) income before income taxes              |       | (29.5                                                | )          | 2.2                                                 |       | (35.2 | ) | 7.5 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| (Benefit) provision for income taxes           |       | (12.0                                                | )          | .9                                                  |       | (14.3 | ) | 3.1 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net (loss) income                              |       | $                                                    | (17.5      | )                                                   | $          | 1.3 |   | $ | (20.9 | ) | $ | 4.4 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Net (loss) earnings per common share:          |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                          |       | $                                                    | (1.61      | )                                                   | $          | .12 |   | $ | (1.92 | ) | $ | .43 |   |
| Diluted                                        |       | $                                                    | (1.61      | )                                                   | $          | .12 |   | $ | (1.92 | ) | $ | .42 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Common equivalent shares:                      |       |                                                 |       |                                                |       |   |   |   |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                          |       | 10.9                                                 |       | 10.5                                                |       | 10.9 |   | 10.3 |   |
| Diluted                                        |       | 10.9                                                 |       | 10.7                                                |       | 10.9 |   | 10.6 |   |
|                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Dividends paid per common share outstanding    |       | $                                                    | —     |                                                | $          | 12.50 |   | $ | — |   | $ | 12.50 |   |

 

See the accompanying notes to consolidated financial statements.

 

6

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CALIFORNIA COASTAL COMMUNITIES,INC.

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
|                                                                              |       |                                                |       |   |   |
| Cash flows from operating activities:                                             |       |                                                |       |   |   |
| Net (loss) income                                                                 |       | $                                                   | (20.9      | ) | $ | 4.4 |   |
| Adjustments to reconcile net (loss) income  to cash used in operating activities: |       |                                                |       |   |   |
| Stock-based compensation expense                                                  |       | .1                                                  |       | .1 |   |
| Distributions from unconsolidated joint  ventures                                 |       | .1                                                  |       | .1 |   |
| Equity in earnings of unconsolidated joint  ventures                              |       | (.5                                                 | )          | — |   |
| (Increase) decrease in deferred tax assets                                        |       | (14.3                                               | )          | 3.1 |   |
| Excess tax benefits from share-based  payment arrangement                         |       | —                                              |       | (3.6 | ) |
| Gains on sales of real estate inventories                                         |       | (1.3                                                | )          | (11.3 | ) |
| Loss on impairment of real estate  inventories                                    |       | 32.0                                                |       | — |   |
| Proceeds from sale of real estate  inventories, net                               |       | 20.7                                                |       | 71.0 |   |
| Investments in real estate inventories                                            |       | (70.6                                               | )          | (76.5 | ) |
| Changes in assets and liabilities:                                                |       |                                                |       |   |   |
| Decrease (increase) in other assets                                               |       | .8                                                  |       | (.4 | ) |
| (Decrease) increase in accounts payable,  accrued and other liabilities           |       | (1.3                                                | )          | .5 |   |
|                                                                              |       |                                                |       |   |   |
| Cash used in operating activities                                                 |       | (55.2                                               | )          | (12.6 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash flows from investing activities:                                             |       |                                                |       |   |   |
| Sales of short-term investments                                                   |       | .5                                                  |       | 67.4 |   |
| Purchases of short-term investments                                               |       | —                                              |       | (38.4 | ) |
| Investments in unconsolidated joint  ventures                                     |       | (.3                                                 | )          | (.6 | ) |
| Change in restricted cash                                                         |       | 1.0                                                 |       | (12.1 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash provided by investing activities:                                            |       | 1.2                                                 |       | 16.3 |   |
|                                                                              |       |                                                |       |   |   |
| Cash flows from financing activities:                                             |       |                                                |       |   |   |
| Special dividend paid                                                             |       | —                                              |       | (135.7 | ) |
| Borrowings of senior secured project  revolver                                    |       | 43.4                                                |       | 9.0 |   |
| Borrowings of senior secured term loan                                            |       | —                                              |       | 125.0 |   |
| Borrowings of other project debt                                                  |       | 16.4                                                |       | 25.0 |   |
| Repayments of other project debt                                                  |       | (11.2                                               | )          | (25.8 | ) |
| Proceeds from exercise of stock options                                           |       | —                                              |       | 3.1 |   |
| Tax benefit from exercise of stock options                                        |       | —                                              |       | 3.6 |   |
| Deferred financing costs                                                          |       | —                                              |       | (3.1 | ) |
| Minority interest distributions                                                   |       | —                                              |       | (.3 | ) |
|                                                                              |       |                                                |       |   |   |
| Cash provided by financing activities                                             |       | 48.6                                                |       | .8 |   |
|                                                                              |       |                                                |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                             |       | (5.4                                                | )          | 4.5 |   |
|                                                                              |       |                                                |       |   |   |
| Cash and cash equivalents - beginning of  period                                  |       | 10.6                                                |       | 7.7 |   |
|                                                                              |       |                                                |       |   |   |
| Cash and cash equivalents - end of period                                         |       | $                                                   | 5.2        |   | $ | 12.2 |   |
|                                                                              |       |                                                |       |   |   |
| Supplemental disclosures of cash flow  information:                               |       |                                                |       |   |   |
| Cash paid during the period for income  taxes, net of refunds received            |       | $                                                   | .2         |   | $ | 4.7 |   |

 

See the accompanying notes toconsolidated financial statements.

 

7

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CALIFORNIA COASTAL COMMUNITIES,INC.

 

NOTES TOCONSOLIDATED 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 that theseunaudited consolidated financial statements reflect all material adjustments(consisting only of normal recurring adjustments) and disclosures necessary forthe fair presentation of the results of operations and statements of financialposition when read in conjunction with the Consolidated Financial Statementsand Notes thereto included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2006 and the current year’s previously issued QuarterlyReports on Form 10-Q. Intercompany accounts and transactions have beeneliminated.

 

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

 

**Note 2 - Significant Accounting Policies**

 

*Basis of Consolidation*

 

Certain of the Company’s wholly-owned subsidiaries are members in jointventures involved in the development and sale of residential projects andresidential loan production. The Company’s consolidated financial statementsinclude the Company’s accounts and all of its majority-owned and controlledsubsidiaries and joint ventures. The financial statements of joint ventures inwhich the Company has a controlling or majority economic interest (and thus arecontrolled by the Company) are consolidated with the Company’s financialstatements. Minority interest represents the equity interest of the Company’sjoint venture partner for one consolidated venture and is further described inNote 10 to the consolidated financial statements included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2006. The Company’sinvestments in unconsolidated joint ventures are accounted for using the equitymethod when the Company does not have voting or economic control of the ventureoperations, as further discussed in Note 4 to the consolidated financialstatements included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2006.

 

*Real Estate*

 

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 since it requires estimatesas to future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and dispose of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic, market, and environmental conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Accordingly,the ultimate values of the Company’s real estate properties depend upon futureeconomic and market conditions, and the availability of financing.

 

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

 

*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of real estate inventories andother long-lived assets in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, *“Accounting for theImpairment or Disposal of Long-Lived Assets”*, (“SFAS 144”) whichrequires that long-lived assets be reviewed for impairment whenever events orchanges in

 

8

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circumstances indicate that the carrying amount of an asset may not berecoverable. As provided by SFAS 144, impairment is evaluated by comparing anasset’s carrying value to the undiscounted estimated cash flows expected fromthe asset’s operations and eventual disposition. If the sum of the undiscountedestimated future cash flows is less than the carrying value of the asset, animpairment loss is recognized based on the fair value of the asset. Ifimpairment occurs, the fair value of an asset for purposes of SFAS 144 isdeemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction. Additionally, as appropriate, the Companyidentifies alternative courses of action to recover the carrying value of itslong-lived assets and evaluates all likely alternatives under aprobability-weighted approach as described in SFAS 144.

 

In accordance with SFAS 144, in developing estimated future cash flowsfor 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 impairment charges recorded during the three and nine months endedSeptember 30, 2007 are as follows (in millions):

 
| **Project**       | ** ** | **Location**                     | ** ** | **Three Months  Ended  September 30,  2007** | ** ** | **Nine Months  Ended  September 30,  2007** | ** ** |
|-------------------|------------|----------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
|              |       |                             |       |                                                   |       |                                                  |       |
| Inland Empire:    |       |                             |       |                                                   |       |                                                  |       |
| Chandler Ranch    |       | North Corona                     |       | $                                                      | .4         |                                                  | $          | .4 |   |
| Alisal at Ontario |       | Ontario                          |       | 1.8                                                    |       | 1.8                                                   |       |
| Woodhaven         |       | Beaumont                         |       | 3.9                                                    |       | 7.9                                                   |       |
| Hearthside Lane   |       | Corona                           |       | 16.5                                                   |       | 16.5                                                  |       |
| * *          |       | *Subtotal –  Inland Empire* |       | 22.6                                                   |       | 26.6                                                  |       |
|              |       |                             |       |                                                   |       |                                                  |       |
| Lancaster:        |       |                             |       |                                                   |       |                                                  |       |
| Quartz Hill       |       | Lancaster                        |       | 5.4                                                    |       | 5.4                                                   |       |
|              |       |                             |       |                                                   |       |                                                  |       |
| * *          |       | *Total –  All Projects*     |       | $                                                      | 28.0       |                                                  | $          | 32.0 |   |

 

The Company recorded additional impairment charges of $28.0 millionduring the third quarter of 2007 as a result of the continuing slowdown in thehousing market and the Company’s current expectations about the pace of salesand sales prices. To date, the Company has recorded impairment charges for fiveof its active projects. As required by SFAS 144, should market conditionsfurther deteriorate in the future or other events occur that indicate thecarrying amount of the Company’s real estate inventories may not berecoverable, the Company will reevaluate the expected cash flows from eachproject to determine whether any additional impairment exists at any point intime.

 

*Earnings Per Common Share*

 

Earnings per common share is accounted for inaccordance with SFAS No. 128, *“Earnings Per Share”*.Basic earnings per common share is computed using the weighted-average numberof common shares outstanding for the period. Diluted earnings per common shareis computed using the weighted-average number of common shares outstanding andthe dilutive effect of potential common shares outstanding. For the three andnine months ended September 30, 2006, the average market price of the Company’scommon stock exceeded the exercise price of outstanding stock options.Therefore, diluted earnings per share includes the dilutive effect of theweighted average number of common shares from the exercise of 12,500 optionsduring the second quarter of 2006, an additional 679,996 options which wereexercised during the third quarter of 2006 and the potential exercise of anadditional 15,000 options which remained outstanding at September 30, 2006.

 

9

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The table below sets forth the reconciliation of the denominator of theearnings per share calculation (in millions):

 
| ** **                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Shares used in computing basic earnings per  common share   |       | 10.9                                                 |       | 10.5                                                |       | 10.9 |   | 10.3 |   |
| Dilutive effect of stock options                            |       | —                                               |       | .2                                                  |       | — |   | .3 |   |
| Shares used in computing diluted earnings  per common share |       | 10.9                                                 |       | 10.7                                                |       | 10.9 |   | 10.6 |   |

 

*Recent Accounting Pronouncements*

 

In July 2006, the FASB issued FASB InterpretationNo. 48,  *“Accounting forUncertainty in Income Taxes”*, (“FIN 48”), which prescribes arecognition threshold and measurement process for recording in the financialstatements uncertain tax positions taken or expected to be taken in a tax return.Additionally, FIN 48 provides guidance on derecognition, classification,interest and penalties, accounting in interim periods and disclosurerequirements for uncertain tax positions. The accounting provisions of FIN 48are effective for reporting periods beginning after December 15, 2006. The Company adopted FIN 48 during the first quarter of 2007 and recorded a netreduction to deferred tax assets of $3.3 million. This reduction was recordedas a $3.1 million decrease in additional paid-in capital and a $200,000decrease in retained earnings as of January 1, 2007 as a cumulative effect of achange in accounting principle.

 

In September 2006, the FASB issued SFAS No. 157, *“Fair ValueMeasurements”* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal periods beginning after November 15,2007 (the Company’s fiscal year beginning January 1, 2008), and interim periodswithin those fiscal years. The Company is currently evaluating the impact ofadopting SFAS 157 on the consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, *“The Fair Value Option for Financial Assets and Financial Liabilities”*(“SFAS 159”), which expands the standards under SFAS 157 and provides entitiesa one-time election to measure financial instruments and certain other items atfair value. SFAS 159 is effective for financial statements issued for fiscalperiods beginning after November 15, 2007 (the Company’s fiscal year beginningJanuary 1, 2008). The Company is currently evaluating the impact of adoptingSFAS 159 on its consolidated financial statements.

 

**Note 3 – Real Estate Inventories**

 

Real estate inventories primarily consist of homesunder construction and lots under development at Brightwater and sevenadditional communities in four Southern California counties. At September 30,2007, real estate inventories aggregated 761 lots and homes, including 21 homescompleted and unsold, and 18 homes completed and in escrow. For the three andnine months ended September 30, 2007, real estate inventories reflects assetimpairment charges of $28.0 million and $32.0 million, respectively. Seeadditional discussion in Note 2. Real estate inventories at September 30, 2007included $208.9 million recorded for the Brightwater community which is locatedon a 105-acre parcel on a mesa north of the Bolsa Chica wetlands (“Upper Mesa”).Brightwater is under development for 356 homes as discussed below. In addition,real estate inventories include approximately 51 acres nearby which have beenoffered for dedication to the County of Orange for inclusion in the Harriet M.Weider Linear Park in conjunction with the development of Brightwater, and 51additional acres which are subject to a conservation easement. The carryingvalue of these two properties is zero. The Company capitalizes carrying costsincluding interest and property taxes, as well as direct construction costs, toreal estate inventories during the development and construction period.

 

The Brightwater planned communityoffers a broad mix of home choices, averaging 2,850 square feet and ranging insize from 1,710 square feet to 4,090 square feet. The community also has 37acres of open space and conservation area. With 349 homes permitted on 68 acresof the Upper Mesa, the resulting low-density plan equates to approximately fivehomes per acre, consistent and compatible with the neighboring Huntington Beachcommunities. In addition, the Company owns land adjacent to the Brightwaterdevelopment, on which it intends to process permits to build seven additionalhomes which will be included in the Brightwater community.

 

Model home construction for TheTrails and The Sands products was completed in July 2007. The Company beganselling homes at The Trails and The Sands in August 2007 and expects to begindelivering homes for these products during the fourth quarter of 2007. As of September30, 2007, there were 10 Brightwater homes in escrow at an average price of $1.2million for homes averaging 1,949 square feet. Construction of models for theremaining two products, The Cliffs and The Breakers, began during the firstquarter of 2007 and is expected to be completed in January 2008. The Companyexpects to

 

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begin offering homes for sale at The Cliffs and TheBreakers in February 2008. However, there can be no assurance in that regard,or as to the absence of further development or construction delay.

 

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

 

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

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Capitalized interest, beginning of period |       | $                                                    | 17.8       |                                                | $          | 6.5 |   | $ | 10.2 |   | $ | 6.1 |   |
| Interest incurred and capitalized         |       | 5.1                                                  |       | 1.6                                                 |       | 13.5 |   | 3.9 |   |
| Charged to cost of sales                  |       | (.3                                                  | )          | (.9                                                 | )          | (1.1 | ) | (2.8 | ) |
| Capitalized interest, end of period       |       | $                                                    | 22.6       |                                                | $          | 7.2 |   | $ | 22.6 |   | $ | 7.2 |   |

 

**Note 4 – Senior Secured Project Revolver**

 

On September 15, 2006, the Company entered into a three-year, $100Million Senior Secured Revolving Credit Agreement with KeyBank NationalAssociation, as a lender and agent for several other lenders (the “Revolving Loan”).The Revolving Loan is secured by a first trust deed on the Brightwater project,and stock pledges of the Company’s material subsidiaries. The Revolving Loanwill fund the first $100 million of development and construction costs for theproject.

 

BeginningDecember 31, 2008 and at the end of each subsequent quarter, thecommitment amount will decrease by $25 million until the commitment under theRevolving Loan is reduced to zero by the final maturity date on September 15,2009. The Revolving Loan is also subject to mandatory repayments based on 40%of the $600,000 release price on the first 50 units closed at the Brightwaterproject, and 40% of the $1 million release price per unit thereafter. Thesemandatory repayments are applicable to the commitment reductions set forthabove.

 

Under the Revolving Loan, the Company is required to comply with anumber of covenants, including a leverage covenant and a minimum consolidatedtangible net worth covenant of $100 million. As a result of the sustaineddownturn in the homebuilding industry, the tangible net worth covenant wasreduced to $80 million, effective as of September 30, 2007, for a fee of $142,500,with no change to the Company’s borrowing rate. As of September 30, 2007, theCompany was in compliance with its covenants. As of September 30, 2007, theCompany has taken impairment charges totaling $32.0 million which havenegatively affected the Company’s earnings and net worth.

 

Availability under the $100 million Revolving Loan is subject to theapplicable borrowing base limitations. The borrowing base limits lenderadvances to 50% of asset value. The borrowing base value is the appraised valueof the Brightwater project, increased for costs incurred subsequent to the mostrecent lender appraisal and reduced by 72% of the sales value of homesdelivered. The initial borrowing base value of the Brightwater project wasdetermined by an independent third-party appraisal of the project on an “as-is”basis as of July 6, 2006. Certain subsidiaries of the Company provided fullunconditional guarantees. The Revolving Loan includes financial covenants whichmay limit the amount that may be borrowed. Outstanding advances bear interestat the Company’s option at either (i) the Alternate Base rate (“Prime”) minus25 basis points or (ii) LIBOR plus 200 basis points.

 

As of September 30, 2007 and December 31, 2006, $61.7 million and$18.3 million, respectively, was outstanding under the Revolving Loan. As ofSeptember 30, 2007, the undrawn availability was $38.3 million, as limitedby the borrowing base formulas. Interest on the facility is calculated on theaverage, outstanding daily balance and is paid monthly. Interest incurred onthe Revolving Loan for the three and nine months ended September 30, 2007 was$900,000 and $2.1 million, respectively, at a weighted-average interest rate of7.31% and 7.32%, respectively, which reflects the Company’s elected rate ofLIBOR plus 2%.

 

Initial loan fees and closing costs of approximately $800,000 incurredfor the Revolving Loan on September 15, 2006 are deferred and included inother assets and amortized over the life of the loan. Amortization of thesecosts is included

 

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in the capitalization of interest allocated to real estate inventorieswhen incurred, and charged to cost of sales when the related homes aredelivered. As of September 30, 2007 and December 31, 2006, approximately$531,000 and $734,000, respectively, of deferred loan fees and closing costsrelated to the Revolving Loan are included in other assets.

 

**Note 5 – Senior Secured Term Loan**

 

On September 15, 2006, the Company entered into a five-year, $125Million Senior Secured Term Loan Agreement with KeyBank National Association,as a lender and agent for several other lenders (the “Term Loan”), and onSeptember 15, 2006, the Company borrowed the maximum loan amount of $125million. The proceeds were used to fund a “special dividend” of $12.50 pershare, totaling $135.7 million, to common stockholders paid on September 28,2006.

 

On December 31, 2008, September 30, 2009 and September 30, 2010, thecommitment amount will decrease by $15 million, $25 million, and $35 million,respectively. Thereafter, at the end of each subsequent quarter, the Term Loancommitment amount will decrease in four equal installments of $12.5 million,until the commitment under the agreement is reduced to zero by the finalmaturity date 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 price perunit thereafter. These mandatory repayments are applicable to the commitmentreductions set forth above.

 

Under the Term Loan, the Company is required to comply with a number ofcovenants, including covenants related to leverage, a minimum ratio of EBITDAto interest, and a minimum consolidated tangible net worth of$100 million. As a result of the sustained downturn in the homebuilding industry,the Term Loan was amended, effective as of September 30, 2007, for a fee of$187,500, with no change to the Company’s borrowing rate. The amendment reducedthe minimum ratio of EBITDA to interest covenant from a range of 1.0 to 2.5,phased in beginning in the first quarter of 2008 through the fourth quarter of2009, to a range of 1.00 to 2.5, phased in beginning in the third quarter of2008 through the fourth quarter of 2009 to provide greater operatingflexibility and accommodate the Company’s currently anticipated operatingresults for 2008. The Term Loan was also amended to reduce the tangible networth covenant from $100 million to $80 million, effective as of September 30,2007. As of September 30, 2007, the Company is in compliance with these covenants.As of September 30, 2007, the Company has taken impairment charges totaling$32.0 million which have negatively affected the Company’s earnings and networth.

 

Availability under the Term Loan is subject to the applicable borrowingbase loan to value limitations. The loan to value limits total lender advancesunder the Term Loan and the Revolving Loan to 65% of asset value. This is basedupon the appraised value of the Brightwater project, increased for costsincurred subsequent to the most recent lender appraisal and reduced by 72% ofthe sales value of homes delivered. The Term Loan is secured by a second trustdeed on the Brightwater project, and a general pledge and assignment of theCompany’s ownership interests in all material subsidiaries. All existingmaterial subsidiaries of the Company have provided full unconditionalguarantees. The Term Loan includes financial covenants which may limit theamount that may be outstanding. The outstanding balance bears interest at theCompany’s option at either (i) the prime interest rate plus 25 basis points, or(ii) LIBOR plus 275 basis points.

 

As of September 30, 2007 and December 31, 2006, $125 million wasoutstanding under the Term Loan. Interest on the Term Loan is calculated on theaverage, outstanding daily balance and is paid monthly. Interest incurred onthe Term Loan for the three and nine months ended September 30, 2007 was $2.7million and $7.9 million, respectively, at a weighted-average interest rate of8.10% and 8.08%, respectively, which reflects the Company’s elected rate ofLIBOR plus 2.75%.

 

Initial loan fees and closing costs of $2.3 million incurred for theTerm Loan on September 15, 2006 are deferred and included in other assetsand amortized over the life of the loan. Amortization of these costs isincluded in the capitalization of interest allocated to real estate inventorieswhen incurred, and charged to cost of sales when the related homes aredelivered. As of September 30, 2007 and December 31, 2006, approximately $1.8million and $2.2 million, respectively, of deferred loan fees and closing costsrelated to the Term Loan are included in other assets.

 

Under the Term Loan agreement, the Company was required to enter into aswap agreement to hedge against risks associated with fluctuating interestsrates related to $62.5 million of floating rate debt. On September 15, 2006 theCompany entered into an interest rate swap transaction to effectively fix theinterest rate on $62.5 million in floating rate debt at 8.015% per annum. Theswap transaction terminates in September 2008. Since the Company does not usederivative financial instruments for trading purposes, the swap did not qualifyfor hedge accounting under SFAS No. 133, *“Accounting for DerivativeInstruments and Hedging Activities”*. The fair value of the interestrate swap agreement represents the spread between the interest rate the Companypaid and the interest rate the Company would receive over the remaining life ofthe agreement, however, this was insignificant at September 30, 2007. Thechange in fair value of the interest rate swap

 

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agreement during the three and nine months ended September 30, 2007 wasnot material. The counterparties to the interest rate swap agreement are financialinstitutions.

 

**Note 6 – Other Project Debt**

 

In conjunction with the acquisitionof single-family residential lots, the Company’s homebuilding subsidiary,Hearthside Homes, Inc. and its subsidiaries, enter into construction loanagreements with commercial banks. These loan facilities finance a portion ofthe land acquisition and the majority of the construction of infrastructure andhomes. Each loan facility requires a guaranty of project completion and anenvironmental indemnity. The loans are secured by first trust deeds and bear aninterest rate of prime plus one-half or prime plus three-fourths percent (8.25%to 8.5% at September 30, 2007). Some of these loan facilities have a minimuminterest rate ranging from 5.75% to 7.5%. During the three and nine monthsended September 30, 2007, Hearthside Homes, Inc. did not enter into any newloan facilities.

 

During the third quarter of 2007,the Company extended the Beaumont loan for three months to December 17, 2007,with the option to exercise three additional three-month extensions subject toachieving minimum sales of four homes for each of the three-month periodsbeginning September 17, 2007, December 18, 2007 and March 18, 2008. Inaddition, during October 2007, the Company extended the Ontario and Lancasterloans to December 1, 2007 and September 30, 2008, respectively. The Company hastwo additional three-month extensions available for the Ontario loan, subjectto achieving minimum sales of two homes for each of the three-month periodsbeginning October 19, 2007 and January 18, 2008, or the equivalent repaymentminimums. The Lancaster loan extension requires minimum repayments of $1million per quarter by January 1, 2008, April 1, 2008 and July 1, 2008. Thefollowing amounts were available and outstanding under these loan facilities asof September 30, 2007 and December 31, 2006 ($ in millions):

 
| ** **      | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **         | ** ** | **Outstanding at**      | ** ** |
|-----------------|------------|------------------------------|------------|--------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **      | ** ** | **Amount  of Facility** | ** ** | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|            |       |                         |       |                     |       |               |       |                         |       |   |   |
| Rancho Santa Fe |       | $                            | 10.4       |                     | —     |               | —     |                         | $          | — |   | $ | 3.8 |   |
| Corona-Chandler |       | 14.8                         |       | —                   |       | —             |       | —                       |       | .8 |   |
| Corona-Chandler |       | 1.9                          |       | —                   |       | —             |       | —                       |       | 1.9 |   |
| Beaumont        |       | 17.9                         |       | 82                       |       | 12/17/07           |       | 11.0                         |       | 10.7 |   |
| Ontario         |       | 11.7                         |       | 15                       |       | 1/19/08            |       | 3.9                          |       | 4.6 |   |
| Lancaster       |       | 14.0                         |       | 69                       |       | 9/30/08            |       | 3.2                          |       | 2.2 |   |
| Corona-Hellman  |       | 54.5                         |       | 151                      |       | 1/7/09             |       | 32.0                         |       | 20.9 |   |
|            |       |                         |       |                     |       |               |       |                         |       |   |   |
|            |       |                         |       |                     |       |               |       | $                            | 50.1       |   | $ | 44.9 |   |
|                 |            |                              |            |                          |            |                    |            |                              |            |  |  |  |  |  |

 

**Note 7 - Other Liabilities**

 

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

 
| ** **                                          | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                       |       | $                            | 3.9        |                        | $          | 4.1 |   |
| Home warranty reserves                              |       | 2.2                          |       | 2.4                         |       |
| Contingent indemnity and environmental  obligations |       | 1.3                          |       | 1.4                         |       |
| Unamortized discount                                |       | (.4                          | )          | (.4                         | )          |
|                                                |       | $                            | 7.0        |                        | $          | 7.5 |   |

 

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

 

*Home Warranty Reserve*

 

The Company provides a home warranty reserve to reflect its contingentobligation for product liability. The Company generally records a provision ashomes are delivered, based upon historical and industry experience, for theitems listed in the homeowner warranty manual, which does not include itemsthat are covered by manufacturers’ warranties or

 

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items that are not installed by the Company’s employees or contractors.The home warranty reserve activity is presented below (in millions):

 
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                     | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Balance at beginning of period |       | $                                                    | 2.4        |                                                | $          | 2.2 |   | $ | 2.4 |   | $ | 2.1 |   |
| Provision                      |       | .1                                                   |       | .3                                                  |       | .3 |   | .5 |   |
| Payments                       |       | (.3                                                  | )          | (.1                                                 | )          | (.5 | ) | (.2 | ) |
| Balance at end of period       |       | $                                                    | 2.2        |                                                | $          | 2.4 |   | $ | 2.2 |   | $ | 2.4 |   |

 

**Note 8 - Income Taxes**

 

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

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Current taxes                        |       | $                                                    | —     |                                                | $          | (.7 | ) | $ | — |   | $ | — |   |
| Deferred taxes                       |       | (12.0                                                | )          | 1.6                                                 |       | (14.3 | ) | 3.1 |   |
| Provision (benefit) for income taxes |       | $                                                    | (12.0      | )                                                   | $          | .9 |   | $ | (14.3 | ) | $ | 3.1 |   |

 

The net deferred tax balance at September 30, 2007 and December 31,2006 is primarily composed of federal net operating losses (“NOLs”). TheCompany has concluded that it is “more likely than not” that the Company willbe able to generate sufficient taxable income to realize such assets.Therefore, the Company has no valuation allowance related to the potentialutilization of its deferred tax assets due to uncertainties. Such uncertaintiesinclude the availability of real estate for development at economically viableprices, government approvals, results of litigation and economic factorsaffecting the Company’s operations. The Company monitors these, as well asother positive and negative factors that may arise in the future, as itassesses the need for a valuation allowance against its deferred tax assets.

 

The federal NOLs available as of September 30, 2007were approximately $137 million. The amount of federal NOLs which expire if notutilized is zero for 2007 and $3 million, $11 million, $49 million, $42million, and $32 million for 2008, 2009, 2010, 2011 and thereafter,respectively.

 

The Internal Revenue Code (the “Code”) generally limitsthe availability of NOLs if an ownership change occurs within any three-yearperiod under Section 382. If the Company were to experience an ownership changeof more than 50%, the use of all remaining NOLs would generally be subject toan annual limitation equal to the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate (4.5% as ofOctober 2007) plus (ii) recognized built-in-gains, defined as those gainsrecognized within five years of the ownership change subject to an overalllimitation of the net unrealized built-in gains existing as of the ownershipchange date. The Company believes it has net unrealized built-in gainssufficient to allow utilization of the entire net operating loss, assuming thatthe Company is able to recognize these gains within the five-year timelimitation. The Company estimates that after giving effect to varioustransactions by stockholders who hold a 5% or greater interest in the Company,it has experienced a three-year cumulative ownership shift of approximately 37%as of October 29, 2007, as computed in accordance with Section 382.

 

On September 18, 2006, the Company’s Board ofDirectors suspended enforcement of the Company’s charter documents thatrestrict stockholders from acquiring more than 5% of the outstanding shares ofCommon Stock. The Board determined that such restrictions were not currentlyrequired to preserve the tax benefits of the Company’s $137 million of NOLs.While the Company remains subject to Code section 382, which limits theavailability of NOLs in the event of an ownership change, the Company wouldhave five years from the date of any such ownership change to recognize itsbuilt in gains and utilize its NOLs. With the commencement of construction at Brightwaterin 2006, and the related built-in-gain of the project, the Company believes itwill fully utilize its NOLs within the next five years if an ownership changedoes occur; however, the Board may reinstitute the 5% ownership limitation ifrequired by currently unanticipated events.

 

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

 

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*Uncertain Tax Positions*

 

The Company adopted the provisions of FASB Interpretation No. 48, *“Accounting for Uncertainty in Income Taxes”* (“FIN 48”), onJanuary 1, 2007. As a result of the implementation of FIN 48, during the firstquarter of 2007, the Company recorded a $5.1 million decrease in deferred taxassets for unrecognized tax benefits, which was offset by an increase indeferred tax assets of $1.8 million for assets re-evaluated as recognizable.The net change in deferred tax assets of $3.3 million resulted in a decrease tothe January 1, 2007 retained earnings balance of $200,000 and a decrease to theadditional paid in capital balance of $3.1 million related to fresh-startaccounting pursuant to a 1997 pre-packaged bankruptcy. There have been nochanges to this amount during the three and nine month periods ended September30, 2007. Of the Company’s unrecognized tax benefits of $5.1 million atSeptember 30, 2007, $200,000 would decrease the Company’s effective tax rate ifrecognized. The Company does not believe that its unrecognized tax benefitswill significantly fluctuate or change within twelve months of the reportingdate.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of September 30, 2007,the Company has not recorded any interest or penalties related to unrecognizedtax benefits.

 

The tax years 2003-2006 remain open to Federal and Californiaexamination, which are the Company’s primary tax jurisdictions. The Company hasutilized NOLs generated between 1990 and 1994 to offset taxable income in thoseyears and expects to utilize NOLs generated between 1994 and 1997 and in 1999, 2006and 2007 in future years.

 

**Note 9 - Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company is subject to the usual obligations associated withentering into contracts for the purchase of land and improved home sites. Thepurchase of properties under these contracts is generally contingent uponsatisfaction of certain requirements by the sellers, including obtainingapplicable property entitlements. The Company also utilizes option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Option contracts generally requirethe payment of a non-refundable cash deposit of 5% to 15% of the purchase pricefor the right to acquire lots over a specified period of time (usually one totwo years) at predetermined prices. The Company has the right at its discretionto terminate its obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As ofDecember 31, 2006, the Company had one consolidated $25,000 land option depositwhich was refunded in September 2007.

 

The Company has outstanding performance and suretybonds, for the benefit of city and county jurisdictions, related principally toits obligations for site improvements at various projects at September 30, 2007.The Company does not believe that draws upon these bonds, if any, will have amaterial effect on the Company’s financial position, results of operations orcash 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 Company is developing a land plan forthe area, which also includes an additional 149 acres owned by otherlandowners, with the intention of entitling the property for residentialdevelopment and annexing it into Oxnard. During October 2003, the Companyentered into a limited liability company joint venture agreement with a majorfinancial partner to pursue the Oxnard development opportunity. The Companyassigned the land purchase option contracts to the Oxnard limited liabilitycompany (“Oxnard LLC”). Hearthside Homes, Inc., the Company’s homebuildingsubsidiary, is the managing member of the Oxnard LLC.

 

The Oxnard LLC is funded by both of its members. Hearthside Homes, Inc.made an initial contribution of $500,000. The non-managing member also made aninitial contribution of $500,000 to the joint venture and, as of December 31,2005, had made an aggregate of $4 million of first tier additionalcontributions. In June 2007, the members agreed to provide up to an additional$5.7 million, to be contributed equally by the members, to complete thebusiness plan. As of September 30, 2007, the members have contributed anaggregate of $3.1 million of additional capital. During the three and ninemonths ended September 30, 2007, the members each contributed approximately$224,000 and $347,000, respectively, to the Oxnard LLC.

 

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The Company’s total investment in the Oxnard LLC as of September 30,2007 is $2.4 million. The Company expects to make additional aggregate capitalcontributions of approximately $140,000 to the Oxnard LLC during the remainingthree months of 2007, bringing the Company’s total expected investment to $2.6million. During the first nine months of 2008, the Company expects to makeadditional aggregate capital contributions of up to approximately $1.2 million.

 

In addition to the land purchase options for the project property, theOxnard LLC held a land purchase option which controlled property which wasexpected to provide fill dirt for the project property. On April 16, 2007, theOxnard LLC sold the non-project land purchase option for $1.8 million since theventure has contracted for an alternate source for the fill dirt. The OxnardLLC received net proceeds of approximately $1.6 million and is utilizing theproceeds to fund ongoing entitlement and development costs.

 

While the Company exerts a large degree of influence over the venture,the Company’s partner does have various substantive participating rights suchas approval rights with regard to the majority of business decisions, includingapproval of project budgets.

 

*Legal Proceedings*

 

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

 

*California Department of Toxic SubstancesControl*

 

On October 13, 2006, the California Department of Toxic SubstancesControl (“DTSC”) filed a civil complaint against the Company’s HearthsideResidential Corp. subsidiary (“HRC”) in the Federal District Court for theSouthern Division of the Central District of California. The DTSC’s complaintrequests that HRC pay for approximately $1.0 million of costs incurred by theDTSC, together with interest on that amount, primarily in connection with theoversight and remediation of PCB contamination found on residential propertiesadjacent to a 43-acre site where HRC completed the removal of PCB contaminatedsoil during September 2005. HRC’s remediation process was approved by the DTSCin December 2005 when it issued a final acceptance of the remediation work. Thecomplaint also seeks an order for HRC to pay any future costs which may beincurred in connection with further remediation, together with court costs andattorney’s fees.

 

Since May 2004, HRC has received invoices from DTSC seekingreimbursement for these costs; however, HRC contends, based upon advice ofcounsel, that it is not responsible for such costs because neither HRC nor anyaffiliate ever developed or built the neighboring residential properties,neither HRC nor any affiliate generated the contamination, and thecontamination did not emanate from the 43-acre site that HRC remediated.Furthermore, HRC has also disputed such charges due to the fact that DTSCimproperly submitted its bill. This litigation is currently scheduled for atrial date in the fourth quarter of 2008. The Company’s subsidiary intends tovigorously defend itself in this matter. Therefore, the Company has not accruedfor any of DTSC’s approximately $1.0 million of claims related to theseresidential properties.

 

See Note 7 for a discussion of other contingencies.

 

*Corporate Indemnification Matters*

 

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

 

**Note 10 – Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

The 1993 Stock Option/Stock Issuance Plan (“1993 Plan”) was approved atthe 1994 Annual Meeting of Stockholders, reserving 7.5 million shares each ofSeries A Preferred Stock and Class A Common Stock for issuance to

 

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officers, key employees and consultants of the Company and itssubsidiaries and the non-employee members of the Board of Directors (the “Board”).On April 28, 1997, in connection with the Recapitalization, a new class ofCommon Stock replaced the Series A Preferred Stock and Class A Common Stock,and the Compensation Committee of the Board authorized the grant of stockoptions for 759,984 shares, equivalent at that time to 6% of the Company’sfully diluted equity, for certain directors and officers. At the May 2004 andJune 2006 stockholder meetings, the stockholders of the Company authorized anadditional 150,000 and 250,000 stock options, respectively, for the 1993 Plan,resulting in total authorized grants of 1,159,984.

 

In January 2007, the Company issued a totalof 3,255 shares of its common stock to three independent directors under theDirector Fee Program, which is a component of the 1993 Plan. These shares vestat the rate of 25% per quarter during 2007. The Company did not grant anyoptions during the three and nine months ended September 30, 2007. During thecomparable periods of 2006, the Company granted 2,500 and 7,500 options,respectively, with a fair value of $24,000 and $71,000, respectively. Thegrants vest 50% after one year and 100% after two years, and the options have aterm of 10 years. Pursuant to SFAS 123 and SFAS 123(R), the Company recorded$28,000 and $98,000 of compensation expense during the three and nine monthsended September 30, 2007, respectively, which is reflected in additionalpaid-in capital. During the comparable periods of 2006, the Company recorded$20,000 and $54,000 of compensation expense. A summary of the status of theCompany’s 1993 Plan for the nine months ended September 30, 2007 follows:

 
| ** **                                    | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                        |       | 17,500                      |       | $                                     | 21.58      |                                  |       |   |
| Granted                                       |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                     |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, September 30                     |       | 17,500                      |       | $                                     | 21.58      |                                  | 8.35 years |   |
|                                          |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at September  30 |       | 15,000                      |       | $                                     | 26.03      |                                  | 8.22 years |   |
| Available for future grants at September 30   |       | 361,733                     |       |                                  |       |                                  |       |

 

As of September 30, 2007, there were 17,500 optionsoutstanding with a weighted-average exercise price of $21.58 (ranging from$13.35 to $25.99) and a weighted-average remaining life of 8.35 years. Alloutstanding unvested stock options are expected to vest. The aggregateintrinsic value of all outstanding, fully-vested and exercisable stock optionsat September 30, 2007 was insignificant.

 

The Company adopted SFAS 123(R) in the first quarterof 2006 using the modified prospective method. Similar to SFAS 123, which theCompany adopted in 2003, SFAS 123(R) requires the cost of all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values measured atthe grant date, or the date of later modification, over the requisite serviceperiod. For tax purposes, the Company expects to be entitled to a taxdeduction, subject to certain limitations, based on the fair value of certainequity awards when stock options are exercised. SFAS****123(R) requires that compensation cost be recognized in thefinancial statements based on the fair value measured at the grant date, or thedate of later modification, over the requisite service period. The cumulativecompensation cost recognized for equity awards pursuant to SFAS 123(R) andamounts that ultimately will be deductible for tax purposes are temporarydifferences as prescribed by SFAS 109,*******“Accounting for Income Taxes”*. The tax effect of compensationdeductions for tax purposes in excess of compensation cost recognized in thefinancial statements, if any, will be recorded as an increase to additionalpaid-in capital when realized. A deferred tax asset recorded for compensationcost recognized in the financial statements that exceeds the amount that isultimately realized on the tax return, if any, will be charged to income taxexpense when the restrictions lapse or stock options are exercised or expireunless the Company has an available additional paid-in capital pool (“APIC Pool”),as defined pursuant to SFAS 123(R). The Company is required to assess whetherthere is an available APIC Pool when the stock options are exercised or expire.

 

SFAS 123(R) also amends SFAS 95, *“Statementof Cash Flows”*, to require companies to change the classification inthe statement of cash flows of any tax benefits realized upon the exercise ofstock options or issuance of nonvested share unit awards in excess of thatwhich is associated with the expense recognized for financial reportingpurposes. These amounts are required to be reported as a financing cash inflowrather than as a reduction of income taxes paid in operating cash flows.

 

In addition, SFAS 123(R) requires a calculation to establish thebeginning pool of excess tax benefits, or the additional paid-in capital pool (“APICpool”), available to absorb any tax deficiencies recognized after the adoptionof SFAS 123(R). The Company has elected the alternative transition method,which includes a simplified calculation method, set forth in FASB StaffPosition No. FAS 123(R)-3, *“Transition ElectionRelated to Accounting for the Tax Effects of Share-Based Payment Awards”*to calculate its beginning APIC pool.

 

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The Company estimates the fair value of its stockoptions using the Black-Scholes option pricing model (the “Option Model”). The Option Model requires the use of subjective and complex assumptions,including the option’s expected term and the estimated future price volatilityof the underlying stock, which determine the fair value of the share-basedawards.  The Company’s estimate of expected term in 2006 was determinedbased on the weighted-average period of time that options granted are expectedto be outstanding considering current vesting schedules and the historicalexercise patterns of the existing option plan.  The expected volatilityassumption used in the Option Model is based on historical volatility of theCompany’s stock in accordance with guidance provided in SFAS 123(R) and SAB107.  The risk-free interest rate used in the Option Model is based on theyield of U.S. Treasuries with a maturity closest to the expected term of theCompany’s stock options.

 

Theweighted-average assumptions used for stock option grants during the ninemonths ended September 30 follows:

 
| ** **               | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Risk-free interest rate  |       | n/a      |       | 5.0      | %          |
| Expected life (in years) |       | n/a      |       | 4        |       |
| Expected volatility      |       | n/a      |       | 23.0     | %          |
| Expected dividends       |       | None     |       | None     |       |

 

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ITEM 2 -MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS

 

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

 

We are a residential land development and homebuilding company withproperties owned or controlled in five Southern California counties (LosAngeles, Orange, Riverside, San Bernardino and Ventura). Our principalactivities include:

 

•                  obtaining zoningand other entitlements for land we own or control through purchase options orjoint ventures;

 

•                  improving theland for residential development; and

 

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

 

Once our residential land is entitled, we may build homes, sellunimproved land to other developers or homebuilders, sell improved land tohomebuilders, or participate in joint ventures with other developers, investorsor homebuilders to finance and construct infrastructure and homes. The majorityof our homes are designed to appeal to move-up homebuyers and are generallyoffered for sale in advance of their construction. During the next 12 months,we will focus our primary efforts to:

 

•                  begin deliveringhomes for The Trails and The Sands neighborhoods at our 356-home Brightwaterproject located on the Bolsa Chica mesa in Huntington Beach, California inDecember 2007;

 

•                  complete modelhome construction for The Cliffs and The Breakers neighborhoods at our 356-homeBrightwater project and begin offering homes for sale in February 2008;

 

•                  complete theentitlement process for a 168-acre joint venture project near Oxnard,California currently being planned for 554 single-family detached homes and 347attached homes (townhomes, condominiums and apartments) during 2008; and

 

•                  maximizedeliveries and revenues of our other homebuilding projects throughout SouthernCalifornia.

 

However, we may also consider other strategic opportunities; and therecan be no assurance that we will accomplish, in whole or in part, all or any ofthese strategic goals.

 

Our total revenues for the three months ended September 30, 2007 and2006 were $5.2 million and $24.8 million, respectively, and $21.6 million and$71.5 million for the nine months ended September 30, 2007 and 2006,respectively. For the three months ended September 30, 2007 and 2006, wedelivered 12 and 36 homes, respectively, and for the nine months endedSeptember 30, 2007 and 2006, we delivered 36 and 113 homes, respectively. Ourtotal assets as of September 30, 2007 and December 31, 2006 were $355.5 millionand $332.3 million, respectively. Our homebuilding subsidiary, HearthsideHomes, Inc., has delivered over 2,000 homes to families throughout SouthernCalifornia since its formation in 1994.

 

Prior to obtaining the Coastal Development Permit for our Brightwaterproject in December 2005, we historically maintained a minimal amount ofleverage. In September 2006, we obtained $225 million of debt financing asdescribed in Notes 4 and 5 to the consolidated financial statements in thisForm 10-Q, which provided $125 million to fund the $12.50 special dividend toour stockholders on September 28, 2006 that is described in Note 13 to theconsolidated financial statements in our Annual Report on Form 10-K for theyear ended December 31, 2006. As of September 30, 2007, we had $236.8 millionof debt against $99.4 million of book equity and a $133.3 million equity marketcapitalization.

 

We were formed in 1988 and our executive offices are located at 6Executive Circle, 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, and amendments tothese reports filed or furnished pursuant to Section 13(d) or 15(d) of theSecurities Exchange Act of 1934 as soon as reasonably practicable after they arefiled with, or furnished to, the Securities and Exchange Commission. Copies ofour Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, andamendments to these reports are available free of charge upon request. Inaddition, at our website we post current versions of our code of ethics, auditcommittee charter and nominating committee charter.

 

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**Outlook**

 

Our homebuilding outlook varies significantly betweenthe high-end coastal location of our Brightwater project in Huntington Beachand our inland projects. Conditions in the Inland Empire and Lancaster marketscontinue to be very challenging and we expect these conditions to continuethrough 2008 or 2009.

 

While our Brightwater community is exposed to current uncertainties inthe housing market which have affected consumer behavior, we remain optimisticabout sales at Brightwater due to the limited supply of new home communities onthe coast and the absence of competition from other homebuilders in theHuntington Beach market. Given today’s challenging market conditions, we arepleased to have 10 sales orders for The Trails and The Sands neighborhoods asof September 30, 2007 (discussed below under “Our Current and FutureHomesites—Brightwater at Bolsa Chica”). We expect the sales pace to increase atBrightwater after we open the larger model homes for The Cliffs and TheBreakers in February 2008. While price competition is essential for usto sell homes in our inland markets, we do not plan to offer discounts atBrightwater, which represents one of the last opportunities to purchase a newhome in a master-planned community on the Southern California coast.

 

The housing market downturn that began in 2006 continued into the firstnine months of 2007 and is expected to continue through 2008 or 2009. Thesustained softness in the housing market is compounded by ongoing difficultiesin the mortgage lending industry and the continued tightening of creditavailable to some homebuyers. During the third quarter of 2007, net new ordersincreased to 23 homes compared with 17 homes during the comparable period of2006, primarily due to the grand opening of The Trails and The Sands atBrightwater in August 2007 which yielded 10 sales orders. Cancellations as apercentage of new orders were 28% during the third quarter of 2007, comparedwith approximately 31% during the first half of 2007, 41% for the fourthquarter of 2006, and 37% for the third quarter of 2006. There were nocancellations at Brightwater during the third quarter of 2007. Backlog as ofSeptember 30, 2007 decreased to 28 homes compared with 31 homes as of September30, 2006 due to fewer homes in backlog at June 30, 2007 and reduced salesactivity in our Inland Empire and Lancaster markets during the first ninemonths of 2007.

 

This sales slowdown reflects an overall softening ofdemand for new homes, as well as an oversupply of homes available for sale. Weattribute the reduction in demand to reduced affordability of new homes due torapid price increases between 2002 and 2005 and declines in consumer confidencerelated to concerns on the part of prospective home buyers about the futuredirection of home prices, and their ability to obtain financing and sellexisting homes. In addition, speculators and investors are no longer helping tofuel demand. We try to avoid selling homes to speculators and start few homeswithout having a signed agreement of sale. As of September 30, 2007 we hadstanding inventory of 21 homes compared with 46 homes as of December 31, 2006and 33 homes as of June 30, 2007.

 

We have also been impacted by an overall increase inthe supply of homes available for sale in our markets as certain largehomebuilders continue to build product in excess of current demand and as speculatorsattempt to sell the homes they previously purchased. At the same time, many ofthe large national homebuilders operating in our markets are aggressivelyattempting to reduce their inventories by offering significant incentivesand/or lowering prices, leading to lower gross margins on home sales.

 

As the housing market downturn continues to unfold, wecontinue to adjust and reevaluate our operating strategy to improve our marginsand liquidity. Our operating strategy includes:

 

•      continuingto assess our owned land position to identify those assets that should be soldor repositioned;

 

•                  adjusting our cost structure to today’s marketconditions by rebidding subcontracts and materials in line with reduced demand;

 

•                  offering more incentives and price reductions at ourinland projects to reduce standing inventories and achieve acceptable levels ofsales volume and cash flow; and

 

•      limitingconstruction starts to better align with sales activity.

 

Despite the housing market slowdown, we continue toremain cautiously optimistic about the future growth of our business given thepotential of our Brightwater project. The long-term outlook for homebuilding inSouthern California remains strong due to the continuing regulation-inducedconstraints on lot supplies. We have traditionally employed a conservativeapproach to managing our real estate inventories and believe we arewell-positioned, with Brightwater representing 74% of our real estateinventories, to withstand the effects of the continuing market downturn. Whilethe

 

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current weaknesses in the homebuilding market has impacted ourBrightwater project, that impact appears less severe than the weakness in ourinland markets. We believe that the reduced impact is a result of Brightwater’ssuperior coastal location, the extremely limited supply of new homes on thecoast of Southern California and the absence of significant competition fromother homebuilders in the Huntington Beach market. However, there can be noassurance that further negative impacts will not occur, and there issubstantial uncertainty regarding the depth and duration of the currentdownturn in the Southern California residential real estate market.

 

In particular, the following events may exertrecessionary pressures on the Southern California economy and may have furthernegative impacts on the Southern California housing market: (i) the ongoingdifficulties in the mortgage lending industry and more stringent lendingstandards which have negatively impacted the ability of certain homebuyers toobtain financing, (ii) increases in foreclosures due to interest rateadjustments on variable rate or “teaser” rate mortgages and other factors,(iii) the significant increases in home prices between 2002 and 2005 and therelated decline in the affordability of new homes in Southern California, (iv)the decline in consumer confidence with respect to the housing market, (v) thestate of the national economy and the possibility of a recession in the future,and (vi) uncertainties with respect to inflation and the direction of futureinterest rate changes.

 

**Our Current and Future Homesites**

 

We currently have on-going Southern California homebuilding projectsin:

 

•                  Orange County inthe Huntington Beach area;

 

•                  Riverside Countynear the cities of Corona and North Corona, and in the City of Beaumont;

 

•                  San BernardinoCounty in the City of Ontario; and

 

•                  Northern LosAngeles County in the City of Lancaster.

 

We started selling homes at our Brightwater community in Orange Countyduring August 2007 and plan to process permits for seven homes on adjacentparcels in the City of Huntington Beach, which would bring the total unit countup to 356. The following chart describes our current projects, their location andour lot inventories as of September 30, 2007:

 
| **Project**                 | ** ** | **Location**                     | ** ** | **9/30/07  Lot  Inventory** | ** ** |
|-----------------------------|------------|----------------------------------|------------|-----------------------------|------------|
|                        |       |                             |       |                        |       |
| Orange County:              |       |                             |       |                        |       |
| The Trails at Brightwater   |       | Huntington  Beach                |       | 62                          |       |
| The Sands at Brightwater    |       | Huntington  Beach                |       | 78                          |       |
| The Cliffs at Brightwater   |       | Huntington  Beach                |       | 107                         |       |
| The Breakers at Brightwater |       | Huntington  Beach                |       | 109                         |       |
| * *                    |       | *Subtotal –  Orange County* |       | 356                         |       |
|                        |       |                             |       |                        |       |
| Inland Empire:              |       |                             |       |                        |       |
| Chandler Ranch              |       | North Corona                     |       | 13                          |       |
| Alisal at Ontario           |       | Ontario                          |       | 15                          |       |
| Woodhaven                   |       | Beaumont                         |       | 82                          |       |
| Hearthside Lane             |       | Corona                           |       | 151                         |       |
| * *                    |       | *Subtotal –  Inland Empire* |       | 261                         |       |
|                        |       |                             |       |                        |       |
| Lancaster:                  |       |                             |       |                        |       |
| Alisal at Lancaster         |       | Lancaster                        |       | 2                           |       |
| Lancaster II                |       | Lancaster                        |       | 73                          |       |
| Quartz Hill                 |       | Lancaster                        |       | 69                          |       |
| * *                    |       | *Subtotal –  Lancaster*     |       | 144                         |       |
|                        |       |                             |       |                        |       |
| * *                    |       | *Total –  All Projects*     |       | 761                         |       |

 

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These homebuilding projects are currently expected to generate cashflows and gross operating margins through mid-2011. Up to approximately 554additional single-family lots could be available for homebuilding operations ifwe obtain entitlements for our Oxnard project; however, the exact number ofhomes will depend on the final outcome of the entitlement process.

 

*Brightwater at Bolsa Chica*

 

The 110-acre Bolsa Chica upper mesa is the largest property in ourportfolio, representing approximately 74% of our real estate inventoriesas of September 30, 2007. The Bolsa Chica upper mesa is one of the last largeundeveloped coastal properties in Southern California, and is located in OrangeCounty, approximately 35 miles south of downtown Los Angeles. Bolsa Chica isbordered on the north and east by residential development in the City ofHuntington Beach and Huntington Harbor, to the south by open space and the1,200-acre Bolsa Chica wetlands, and to the west by 120 acres of publicly-ownedconservation land and open space on the lower bench of the Bolsa Chica mesa,Pacific Coast Highway, Bolsa Chica State Beach, and the Pacific Ocean. Ourholdings on the Bolsa Chica mesa include 68 acres of developable land on theupper mesa currently under development for a residential community known asBrightwater, 37 acres of open space and conservation area in the plannedcommunity, and five acres in the City of Huntington Beach which are currentlyzoned agricultural. We are analyzing development alternatives for this 5-acreparcel and expect to submit a proposed site plan to the City of HuntingtonBeach during 2008.

 

We also own approximately 104 non-developable acres on, or adjacent to,the Huntington Mesa. Approximately 51 acres of land on the Huntington Mesa havebeen offered for dedication to the County of Orange for inclusion in theHarriet M. Weider Linear Park in conjunction with the development ofBrightwater and an additional 51 acres are subject to a conservation easement.

 

The Brightwater residential community offers a broad mix of homechoices averaging 2,850 square feet and ranging in size from 1,710 square feetto 4,090 square feet. We completed construction of eight model homes for TheTrails and The Sands products, which range from 1,710 to 2,160 square feet, inJuly 2007 and held a grand opening on August 11, 2007. Homes at The Trails andThe Sands are currently offered at prices ranging from $1.0 to $1.3 million andthe larger homes at The Cliffs (2,724 to 3,477 square feet) and The Breakers(3,174 to 4,090 square feet) are currently expected to be offered for salebeginning in February 2008 at prices starting at approximately $1.7 million andin excess of $2 million, respectively. To date, over 3,000 people haveregistered on our website requesting information about purchasing a home atBrightwater.

 

During the third quarter of 2007, we had sales orders for 10 homes atThe Trails and The Sands at sales prices ranging from $1.1 to $1.3 million, forhomes ranging from 1,710 to 2,160 square feet. For sales orders generatedduring the third quarter of 2007, the average home size was 1,949 square feetand the average sales price was $1,188,000 or $610 per square foot. Weanticipate first deliveries at The Trails and The Sands during the fourthquarter of 2007 which should generate significant gross operating profits. Wealso currently expect to:

 

•                  completeconstruction of nine additional model homes for The Cliffs and The Breakersduring January 2008, and

 

•                  start sellingproduction homes for The Cliffs and The Breakers products during February 2008.

 

However, there can be no assurance that these targeted dates will berealized, or that further delays will not be encountered.

 

We used the following facts and assumptions in estimating the valuethat we expect to receive from the Brightwater development project:

 

•                  The Brightwatercoastal development permit provides for 349 homes aggregating approximately995,000 square feet.

 

•                  We own landadjacent to Brightwater in the City of Huntington Beach, for which we intend toprocess permits to build seven additional homes which would be included in theBrightwater community.

 

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

 

•                  Build-out ofproduction homes, which is subject to market conditions, is currently expectedto take approximately four years and be completed by the end of 2011.

 

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•                  We completedconstruction of model homes for The Trails and The Sands products atBrightwater during July 2007. As of September 30, 2007 we have sales orders for10 homes at The Trails and The Sands ranging from 1,710 to 2,160 square feet.For sales orders generated during the third quarter of 2007, the average homesize was 1,949 square feet and the average sales price was $1,188,000 or $610per square foot.

 

•                  The finished lotcomponent of home prices ranges from 60% to 65%.

 

•                  Costs to improvethe lots from their raw condition to finished lots, including County permits,City annexation fees and school fees, approximate $199,000 per lot.

 

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

 

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

 

•                  Brightwater iscurrently expected to generate gross margins of approximately 30-40% due to ourlow carrying value in Brightwater.

 

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 Joint Venture*

 

In February 2003, we entered into two option contracts to acquireapproximately 168 acres of land adjacent to the City of Oxnard in VenturaCounty, California. We are developing a land plan for the area, which alsoincludes an additional 149 acres owned by other landowners, with the intentionof entitling the property for residential development and annexing it intoOxnard. During October 2003, we entered into a joint venture agreement with amajor financial partner to pursue the Oxnard development opportunity. Weassigned the land purchase option contracts to the Oxnard joint venture.Hearthside Homes, Inc., our homebuilding subsidiary, is the manager of theOxnard joint venture.

 

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 wecurrently expect the Oxnard joint venture to purchase. The single-familydetached product is currently expected to range from approximately 1,700 squarefeet to 3,000 square feet and the attached units are currently expected torange from approximately 1,450 square feet to 1,575 square feet.

 

The option contracts give the Oxnard joint venture two years, plus upto three and one half additional years through the exercise of extensions, tocomplete entitlement activities before purchasing the land. The Oxnard jointventure has the right to terminate these option agreements by forfeiting thecash deposits. The Oxnard joint venture is attempting to obtain approval of itsplan from the Oxnard City Council in the first half of 2008 and approval ofannexation into the City of Oxnard from the Local Agency Formation Commissionin the second half of 2008; however, delays could be encountered. If the Oxnardjoint venture completes the entitlement process in the time frame set forthabove, and decides to build homes (rather than sell lots), most of the homeswould be delivered between 2011 and 2015, based on current expectations andassumptions. The Oxnard joint venture has exercised six six-month extensions,extending the current closing date for the option contracts to February 2008,and there is one remaining six-month extension through August 2008.

 

The Oxnard joint venture is funded by both of its members. HearthsideHomes, Inc. made an initial contribution of $500,000. The non-managing memberalso made an initial contribution of $500,000 to the joint venture and, as ofDecember 31, 2005, had made an aggregate of $4 million of first tier additionalcontributions. In June 2007, the members agreed to provide up to an additional$5.7 million, to be contributed equally by the members, to complete thebusiness plan. As of September 30, 2007, the members have contributed anaggregate of $3.1 million of additional capital. During the three and

 

23

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nine months ended September 30, 2007, the members each contributedapproximately $224,000 and $347,000, respectively, to the joint venture.

 

Our total investment in the venture as of September 30, 2007 is $2.4million. We expect to make additional aggregate capital contributions ofapproximately $140,000 to the joint venture during the remaining three monthsof 2007, bringing our total expected investment in the venture to $2.6 million.During the first nine months of 2008, we expect to make additional aggregatecapital contributions of up to approximately $1.2 million.

 

In addition to the land purchase options for the project property, theOxnard joint venture held a land purchase option which controlled propertywhich was expected to provide fill dirt for the project property. On April 16,2007, the Oxnard joint venture sold the non-project land purchase option for$1.8 million since the venture has contracted for an alternate source for thefill dirt. The Oxnard joint venture received net proceeds of approximately $1.6million for the land and is utilizing the proceeds to fund ongoing entitlementand development costs.

 

After payment of a 10% preferred return on invested capital to us andour partner, the first $8 million of profits are allocated 75% to our partnerand 25% to us, and profits over $8 million and losses over $5 million aregenerally allocated on a 50/50 basis in accordance with the operatingagreement. The first $5 million of losses are generally allocated 80% to ourpartner and 20% to us.

 

While we exert a large degree of influence over the joint venture, ourpartner does have various substantive participating rights such as approvalrights with regard to the majority of business decisions, including approval ofproject budgets.

 

*Homebuilding*

 

Wedelivered 12 homes during the third quarter of 2007, compared with 36 deliveriesduring the comparable period of 2006. We acquired no single-family residentiallots during 2006 or the first nine months of 2007. After several years ofdramatic home price appreciation in Southern California, we have seen pricedepreciation during 2006 and 2007 in the Inland Empire (Corona, Ontario andBeaumont) and Lancaster markets. Therefore, we have further reduced salesprices and offered incentives for a number of our homes which are not yet inescrow in response to our competition and to reflect current market pricing.The price reductions and additional incentives are expected to result insignificantly reduced gross profits for the Inland Empire and Lancastermarkets. As a result, we recorded asset impairment charges of $28.0 million and$32.0 million, respectively, during the three and nine months ended September30, 2007. These charges relate to our real estate inventories for the remaininghomes at our Chandler Ranch, Alisal at Ontario, Woodhaven, Hearthside Lane andQuartz Hill projects. The impairment charges reflect our expectations abouthome prices, sales pace, sales and marketing costs, infrastructure andhomebuilding costs and financing costs for these projects. As required by SFAS144, should market conditions further deteriorate, we will reevaluate theexpected cash flows from our homebuilding projects to determine whether anyadditional impairment exists.

 

Deliveriesof homes at our Brightwater project in coastal Huntington Beach are expected tocommence during the fourth quarter of 2007. We expect to begin offering homesfor sale at The Breakers and The Cliffs in February 2008.

 

24

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Ourhomebuilding projects are described below:

 
| ** **          | ** ** | ** **                   | ** ** | ** **      | ** ** | ** **       | ** ** | ** **          | ** ** | **Deliveries**         | ** ** |
|---------------------|------------|------------------------------|------------|-----------------|------------|------------------|------------|---------------------|------------|------------------------|------------|
| ** **          | ** ** | ** **                   | ** ** | ** **      | ** ** | ** **       | ** ** | ** **          | ** ** | **Three Months**  | ** ** | **Nine Months** | ** ** |
| ** **          | ** ** | ** **                   | ** ** | ** **      | ** ** | ** **       | ** ** | ** **          | ** ** | **Ended**              | ** ** | **Ended** | ** ** |
| ** **          | ** ** | ** **                   | ** ** | **Land**        | ** ** | **Commenced**    | ** ** | **Commenced**       | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **          | ** ** | **Location**                 | ** ** | **Acquisition** | ** ** | **Construction** | ** ** | **Sales**           | ** ** | **2007**               | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **          | ** ** | ** **                   | ** ** | ** **      | ** ** | ** **       | ** ** | ** **          | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Completed  Projects |       | Rancho Santa  Fe / Riverside |       | n/a             |       | n/a              |       | n/a                 |       | —                 |       | 8 |   | 6 |   | 15 |   |
|                |       |                         |       |            |       |             |       |                |       |                   |       |   |   |   |   |   |   |
| Active  Projects    |       |                         |       |            |       |             |       |                |       |                   |       |   |   |   |   |   |   |
| Brightwater         |       | Huntington  Beach            |       | 1970            |       | 2006             |       | 2007                | (a)        | —                 |       | — |   | — |   | — |   |
| Chandler Ranch      |       | North Corona                 |       | 2004            |       | 2005             |       | 2005                |       | 5                      |       | 4 |   | 12 |   | 48 |   |
| Alisal at Ontario   |       | Ontario                      |       | 2005            |       | 2005             |       | 2006                |       | —                 |       | — |   | 2 |   | — |   |
| Woodhaven           |       | Beaumont                     |       | 2005            |       | 2005             |       | 2006                |       | 4                      |       | 10 |   | 5 |   | 10 |   |
| Hearthside Lane     |       | Corona                       |       | 2005            |       | 2005             |       | 2007                |       | —                 |       | — |   | — |   | — |   |
| Alisal at Lancaster |       | Lancaster                    |       | 2004            |       | 2004             |       | 2005                |       | 1                      |       | 14 |   | 6 |   | 40 |   |
| Quartz Hill         |       | Lancaster                    |       | 2005            |       | 2006             |       | 2006                |       | 2                      |       | — |   | 5 |   | — |   |
| Lancaster II        |       | Lancaster                    |       | 2005            |       |             | (b)        |                | (b)        | —                 |       | — |   | — |   | — |   |
| * *            |       |                         |       |            |       |             |       | *Total  Deliveries* |       | 12                     |       | 36 |   | 36 |   | 113 |   |

 

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(a) Sales for The Trails and The Sandscommenced in August 2007 and sales for The Cliffs and The Breakers are expectedto commence in February 2008.

(b) To be determined subject to market conditions.

 

*HuntingtonBeach.*We completedconstruction of the first eight model homes for The Trails and The Sandsproducts which range from 1,710 to 2,160 square feet during July 2007. Weopened for sales during the third quarter of 2007 and, as of October 31, 2007,10 homes are in escrow at an average price of $1.2 million and 13 additionalhomes have been released for sale. We expect to begin delivering The Trails andThe Sands homes in December 2007. We currently expect to complete constructionof nine model homes for The Cliffs and The Breakers in January 2008 and openfor sales in February 2008.

 

*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. During the first nine months of 2007, we delivered 12 homesat an average price of $555,000. As of October 31, 2007, six homes are inescrow at an average price of $474,000 and six additional homes are completedand have been released for sale.

 

DuringApril 2005, we acquired 151 additional lots in Corona. Following constructionof infrastructure, construction of five model homes averaging 3,600 square feeton lots of approximately 7,200 square feet began during the fourth quarter of2006. These models were completed during April 2007, and we opened for salesduring the second quarter of 2007. We delivered two homes at an average priceof $599,000 during October 2007. As of October 31, 2007, three homes are inescrow at an average price of $589,000 and 17 additional homes have beenreleased for sale.

 

*Ontario.*During April 2005, we acquired 26 lots in the Cityof Ontario in Riverside County, California. This small community of homes,averaging 3,380 square feet, is an infill site situated very close to theprojects we completed in the City of Chino in 2005. Construction of the firstphase of 13 homes began during the fourth quarter of 2005, and we opened forsales during March 2006. We delivered nine homes during 2006 at an averageprice of $675,000, and two homes during the first nine months of 2007 at anaverage price of $673,000. We delivered two additional homes at an averageprice of $626,000 during October 2007. As of October 31, 2007, three homes arein escrow at an average price of $635,000 and 10 additional homes are completedor under construction and have been released for sale.

 

*Beaumont*. We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. We delivered 15 homesduring 2006 at an average price of $387,000. During the first nine months of2007 we delivered five homes at an average price of $314,000. We delivered oneadditional home at a price of $384,000 during October 2007. As of October 31,2007, four homes are in escrow at an average price of $362,000 and 11additional homes are completed or under construction and have been released forsale.

 

25

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*Lancaster.*We acquired 104 lots in the City of Lancaster innorthern Los Angeles County during May 2004. We began construction of modelhomes averaging approximately 2,850 square feet during the third quarter of2004 and opened for home sales in January 2005. During 2005 and 2006, wedelivered 55 homes and 41 homes, respectively, at average prices of $406,000and $448,000, respectively. We delivered six homes during the first nine monthsof 2007 at an average price of $407,000. As of October 31, 2007, one home is inescrow at a price of $369,000 and the final home is under construction and hasbeen released for sale.

 

InApril 2005, we acquired an additional 73 unentitled lots in Lancaster. We havedetermined that the construction start for the 73-unit project, which has norecorded loan, will be deferred until sales activity in the market hasimproved. The tentative map for this project is prepared, but we have delayedfiling for approval in order to defer the entitlement fees required to be paidat the time of filing.

 

InDecember 2005, we acquired 77 additional lots in an area known as Quartz Hillin the City of Lancaster. The homes in this community are on 10,000 square footlots and will average 3,640 square feet. Construction of models began in May2006 and we opened for sales during July 2006. During 2006, we delivered threehomes at an average price of $537,000. We delivered five homes during the firstnine months of 2007 at an average price of $479,000. During October 2007, wedelivered two additional homes at an average price of $434,000. As of October31, 2007 two homes are in escrow at an average price of $392,000 and eight additionalhomes are completed or under construction and have been released for sale.

 

**Critical Accounting 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 Notes 2 and 8 to the consolidated financial statements.

 

*Basis of Consolidation*

 

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. Thefinancial statements of joint ventures in which we have a controlling ormajority economic interest (and thus are controlled by us) are consolidatedwith our financial statements. Minority interest represents the equity interestof our joint venture partner for one consolidated venture and is furtherdescribed in Note 10 to the consolidated financial statements included in ourAnnual Report on Form 10-K for the year ended December 31, 2006. Ourinvestments in unconsolidated joint ventures are accounted for using the equitymethod when we do not have voting or economic control of the ventureoperations, as further discussed in Note 4 to the consolidated financialstatements included in our Annual Report on Form 10-K for the year endedDecember 31, 2006.

 

*Impairment of 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 theImpairment or Disposal of Long-Lived Assets,”*(“SFAS 144”) whichrequires that long-lived assets be reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. As provided by SFAS 144, impairment is evaluated by comparingan asset’s carrying value to the undiscounted estimated cash flows expectedfrom the asset’s operations and eventual disposition. If the sum of theundiscounted estimated future cash flows is less than the carrying value of theasset, an impairment loss is recognized based on the fair value of the asset.If impairment occurs, the fair value of an asset for purposes of SFAS 144 isdeemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction. Additionally, as appropriate, we identifyalternative courses of action to recover the carrying value of our long-livedassets and evaluate all likely alternatives under a probability-weightedapproach as described in SFAS 144.

 

In accordance with SFAS 144, in developing estimated future cash flowsfor impairment testing for our real estate inventories, we incorporated our ownmarket assumptions including those regarding home prices, sales pace, sales andmarketing costs, infrastructure and home-building costs and financing costsregarding real estate inventories. Our assumptions are based, in part, ongeneral economic conditions, the current state of the homebuilding industry,expectations about the short- and long-term outlook for the housing market, andcompetition from other homebuilders in the areas in

 

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which we build and sell homes. These assumptions can significantlyaffect our estimates of future cash flows. For those communities deemed to beimpaired, we determined fair value based on discounted estimated future cashflows using estimated absorption rates for each community.

 

The impairment charges recorded during the three and nine months endedSeptember 30, 2007 are as follows (in millions):

 
| **Project**       | ** ** | **Location**                     | ** ** | **Three Months  Ended  September 30,  2007** | ** ** | **Nine Months  Ended  September 30,  2007** | ** ** |
|-------------------|------------|----------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
|              |       |                             |       |                                                   |       |                                                  |       |
| Inland Empire:    |       |                             |       |                                                   |       |                                                  |       |
| Chandler Ranch    |       | North Corona                     |       | $                                                      | .4         |                                                  | $          | .4 |   |
| Alisal at Ontario |       | Ontario                          |       | 1.8                                                    |       | 1.8                                                   |       |
| Woodhaven         |       | Beaumont                         |       | 3.9                                                    |       | 7.9                                                   |       |
| Hearthside Lane   |       | Corona                           |       | 16.5                                                   |       | 16.5                                                  |       |
| * *          |       | *Subtotal –  Inland Empire* |       | 22.6                                                   |       | 26.6                                                  |       |
|              |       |                             |       |                                                   |       |                                                  |       |
| Lancaster:        |       |                             |       |                                                   |       |                                                  |       |
| Quartz Hill       |       | Lancaster                        |       | 5.4                                                    |       | 5.4                                                   |       |
|              |       |                             |       |                                                   |       |                                                  |       |
| * *          |       | *Total –  All Projects*     |       | $                                                      | 28.0       |                                                  | $          | 32.0 |   |

 

We recorded additional impairment charges of $28.0 million during thethird quarter of 2007 as a result of the continuing slowdown in the housingmarket and our expectations about the pace of sales and sales prices. To date,we have recorded impairment charges for five of our active projects. Asrequired by SFAS 144, should market conditions further deteriorate in thefuture or other events occur that indicate the carrying amount of our realestate inventories may not be recoverable, we will reevaluate the expected cashflows from each project to determine whether any additional impairment existsat any point in time.

 

*Income Taxes*

 

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 8 to the consolidated financial statements, theapplication 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 amounts at whichassets and liabilities are recorded.

 

We remain subject to the generalrules of Section 382 of the Internal Revenue Code, which limit the availabilityof net operating losses if an ownership change occurs. If we were to experienceanother ownership change, the amount of net operating losses available wouldgenerally be limited to an annual amount equal to (i) the value of our equityimmediately before the ownership change, multiplied by the long-term tax-exemptrate (4.5% as of October 2007) plus (ii) recognized built-in-gains, defined asthose gains recognized within five years of the ownership change subject to anoverall limitation of the net unrealized built-in gains existing as of theownership change date. We believe we have net unrealized built-in gainssufficient to allow utilization of the entire net operating loss, assuming thatwe are able to recognize these gains within the five-year time limitation. Weestimate that as of October 29, 2007, we have experienced a three-yearcumulative ownership shift of approximately 37%, as computed in accordance withSection 382.

 

*Homebuilding Revenues andCost of Sales*

 

Ourhomebuilding operation generates revenues from the sale of homes to homebuyers.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. Salescontracts 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 

 

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recognition process does notinvolve significant judgments or estimates. However, we do rely on certainprojections and estimates to determine the related construction costs andresulting gross margins associated with revenues recognized. The cost of salesis recorded based upon total estimated costs within a subdivision and allocatedusing the relative sales value method. Our construction costs are comprised ofdirect and allocated costs, including estimated costs for future warranties andindemnities. Our estimates are based on historical results, adjusted forcurrent factors.

 

*Litigation Reserves*

 

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 cases basedupon information provided by our legal counsel. There can be no assurance thattotal litigation costs actually incurred will not exceed the amount of suchreserve.

 

**Recent Accounting Pronouncements**

 

See discussion regarding recent accountingpronouncements in Note 2 to the consolidated financial statements.

 

**Results of Operations**

 

The following tables set forth key operating andfinancial data for our homebuilding operations for the three and nine monthsended September 30, 2007 and 2006.

 

**Backlog asof September 30**

** **
| **Homes in Backlog** | ** ** | **Value ****($ in millions)** | ** ** | **Average Selling Price****($ in thousands)** | ** ** |
|--------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **2007**                       | ** ** | **2006**                                     | ** ** | **% Change**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** |
| 28                             |       | 31                                           |       | (9.7                                                              | )%         | $ | 21.4 |   | $ | 22.0 |   | (2.7 | )% | $ | 765 |   | $ | 710 |   | 7.7 | % |
|                                |            |                                              |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**HomesDelivered****Three Months Ended September 30**

** **
| **Homes Delivered** | ** ** | **Value ****($ in millions)** | ** ** | **Average Selling Price****($ in thousands)** | ** ** |
|--------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **2007**                 | ** ** | **2006**                                     | ** ** | **% Change**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** |
| 12                       |       | 36                                           |       | (66.7                                                             | )%         | $ | 5.2 |   | $ | 24.8 |   | (79.0 | )% | $ | 433 |   | $ | 689 |   | (37.2 | )% |
|                          |            |                                              |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

**HomesDelivered****Nine Months Ended September 30**

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|--------------------------------|------------|--------------------------------------------------|------------|
| **2007**                 | ** ** | **2006**                       | ** ** | **% Change**                                | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2007** | ** ** | **2006** | ** ** | **% Change** | ** ** |
| 36                       |       | 113                            |       | (68.1                                            | )%         | $ | 21.6 |   | $ | 71.5 |   | (69.8 | )% | $ | 600 |   | $ | 633 |   | (5.2 | )% |
|                          |            |                                |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Three Months Ended September 30, 2007 Compared withthe Three Months Ended September 30, 2006*

 

We reported revenues of $5.2 million and grossoperating loss of $27.8 million for the third quarter of 2007, compared with$24.8 million in revenues and gross operating profit of $3.4 million for thethird quarter of 2006. Revenues in the current period reflect deliveries of 12homes, including five homes at the Chandler Ranch project in North Corona, fourhomes at our Woodhaven project in Beaumont, two homes at our Las Colinasproject in Quartz Hill, and one home at our Alisal project in Lancaster. Thecomparable period of the prior year reflects deliveries of 36 homes, including14 homes at our Alisal project in Lancaster, 10 homes at our Woodhaven projectin Beaumont, eight homes at our Rancho Santa Fe project, and four homes at ourChandler Ranch project. The 37.2% decrease in the average selling price (seetable above) primarily reflects deliveries of our higher-end Rancho Santa Feproject in the third quarter of 2006 and the completion of the project duringthe first quarter of 2007, as well as sales price reductions that werenecessary to be competitive in today’s challenging housing market.

 

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We generated $3.2 million less in gross operatingprofit from home sales during the third quarter of 2007 compared with 2006 as aresult of delivering 24 fewer homes and reduced margins due to the continuingreal estate slowdown which has resulted in lower selling prices and greaterincentives. The current quarter’s homebuilding gross margin of 3.8% beforeimpairment charges is lower than the comparable 2006 period gross margin of13.7% and fourth quarter 2006 margin of 9.5% primarily due to sales price reductionsand the use of incentives in order to move standing inventory and becompetitive in today’s market.

 

Gross operating loss for the third quarter of 2007includes an impairment charge of $28.0 million related to the remaining homesat our Chandler Ranch, Alisal at Ontario, Woodhaven, Hearthside Lane and QuartzHill projects. This impairment charge reflects our current expectations aboutselling prices and gross margins for the project. As required by SFAS 144,should market conditions further deteriorate in the future or other eventsoccur that indicate the carrying amount of our real estate inventories may notbe recoverable, we will reevaluate our expected cash flows from each project todetermine whether any additional impairment exists at any point in time.

 

The $300,000 decrease in other expense (income), netduring the third quarter of 2007 compared with the third quarter of 2006primarily reflects a reduction in interest income on short-term investments.

 

*Nine Months Ended September 30, 2007 Compared withthe Nine Months Ended September 30, 2006*

 

We reported revenues of $21.6 million and grossoperating loss of $30.7 million for the nine months ended September 30, 2007,compared with $71.5 million in revenues and gross operating profit of $11.3 millionfor the comparable period of 2006. Revenues in the first nine months of 2007reflect deliveries of 36 homes, including 12 homes at our Chandler Ranchproject in North Corona, six homes each at our completed Rancho Santa Feproject and our Alisal project in Lancaster, five homes each at our Las Colinasproject in Quartz Hill and our Woodhaven project in Beaumont, and two homes atour Alisal project in Ontario. The comparable period of the prior year reflectsdeliveries of 113 homes, including 48 at our Chandler Ranch project, 40 homesat our Alisal project in Lancaster, 14 homes at our completed Rancho Santa Feproject, 10 homes at our Woodhaven project in Beaumont, and one home at ourJasper Ranch project.

 

Gross operating loss for the first nine months of 2007includes impairment charges of $32.0 million related to the remaining homes atour Chandler Ranch, Alisal at Ontario, Woodhaven, Hearthside Lane and QuartzHill projects. These impairment charges reflect our current expectations aboutselling prices, gross margins, and sales pace for the projects. As required bySFAS 144, should market conditions further deteriorate in the future or otherevents occur that indicate the carrying amount of our real estate inventoriesmay not be recoverable, we will reevaluate our expected cash flows from eachproject to determine whether any additional impairment exists at any point intime.

 

We generated $10.0 million less in gross operatingprofit from home sales during the nine months ended September 30, 2007 comparedwith the comparable period of 2006 as a result of delivering 77 fewer homes andreduced margins due to the continuing real estate slowdown which has resultedin lower selling prices and greater incentives. The homebuilding gross marginfor the first nine months of 2007 of 6.0% before impairment charges is lowerthan the comparable 2006 period gross margin of 15.8% and fourth quarter 2006margin of 9.5% primarily due to sales price reductions and the use ofincentives in order to move standing inventory and be competitive in today’smarket.

 

The $900,000 increase in other expense (income), netduring the first nine months of 2007 compared with the comparable period of2006 primarily reflects a $600,000 reduction in interest income on short-terminvestments, a $200,000 increase in warranty costs for a completedunconsolidated project, and a $100,000 increase in legal expense related to theGolden State Water litigation, which was settled for an immaterial amount inthe second quarter of 2007 and is described in Note 11 of Notes to FinancialStatements in our 2006 Annual Report on Form 10-K.

 

*Payments Under Contractual Obligations*

 

We have entered into certain contractual obligationsto make future payments for items such as loans, project debt, and lease agreements.A summary of the payments due under specified contractual obligations,aggregated by category of contractual obligation, for specified time periods ispresented below as of September 30, 2007 (in millions):

 

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| ** **             | ** ** | ** ** | ** ** | **Payments due by period** | ** ** |
|------------------------|------------|------------|------------|-------------------------------------------|------------|
| ** **             | ** ** | ** ** | ** ** | **Less**                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **More** | ** ** |
| ** **             | ** ** | ** ** | ** ** | **than 1**                           | ** ** | **1-3** | ** ** | **4-5** | ** ** | **than 5** | ** ** |
| ** **             | ** ** | **Total**  | ** ** | **year**                                  | ** ** | **years** | ** ** | **years** | ** ** | **years** | ** ** |
| Revolving loan (a)     |       | $          | 72.5       |                                      | $          | 31.6 |   | $ | 40.9 |   | $ | — |   | $ | — |   |
| Term loan (a)          |       | 141.9      |       | 24.9                                      |       | 67.0 |   | 50.0 |   | — |   |
| Other project debt (a) |       | 56.9       |       | 22.1                                      |       | 34.8 |   | — |   | — |   |
| Operating leases       |       | 1.5        |       | .3                                        |       | .7 |   | .5 |   | — |   |
| Total                  |       | $          | 272.8      |                                      | $          | 78.9 |   | $ | 143.4 |   | $ | 50.5 |   | $ | — |   |

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(a)          Amounts include estimated interest expensewhich is calculated based on forecasted debt balances and the applicable interestrate at September 30, 2007.

 

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 (including unrecognized tax benefits recorded pursuant to FIN 48),accrued benefit liability for a frozen retirement plan and other accruedpensions, home warranty reserves and contingent indemnity and environmentalobligations are estimated based on various factors. Payments are not due as ofa given date, but rather are dependent upon the incurrence of professionalservices, the lives of annuitants and other factors. The estimation processinvolved in the determination of carrying values of these obligations isinherently uncertain since it requires estimates as to future events andcontingencies. We have provided additional disclosure in Item 1. “LegalProceedings” and in Note 9 to our consolidated financial statements in thisQuarterly Report.

 

**Liquidity and Capital Resources**

 

Year-over-yearchanges in the principal components of our liquidity and capital resources areas follows (in millions, except percentages):

 
| ** **                            | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | **September 30,**          | ** ** |
| ** **                            | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Cash and cash equivalents             |       | $                               | 5.2        |   | $ | 12.2 |   |
| Short-term investments                |       | —                          |       | 1.3 |   |
| Cash used in operating activities     |       | (55.2                           | )          | (12.6 | ) |
| Cash provided by investing activities |       | 1.2                             |       | 16.3 |   |
| Cash provided by financing activities |       | 48.6                            |       | .8 |   |
|                                       |            |                                 |            |  |  |  |  |

 

The principal assets in our portfolio are residentialland which must be held over an extended period of time in order to bedeveloped to a condition that, in management’s opinion, will ultimatelymaximize our return. Consequently, we require significant capital to financeour real estate development and homebuilding operations. Historically, sourcesof capital have included loan facilities secured by specific projects, assetsales and available internal funds. Our unrestricted cash and cash equivalentsas of September 30, 2007 aggregated $5.2 million. The decrease in our cash andcash equivalents reflects our cash management practice of minimizingoutstanding borrowings to reduce the negative arbitrage between interest incomeearned on our cash and interest costs on outstanding debt. At September 30,2007, we had $9.5 million of immediately available borrowing capacity asfurther described below. Restricted cash also includes approximately $7.7million in an interest reserve account which will become unrestricted when wecommence home deliveries at Brightwater in December 2007.

 

On September 15, 2006 we obtained the $100 million Senior SecuredProject Revolver (the “Revolving Loan”) as a construction facility to financeinfrastructure and homebuilding activities at Brightwater as further describedin Note 4 to the consolidated financial statements. This loan is funding thefirst $100 million of development and construction costs for the Brightwaterproject. Availability under the $100 million Revolving Loan is subject to theapplicable borrowing base limitations and includes financial covenants whichmay limit the amount that may be borrowed. The initial borrowing base value ofthe Brightwater project was determined by an independent third-party appraisalof the project on an “as-is” basis, which was $302 million as of July 6, 2006.This appraisal reflects substantial value in excess of the book value of $142million as of June 30, 2006. Outstanding advances bear interest at our optionat either (i) the Alternate Base rate (“Prime”) minus 25 basis points or (ii)LIBOR plus 200 basis points.

 

Wehave substantial borrowing capacity available to us. As of September 30, 2007,based on construction in place, the immediately available borrowing capacity onour Revolving Loan and other project debt construction loan facilities is 

 

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approximately $4.0 million and $5.5million, respectively. The additional facility availability for futureconstruction costs is $34.3 million for Brightwater and approximately $27.6million for other project debt. We repaid $6.6 million of other project debt onthe Rancho Santa Fe and Chandler projects in full during the first quarter of2007. During the third quarter of 2007, we extended the Beaumont loan for threemonths to December 17, 2007, with the option to exercise three additionalthree-month extensions subject to achieving minimum sales of four homes foreach of the three-month periods beginning September 17, 2007, December 18, 2007and March 18, 2008. In addition, during October 2007, we extended the Ontarioand Lancaster loans to December 1, 2007 and September 30, 2008, respectively.We have two additional three-month extensions available for the Ontario loan,subject to achieving minimum sales of two homes for each of the three-monthperiods beginning October 19, 2007 and January 18, 2008, or the equivalentrepayment minimums.

 

In October 2007, we amended the Term Loan and Revolving Loan to reducethe tangible net worth covenant from $100 million to $80 million, effectiveSeptember 30, 2007. In addition, the Term Loan was also amended to reduce theminimum ratio of EBITDA to interest incurred covenant from a range of 1.0 to2.5, phased in beginning in the first quarter of 2008 through the fourthquarter of 2009, to a range of 1.0 to 2.5, phased in beginning in the thirdquarter of 2008 through the fourth quarter of 2009 to provide greater operatingflexibility and accommodate our currently anticipated operating results for2008.

 

We areutilizing internally generated cash and joint venture contributions to fund theOxnard land development project. We currently expect to make aggregateadditional capital contributions of approximately $140,000 to the Oxnard jointventure during the remaining three months of 2007, bringing our total expectedinvestment in the venture to $2.6 million (see Note 9 to the consolidatedfinancial statements). During the first nine months of 2008, we expect to makeadditional aggregate capital contributions of up to approximately $1.2 million.

 

We believethat our cash and cash equivalents, future real estate sales proceeds, andfunds available under our current credit agreements will be sufficient to meetanticipated operating and capital investment requirements and projectdevelopment costs for homebuilding projects, the Oxnard land developmentproject, and general and administrative expenses, for at least the next 12months.

 

We aresubject to the usual obligations associated with entering into contracts forthe purchase of land and improved homesites. The purchase of properties underthese contracts is generally contingent upon satisfaction of certainrequirements by the sellers, including obtaining applicable propertyentitlements. We also utilize option contracts with third-party land sellersand financial entities as a method of acquiring land in staged takedowns andminimizing the use of funds from other corporate financing sources. Theseoption contracts also help to manage the financial and market risk associatedwith land holdings. Purchase and option contracts generally require the paymentof a non-refundable cash deposit of 5% to 15% of the purchase price for theright to acquire lots over a specified period of time (usually one to twoyears) at predetermined prices. We have the right at our discretion toterminate our obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As ofSeptember 30, 2007, we have no consolidated land option deposits. However, ourunconsolidated Oxnard joint venture does have land deposits of $2.5 million.

 

We mayenter into land development and homebuilding joint ventures from time to timeas a means of expanding our market opportunities, establishing strategicalliances, managing our risk profile and leveraging our capital base. Thesejoint ventures may obtain secured acquisition, development and constructionfinancing, which minimize the use of funds from other corporate financingsources.

 

*September 30, 2007 Compared with December 31, 2006*

 

Cash used in operating activities of $55.2 million forthe first nine months of 2007 primarily reflects investments in Brightwater of$53.1 million, which were partially offset by $3.2 million of net cash flowgenerated by our inland projects ($20.7 million generated from deliveries of 36homes less $17.5 million of project investments).

 

Our primary sources of cash during the first ninemonths of 2007 include $43.4 million of borrowings from our Senior SecuredProject Revolver (“Revolver”) and $5.2 million of borrowings of other projectdebt in excess of repayments.

 

The $5.4 million decrease in cash and cash equivalentsreflects our cash management practice of minimizing outstanding borrowings toreduce the negative arbitrage between interest income earned on our cash andinterest costs on outstanding debt. At September 30, 2007, we had $9.5 millionof immediately available borrowing capacity as further described above. Restrictedcash also includes $7.7 million in an interest reserve account which will becomeunrestricted when we commence home deliveries at Brightwater in December 2007.

 

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The $1.0 million decrease in restricted cash reflectsthe release of collateral for costs related to the construction of projectinfrastructure for two homebuilding projects in the Inland Empire andLancaster.

 

The $11.0 million increase in deferred tax assetsprimarily reflects a $14.3 million tax benefit for additional net operatinglosses generated during the first nine months of 2007, partially offset by the$3.3 million adjustment recorded upon the adoption of FIN 48 discussed in Note8 to Consolidated Financial Statements.

 

The $800,000 decrease in accounts payable and accruedliabilities reflects payments for insurance premiums related to our Brightwaterproject of $1.4 million and accrued compensation of $900,000, partially offsetby a $1.8 million increase in accounts payable related to project constructioncosts.

 

**Off Balance 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 toforfeiture of the nonrefundable deposits, letters of credit and othernonrefundable amounts incurred. As of September 30, 2007, we have noconsolidated land option deposits and no third party guarantees.

 

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

 

Our investment in unconsolidated jointventures totaled $2.5 million and $1.7 million at September 30, 2007 andDecember 31, 2006, respectively. These joint ventures had total assets of $10.4million and $9.5 million as of September 30, 2007 and December 31, 2006,respectively, which included land deposits of $2.5 million for both periods. Incertain instances, we may provide varying levels of guarantees on debt ofunconsolidated joint ventures. As of September 30, 2007, we provide noguarantees on debt of unconsolidated joint ventures.

 

Under the requirements of FASB InterpretationNo. 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 ofSeptember 30, 2007, we had no deposits with VIEs.

 

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ITEM 3 - QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

Weutilize variable rate debt financing for acquisition, development andconstruction of homes. The interest rates on our debt approximate the currentrates available for secured real estate financing with similar terms andmaturities, 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 of $174.3 million constant as of September 30, 2007,each one point percentage increase in interest rates would result in anincrease in variable rate interest incurred for the next 12 months of approximately$1.7 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 million ofour variable rate-based Term Loan, we did not utilize swaps, forward or optioncontracts on interest rates, or other types of derivative financial instrumentsas of or during the quarter ended September 30, 2007. We do not enter into orhold derivatives for trading or speculative purposes.

 

 Under the Term Loan agreement,we were required to enter into a swap agreement to hedge against risksassociated with fluctuating interest rates related to $62.5 million of floatingrate debt. On September 15, 2006 we entered into an interest rate swaptransaction to effectively fix the interest rate on $62.5 million in floatingrate debt at 8.015% per annum for two years. The swap transaction terminates inSeptember 2008. Since we do not use derivative financial instruments for tradingpurposes, the swap did not qualify for hedge accounting under SFAS No. 133. Thefair value of the interest rate swap agreement represents the spread betweenthe interest rate we paid and the interest rate we would receive over theremaining life of the agreement; however, this was not considered material atSeptember 30, 2007. The change in fair value of the interest rate swapagreement during the quarter ended September 30, 2007 was not material to us.The counterparties to the interest rate swap agreement are financialinstitutions.

 

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 “Cautionary Statement About Forward-LookingStatements.”

 

ITEM 4 - EVALUATION OF DISCLOSURE CONTROLSAND PROCEDURES

 

*Conclusion Regarding the Effectiveness of Disclosure Controls andProcedures*

 

Our chief executive officer and chief financial officer, with theassistance of management, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities 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 information isaccumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

 

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

 

*Changes in Internal Controls*

 

There have been no changes in our internal control over financialreporting during the three months ended September 30, 2007 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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PART II -OTHER INFORMATION

 

ITEM 1 -                LEGALPROCEEDINGS

 

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 the yearended December 31, 2006.

 

ITEM 1A -             RISKFACTORS THAT MAY AFFECT RESULTS OF OPERATIONS AND FINANCIAL CONDITION

 

Set forth below is a discussion of the materialchanges in our risk factors as previously disclosed in Item 1A ofPart I of our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2006; however, the risks and uncertainties described in the Form10-K are not the only ones facing us. Other events that we do not currentlyanticipate or that we currently deem immaterial also may affect our results ofoperations and financial condition.

 

The information presented below updates, and should be read inconjunction with, the risk factors and other information disclosed in ourDecember 31, 2006 Form 10-K.

 

***We are being negatively impacted by the downturn in the SouthernCalifornia real estate market which may continue through 2008 or 2009.***

 

As previously disclosed in a risk factor contained in our December 31,2006 Form 10-K, in recent periods we reported declines in the volume of homessold, which reflect continued deteriorating market conditions in thehomebuilding industry and such deterioration is expected to continue in thefuture. These trends became more pronounced during the first half of 2007, andwe experienced a significant decline in sales orders in all of the principalareas in which we are currently selling homes. We attribute these developmentsto, among other things, a decline in homebuyer demand due to lower consumerconfidence in the consumer real estate market, recent problems in the mortgagelending market, decreases in the affordability of homes in the Inland Empireand Lancaster markets, increased inventory of new and used homes for sale, andpricing pressures resulting from the imbalance between supply and demand in theInland Empire and Lancaster markets. These developments have had and maycontinue to have a material adverse effect on our results of operations and arecurrently expected to continue through 2008 or 2009. During the quarters endedSeptember 30, 2007 and March 31, 2007, we recorded $28.0 and $4.0 millionof impairments, respectively, to our real estate inventories in SouthernCalifornia due to challenging market conditions. If market conditions do notimprove in future periods, we may decide not to pursue development andconstruction in additional areas, and the value of existing land holdings maycontinue to decline, which could lead to further write-offs for landimpairments.

 

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

 

Our Brightwater project, which recently commenced sales and represents74% of our real estate assets as of September 30, 2007, is located in a highrisk geographical area for earthquakes. In addition, all of our other realestate assets are in California and could be directly or indirectly impacted bythe event of an earthquake. Our real estate assets are also located in areasthat are subject to the risks of wildfires, floods and other natural disasters;and they are also in proximity to urban and coastal areas which have, in recentyears, been high risk geographical areas for terrorism and threats ofterrorism. Finally, our real estate assets are located within 40 miles of theSan Onofre nuclear power facility. Future earthquakes or other naturaldisasters, acts of terrorism or nuclear accidents could result in thedestruction or loss of our real estate assets or adversely impact the demandfor our homes and could, thereafter, materially impact the availability or costof any insurance we might obtain to protect against these events. Anyearthquake or other natural disaster, terrorist attack, or nuclear accident,whether or not insured, could have a material adverse effect on our financialperformance, the market value of our common stock and our ability to paydividends.

 

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

 

Our quarterly operating results could fluctuate; therefore, you shouldnot rely on past quarterly results to be indicative of our performance infuture quarters. Factors that could cause quarterly operating results tofluctuate include, among others, the risk factors in this Report on Form 10-Qand those set forth in our December 31, 2006 Form 10-K.

 

The following risk factor was provided in our Report on Form 10-Q forthe quarter ended March 31, 2007 and was added to Item 1A of the December31, 2006 Form 10-K:

 

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***If any taxingauthorities are successful in asserting tax positions that are contrary to ourpositions, our income tax provision and other tax reserves may be insufficient.***

 

In order to determine our provision for income taxes and for ourreserves for federal, state, local and other taxes we must use significantjudgment and there may be matters for which the ultimate tax outcome isuncertain. Therefore, no assurance can be given that the final tax authorityreview will not be materially different than that which is reflected in ourincome tax provision and other tax reserves. Any adverse differences could havea material adverse effect on our income tax provision or benefits, or other taxreserves, in the period in which such determination is made and, consequently,on our net income for such period. To provide for potential tax exposures, wemaintain reserves for tax contingencies based on reasonable estimates of ourpotential exposure with respect to the tax liabilities that may result fromsuch audits. However, if the reserves are insufficient upon completion of anyaudit process, there could be an adverse impact on our financial position andresults of operations.

 

ITEM 6 -                EXHIBITS

 
| 10.12A *  |   | First  Amendment to Senior Secured Term Loan Agreement with KeyBank National  Association.                                                                       |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13A  * |   | First  Amendment to Senior Secured Revolving Credit Agreement with KeyBank National  Association.                                                                |
| 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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*              Filed herewith.

 

**           These certificationsare being furnished solely to accompany this report pursuant to 18 U.S.C.Section 1350, and are not being filed for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended, and are not to be incorporated byreference into any filing of the Company, whether made before or after the datehereof, regardless of any general incorporation language in such filing.

 

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**SIGNATURE**

 

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

 

 
| Date: November 5, 2007 | CALIFORNIA COASTAL  COMMUNITIES, INC. |
|------------------------|---------------------------------------|
|                   |                                  |   |
|                   |                                  |   |
|                   | By:                                   | */s/ Sandra G. Sciutto* | * * |
|                   |                                  | SANDRA G. SCIUTTO |
|                   |                                  | Senior Vice President  and |
|                   |                                  | Chief Financial Officer |

 

 

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