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EX-32.1 - FIRST RELIANCE BANCSHARES INCv222528_ex32-1.htm
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EX-32.2 - FIRST RELIANCE BANCSHARES INCv222528_ex32-2.htm
EX-31.1 - FIRST RELIANCE BANCSHARES INCv222528_ex31-1.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.

FORM 10-Q

(Mark One)
 
x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended March 31, 2011

OR
 
o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _________to_________

Commission File Number 000-49757

FIRST RELIANCE BANCSHARES, INC.
(Exact name of small business issuer as specified in its charter)

South Carolina
80-0030931
(State or other jurisdiction of
 incorporation or organization)
(I.R.S. Employer
Identification No.)
 
2170 West Palmetto Street
Florence, South Carolina 29501
(Address of principal executive
offices, including zip code)
 
(843) 656-5000
(Issuer’s telephone number, including area code)
 


State the number of shares outstanding of each of the issuer’s classes of common equity as of the latest practicable date:

4,098,256 shares of common stock, par value $0.01 per share, as of April 30, 2011

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 x Yes o No.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
Smaller reporting company x
    (Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 
 

 
 
INDEX

   
Page No.
PART I. FINANCIAL INFORMATION
   
     
Item 1. Financial Statements (Unaudited)
   
     
Condensed Consolidated Balance Sheets - March 31, 2011 and December 31, 2010
 
3
     
Condensed Consolidated Statements of Operations - Three months ended March 31, 2011 and 2010
 
4
     
Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income - Three months ended March 31, 2011 and 2010
 
5
     
Condensed Consolidated Statements of Cash Flows - Three months ended March 31, 2011 and 2010
 
6
     
Notes to Condensed Consolidated Financial Statements
 
7-19
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
20-36
     
Item 3. Quantitative and Qualitative Disclosure About Market Risk
 
36
     
Item 4. Controls and Procedures
 
36
     
PART II. OTHER INFORMATION
   
     
Item 1. Legal Proceedings
 
37
     
Item 1A.Risk Factors
 
37
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
37
     
Item 6. Exhibits
 
37
 
 
2

 
 
FIRST RELIANCE BANCSHARES, INC
Condensed Consolidated Balance Sheets
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Assets
 
(Unaudited)
   
(Audited)
 
Cash and cash equivalents:
           
Cash and due from banks
  $ 1,648,976     $ 1,806,512  
Interest-bearing deposits with other banks
    35,436,975       23,863,781  
Total cash and cash equivalents
    37,085,951       25,670,293  
                 
Time deposits in other banks
    100,000       100,000  
                 
Securities available-for-sale
    83,738,531       84,472,553  
Nonmarketable equity securities
    4,357,300       4,357,300  
Total investment securities
    88,095,831       88,829,853  
                 
Loans held for sale
    973,477       1,185,576  
                 
Loans receivable
    340,930,851       354,327,969  
Less allowance for loan losses
    (5,697,858 )     (6,271,045 )
Loans, net
    335,232,993       348,056,924  
                 
Premises, furniture and equipment, net
    25,775,088       25,922,343  
Accrued interest receivable
    2,093,616       2,417,134  
Other real estate owned
    17,852,080       14,669,051  
Cash surrender value life insurance
    11,928,418       11,827,957  
Other assets
    11,095,929       11,415,794  
                 
Total assets
  $ 530,233,383     $ 530,094,925  
Liabilities and Shareholders’ Equity
               
Liabilities
               
Deposits
               
Noninterest-bearing transaction accounts
  $ 46,578,421     $ 41,166,965  
Interest-bearing transaction accounts
    37,665,730       41,761,498  
Savings
    118,491,734       108,890,398  
Time deposits $100,000 and over
    139,209,227       157,480,480  
Other time deposits
    106,388,289       105,951,124  
Total deposits
    448,333,401       455,250,465  
                 
Securities sold under agreement to repurchase
    396,883       476,522  
Advances from Federal Home Loan Bank
    20,000,000       13,000,000  
Junior subordinated debentures
    10,310,000       10,310,000  
Accrued interest payable
    471,128       547,222  
Other liabilities
    2,047,586       1,918,872  
Total liabilities
    481,558,998       481,503,081  
Shareholders’ Equity
               
Preferred stock, no par value, authorized 10,000,000 shares:
               
Series A cumulative perpetual preferred stock - 15,349 shares issued and outstanding
  $ 14,778,691     $ 14,730,721  
Series B cumulative perpetual preferred stock - 767 shares issued and outstanding
    815,385       819,455  
Series C cumulative mandatory convertible preferred stock - 2,293 shares shares issued and outstanding
    2,293,000       2,293,000  
Common stock, $0.01 par value; 20,000,000 shares authorized, 4,098,256 and 4,115,903 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively
    40,982       41,159  
Capital surplus
    28,076,665       28,140,094  
Treasury stock, at cost, 12,632 shares
    (169,048 )     (168,864 )
Nonvested restricted stock
    (556,287 )     (679,264 )
Retained earnings
    3,823,991       4,002,469  
Accumulated other comprehensive loss
    (428,994 )     (586,926 )
Total shareholders’ equity
    48,674,385       48,591,844  
                 
Total liabilities and shareholders’ equity
  $ 530,233,383     $ 530,094,925  
 
See notes to condensed consolidated financial statements
 
 
3

 
 
FIRST RELIANCE BANCSHARES, INC
Condensed Consolidated Statements of Operations
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Interest income
           
Loans, including fees
  $ 5,070,274     $ 6,213,086  
Investment securities
               
Taxable
    305,160       609,994  
Nontaxable
    534,457       652,898  
Other interest income
    24,063       28,873  
Total
    5,933,954       7,504,851  
Interest expense
               
Time deposits over $100,000
    1,055,833       1,520,163  
Other deposits
    720,231       1,352,808  
Other interest expense
    78,585       388,799  
Total
    1,854,649       3,261,770  
Net interest income
    4,079,305       4,243,081  
Provision for loan losses
    241,114       186,089  
Net interest income after provision for loan losses
    3,838,191       4,056,992  
Noninterest income
               
Service charges on deposit accounts
    445,562       468,220  
Gain on sale of mortgage loans
    123,045       210,043  
Income from bank owned life insurance
    100,462       104,658  
Other charges, commissions and fees
    192,053       152,984  
Gain on sale of securities available-for-sale
    45,275       1,602  
Other non-interest income
    100,296       104,778  
Total
    1,006,693       1,042,285  
Noninterest expenses
               
Salaries and benefits
    2,376,045       2,396,066  
Occupancy expense
    377,196       399,534  
Furniture and equipment expense
    314,670       310,225  
Other operating expenses
    1,955,989       1,529,550  
Total
    5,023,900       4,635,375  
Income (loss) before taxes
    (179,016 )     463,902  
Income tax benefit
    (293,686 )     (66,232 )
Net income
    114,670       530,134  
Preferred stock dividends
    249,248       204,574  
Deemed dividends on preferred stock resulting from net accretion of discount and amortization of premium
    43,900       43,900  
Net Income (loss) available to common shareholders
  $ (178,478 )   $ 281,660  
                 
Average common shares outstanding, basic
    4,110,477       3,584,032  
Average common shares outstanding, diluted
    4,110,477       3,584,032  
                 
Income (loss) per share:
               
Basic earnings (loss) per share
  $ (0.04 )   $ 0.08  
Diluted earnings (loss) per share
  $ (0.04 )   $ 0.08  
 
See notes to condensed consolidated financial statements
 
 
4

 
 
FIRST RELIANCE BANCSHARES, INC
Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income
For the Three Months Ended March 31, 2011 and 2010
(Unaudited)
 
   
Preferred
Stock
   
Common
Stock
   
Capital
Surplus
   
Treasury
Stock
   
Nonvested
Restricted
Stock
   
Retained
Earnings
   
Accumulated
Other
Comprehensive
Income
(Loss)
   
Total
 
Balance, December 31, 2009
  $ 15,372,136     $ 35,827     $ 26,181,576     $ (163,936 )   $ (206,004 )   $ 5,269,463     $ (1,265,235 )   $ 45,223,827  
                                                                 
Net income
                                            530,134               530,134  
                                                                 
Other comprehensive gain, net of tax expense of $294,897
                                                    572,448       572,448  
                                                                 
Other comprehensive income
                                                            1,102,582  
                                                                 
Preferred Stock Dividend
                                            (209,120 )             (209,120 )
                                                                 
Accretion of Series A Preferred stock discount
    47,970                                       (47,970 )             -  
                                                                 
Amortization of Series B Preferred stock premium
    (4,070 )                                     4,070               -  
                                                                 
Net Change in Restricted Stock
            1,207       421,187               (391,921 )                     30,473  
                                                                 
Purchase of treasury stock
                                  (2,386 )                                   (2,386 )
                                                                 
Balance, March 31, 2010
  $ 15,416,036     $ 37,034     $ 26,602,763     $ (166,322 )   $ (597,925 )   $ 5,546,577     $ (692,787 )   $ 46,145,376  
                                                                 
                                                                 
Balance, December 31, 2010
  $ 17,843,176     $ 41,159     $ 28,140,094     $ (168,864 )   $ (679,264 )   $ 4,002,469     $ (586,926 )   $ 48,591,844  
                                                                 
Net income
                                            114,670               114,670  
                                                                 
Other comprehensive gain, net of tax expense of $81,359
                                                    157,932       157,932  
                                                                 
Other comprehensive income
                                                            272,602  
                                                                 
Preferred Stock Dividend
                                            (249,248 )             (249,248 )
                                                                 
Accretion of Series A Preferred stock discount
    47,970                                       (47,970 )             -  
                                                                 
Amortization of Series B Preferred stock premium
    (4,070 )                                     4,070               -  
                                                                 
Issuance Common Stock
            3       999                                       1,002  
                                                                 
Net Change in Restricted Stock
            (180 )     (64,428 )             122,977                       58,369  
                                                                 
Purchase of treasury stock
                                  (184 )                                   (184 )
                                                                 
Balance, March 31, 2011
  $ 17,887,076     $ 40,982     $ 28,076,665     $ (169,048 )   $ (556,287 )   $ 3,823,991     $ (428,994 )   $ 48,674,385  
 
See notes to condensed consolidated financial statements
 
 
5

 
 
FIRST RELIANCE BANCSHARES, INC
Condensed Consolidated Statements of Cash Flows
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net income
  $ 114,670     $ 530,134  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    241,114       186,089  
Depreciation and amortization expense
    240,324       274,165  
Gain on sale of securities available-for-sale
    (45,275 )     (1,602 )
(Gain) loss on sale of other real estate owned
    43,444       (242,122 )
Write down of other real estate owned
    -       187,582  
Discount accretion and premium amortization
    53,914       62,220  
Disbursements for mortgage loans held for sale
    (3,941,849 )     (7,343,801 )
Proceeds from sale of mortgage loans held for sale
    4,153,948       11,860,458  
Decrease in interest receivable
    323,518       214,435  
Decrease in interest payable
    (76,094 )     (26,798 )
Increase for cash surrender value of life insurance
    (100,461 )     (104,658 )
Amortization of deferred compensation on restricted stock
    58,369       30,473  
Decrease in other assets
    212,845       239,289  
Increase in other liabilities
    128,714       2,840,751  
Net cash provided by operating activities
    1,407,181       8,706,615  
Cash flows from investing activities:
               
Net decrease in loans receivable
    8,195,744       10,826,774  
Purchases of securities available-for-sale
    (11,148,751 )     (2,888,381 )
Maturities of securities available-for-sale
    1,591,694       892,813  
Sales of securities available-for-sale
    10,521,731       3,117,545  
Sales of other real estate owned
    1,160,600       2,105,583  
Increase in time deposits in other banks
    -       (1,018 )
Purchases of premises and equipment
    (67,408 )     (80,507 )
Net cash provided by investing activities
    10,253,610       13,972,809  
Cash flows from financing activities:
               
Net increase (decrease) in demand deposits, interest-bearing transaction accounts and savings accounts
    10,917,024       (7,730,944 )
Net decrease in certificates of deposit and other time deposits
    (17,834,088 )     (18,352,840 )
Net increase (decrease) in securities sold under agreements to repurchase
    (79,639 )     4,720  
Net increase (decrease) in advances from the Federal Home Loan Bank
    7,000,000       (7,000,000 )
Issuance of common stock
    1,002       -  
Purchase of treasury stock
    (184 )     (2,386 )
Payment of preferred stock dividends
    (249,248 )     (209,120 )
Net cash used by financing activities
    (245,133 )     (33,290,570 )
Net increase (decrease) in cash and cash equivalents
    11,415,658       (10,611,146 )
Cash and cash equivalents, beginning
    25,670,293       53,298,486  
Cash and cash equivalents, end
  $ 37,085,951     $ 42,687,340  
Cash paid during the period for:
               
Income taxes
  $ -     $ -  
Interest
  $ 1,930,743     $ 3,244,109  
                 
Supplemental noncash investing and financing activities:
               
Foreclosures on loans
  $ 4,357,723     $ 346,230  
                 
 
See notes to condensed consolidated financial statements
 
 
6

 

Note to Condensed Consolidated Financial Statements

Note 1 - Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with the requirements for interim financial statements and, accordingly, they are condensed and omit certain disclosures, which would appear in audited annual consolidated financial statements.  The consolidated financial statements as of March 31, 2011 and for the interim periods ended March 31, 2011 and 2010 are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation.  The consolidated financial information as of December 31, 2010 has been derived from the audited consolidated financial statements as of that date.  For further information, refer to the consolidated financial statements and the notes included in First Reliance Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2010.

Note 2 - Recently Issued Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and / or disclosure of financial information by the Company.

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis.  The Company is required to include these disclosures in their interim and annual financial statements.  See Note 6.

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011 FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR.   The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present.

Disclosures related to TDRs under ASU 2010-20 will be effective for reporting periods beginning after June 15, 2011.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 3 - Reclassifications

Certain captions and amounts in the financial statements in the Company’s Form 10-Q for the quarter ended March 31, 2010 were reclassified to conform to the March 31, 2011 presentation.

Note 4 - Comprehensive Income

Accounting principles generally require that recognized income, expenses, gains, and losses be included in net income.  Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

The components of other comprehensive income and related tax effects are as follows:
 
   
Pre-tax
Amount
   
Tax
Expense
   
Net-of-Tax
Amount
 
For the Quarter Ended March 31, 2011:
                 
Unrealized gains on securities available-for-sale
  $ 284,566     $ (96,753 )   $ 187,813  
Reclassification adjustment for gains realized in net income
    45,275       (15,394 )     29,881  
    $ 239,291     $ (81,359 )   $ 157,932  
                         
For the Quarter Ended March 31, 2010:
                       
Unrealized gains on securities available-for-sale
  $ 868,947     $ (295,442 )   $ 573,505  
Reclassification adjustment for gains realized in net income
    1,602       (545 )     1,057  
    $ 867,345     $ (294,897 )   $ 572,448  
 
 
7

 
 
Note 5 - Investment Securities

The amortized cost and estimated fair values of securities available-for-sale were:
 
   
Amortized
   
Gross Unrealized
   
Estimated
 
   
Cost
   
Gains
   
Losses
   
Fair Value
 
March 31, 2011
                       
U.S. Government agencies
  $ 2,911     $ 55     $ -     $ 2,966  
Mortgage-backed securities
    35,366,442       195,738       91,357       35,470,823  
Municipals
    48,828,388       328,250       921,721       48,234,917  
Other
    200,000       -       170,175       29,825  
    $ 84,397,741     $ 524,043     $ 1,183,253     $ 83,738,531  
                                 
December 31, 2010
                               
U.S. Government agencies
  $ 5,031     $ 147     $ -     $ 5,178  
Mortgage-backed securities
    35,361,686       408,027       -       35,769,713  
Municipals
    49,804,336       186,999       1,334,173       48,657,162  
Other
    200,000       -       159,500       40,500  
    $ 85,371,053     $ 595,173     $ 1,493,673     $ 84,472,553  
 
The following is a summary of maturities of securities available-for-sale as of March 31, 2011.  The amortized cost and estimated fair values are based on the contractual maturity dates.  Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty.
 
   
Securities
 
   
Available-For-Sale
 
   
Amortized
   
Estimated
 
   
Cost
   
Fair Value
 
Due after one year but within five years
  $ 6,683,900     $ 6,585,833  
Due after five years but within ten years
    17,534,092       17,233,156  
Due after ten years
    24,613,307       24,418,894  
      48,831,299       48,237,883  
Mortgage-backed securities
    35,366,442       35,470,823  
Other
    200,000       29,825  
Total
  $ 84,397,741     $ 83,738,531  
 
The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010.
 
   
March 31, 2011
   
December 31, 2010
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
 
Less Than 12 Months
                       
Mortgage-backed securities
  $ 16,140,259     $ 91,357     $ -     $ -  
Municipals
    22,705,117       635,874       30,472,741       1,047,688  
      38,345,376       727,231       30,472,741       1,047,688  
12 Months or More
                               
Municipals
    2,199,213       285,847       2,200,477       286,485  
Other
    200,000       170,175       200,000       159,500  
      2,399,213       456,022       2,400,477       445,985  
                                 
Total securities available-for-sale
  $ 41,244,589     $ 1,183,253     $ 32,873,218     $ 1,493,673  
 
 
8

 
 
At March 31, 2011, securities classified as available-for-sale are recorded at fair market value.  Approximately 38.54% of the unrealized losses, or five individual securities, consisted of securities in a continuous loss position for twelve months or more.  The Company does not intend to sell these securities in the near future and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. The Company believes, based on industry analyst reports and credit ratings, that the deterioration in value is attributable to changes in market interest rates and is not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary.

During the first quarter of 2011 and 2010, gross proceeds from the sale of available-for-sale securities were $10,521,731 and $3,117,545, respectively.  Gains on available-for-sale securities totaled $45,275 and $1,602 for the first quarter 2011 and 2010, respectively.

Note 6 – Loans Receivable and Allowance for Loan Losses

Major classifications of loans receivable are summarized as follows:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Mortgage loans on real estate:
           
Construction
  $ 58,413,807     $ 62,635,354  
Residential 1-4 family
    49,702,946     $ 50,085,085  
Multifamily
    8,572,050       9,337,285  
Second mortgages
    4,662,649       4,782,583  
Equity lines of credit
    26,635,843       27,989,649  
Commercial
    145,279,680       152,178,318  
      293,266,975       307,008,274  
Commercial and industrial
    39,619,169       40,856,292  
Consumer
    6,806,996       6,057,089  
Other
    1,237,711       406,314  
Total gross loans
  $ 340,930,851     $ 354,327,969  
 
The Company has pledged certain loans as collateral to secure its borrowings from the Federal Home Loan Bank.  The total of loans pledged was $42,271,624 and $44,940,440 at March 31, 2011 and December 31, 2010, respectively.

A summary of the allowance for loan losses for the three months ended March 31, 2011 and year ended December 31, 2010 is as follows:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Beginning balance
  $ 6,271,045     $ 9,800,746  
Provision charged to operations
    241,114       3,541,650  
Recoveries on loans previously charged-off
    315,875       3,323,380  
Loans charged-off
    (1,130,176 )     (10,394,731 )
Ending balance
  $ 5,697,858     $ 6,271,045  
 
The following is an analysis of the allowance for loan losses by class of loans for the three months ended March 31, 2011 and the year ended December 31, 2010.
 
March 31, 2011

                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non-
   
Estate
         
Consumer
 
(Dollars in Thousands)
 
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
Beginning balance
  $ 6,271     $ 2,548     $ 1,730     $ 947     $ 5,225     $ 998     $ 48  
Charge-offs
    (1,130 )     (261 )     (550 )     (5 )     (816 )     (305 )     (9 )
Recoveries
    316       216       63       34       313       3       -  
Provisions
    241       (416 )     304       150       38       199       4  
                                                         
Ending balance
  $ 5,698     $ 2,087     $ 1,547     $ 1,126     $ 4,760     $ 895     $ 43  
 
 
9

 
 
December 31, 2010
 
                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non-
   
Estate
         
Consumer
 
(Dollars in Thousands)
 
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
Beginning balance
  $ 9,801     $ 4,192     $ 2,773     $ 1,271     $ 8,236     $ 1,520     $ 45  
Charge-offs
    (10,395 )     (4,430 )     (2,501 )     (1,879 )     (8,810 )     (1,469 )     (116 )
Recoveries
    3,323       1,311       286       1,123       2,720       438       165  
Provisions
    3,542       1,475       1,172       432       3,079       509       (46 )
                                                         
Ending balance
  $ 6,271     $ 2,548     $ 1,730     $ 947     $ 5,225     $ 998     $ 48  
 
Allowance for Loan Losses
 
March 31, 2011
 
                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non-
   
Estate
         
Consumer
 
(Dollars in Thousands)
 
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
Evaluated for impairment                                          
Individually
  $ 499     $ 432     $ 2     $ 54     $ 488     $ 11     $ -  
Collectively
    5,199       1,655       1,545       1,072       4,272       884       43  
                                                         
Allowance for loan losses
  $ 5,698     $ 2,087     $ 1,547     $ 1,126     $ 4,760     $ 895     $ 43  
                                                         
Total Loans
                                                       
                                                         
Evaluated for impairment                                                        
Individually
  $ 28,555     $ 16,726     $ 4,924     $ 5,880     $ 27,530     $ 995     $ 30  
Collectively
    312,376       41,687       84,650       139,400       265,737       38,624       8015  
                                                         
Loans receivable
  $ 340,931     $ 58,413     $ 89,574     $ 145,280     $ 293,267     $ 39,619     $ 8,045  
 
December 31, 2010
 
                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non-
   
Estate
         
Consumer
 
(Dollars in Thousands)
 
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
Evaluated for impairment
                                         
Individually
  $ 560     $ 508     $ 41     $ -     $ 549     $ 11     $ -  
Collectively
    5,711       2,040       1,689       947       4,676       987       48  
                                                         
Allowance for loan losses
  $ 6,271     $ 2,548     $ 1,730     $ 947     $ 5,225     $ 998     $ 48  
                                                         
Total Loans
                                                       
                                                         
Evaluated for impairment
                                                       
Individually
  $ 19,302     $ 15,558     $ 1,903     $ 1,541     $ 19,002     $ 300     $ -  
Collectively
    335,026       47,077       90,292       150,637       288,006       40,557       6,463  
                                                         
Loans receivable
  $ 354,328     $ 62,635     $ 92,195     $ 152,178     $ 307,008     $ 40,857     $ 6,463  
 
 
10

 
 
The Company identifies impaired loans through its normal internal loan review process.  Loans on the Company’s problem loan watch list are considered potentially impaired loans.  These loans are evaluated in determining whether all outstanding principal and interest are expected to be collected.  Loans are not considered impaired if a minimal delay occurs and all amounts due including accrued interest at the contractual interest rate for the period of delay are expected to be collected.

The following summarizes the Company’s impaired loans as of March 31, 2011.
 
         
Unpaid
         
Average
 
   
Recorded
   
Principal
   
Related
   
Recorded
 
   
Investment
   
Balance
   
Allowance
   
Investment
 
With no related allowance recorded:
                       
(Dollars in Thousands)
                       
Real estate
                       
Construction
  $ 6,871     $ 7,023     $ -     $ 6,535  
Residential
    4,692       5,133       -       4,783  
Nonresidential
    5,452       5,452       -       5,398  
Total real estate loans
    17,015       17,608       -       16,716  
Commercial
    840       841       -       846  
Consumer and other
    30       30       -       30  
      17,885       18,479       -       17,592  
                                 
With an allowance recorded:
                               
Real estate
                               
Construction
  $ 9,855     $ 11,563     $ 432     $ 10,213  
Residential
    232       312       2       230  
Nonresidential
    428       428       54       430  
Total real estate loans
    10,515       12,303       488       10,873  
Commercial
    155       284       11       155  
Consumer and other
    -       -       -       -  
      10,670       12,587       499       11,028  
                                 
Total
                               
Real estate
                               
Construction
  $ 16,726     $ 18,586     $ 432     $ 16,748  
Residential
    4,924       5,445       2       5,013  
Nonresidential
    5,880       5,880       54       5,828  
Total real estate loans
    27,530       29,911       488       27,589  
Commercial
    995       1,125       11       1,001  
Consumer and other
    30       30       -       30  
                                 
Total
  $ 28,555     $ 31,066     $ 499     $ 28,620  
 
The following summarizes the Company’s impaired loans as of December 31, 2010.
 
         
Unpaid
         
Average
 
   
Recorded
   
Principal
   
Related
   
Recorded
 
   
Investment
   
Balance
   
Allowance
   
Investment
 
With no related allowance recorded:
                       
(Dollars in Thousands)
                       
Real estate
                       
Construction
  $ 6,937     $ 8,115     $ -     $ 7,823  
Residential
    613       962       -       1,139  
Nonresidential
    1,541       1,541       -       2,723  
Total real estate loans
    9,091       10,618       -       11,685  
Commercial
    80       145       -       152  
Consumer and other
    -       -       -       -  
      9,171       10,763       -       11,837  
With an allowance recorded:
                               
Real estate
                               
Construction
  $ 8,621     $ 10,416     $ 507     $ 10,265  
Residential
    1,290       1,687       42       1,666  
Nonresidential
    -       -       -       -  
Total real estate loans
    9,911       12,103       549       11,931  
Commercial
    220       285       11       290  
Consumer and other
    -       -       -       -  
      10,131       12,388       560       12,221  
                                 
Total
                               
Real estate
                               
Construction
  $ 15,558     $ 18,531     $ 507     $ 18,088  
Residential
    1,903       2,649       42       2,805  
Nonresidential
    1,541       1,541       -       2,723  
Total real estate loans
    19,002       22,721       549       23,616  
Commercial
    300       430       11       442  
Consumer and other
    -       -       -       -  
                                 
Total
  $ 19,302     $ 23,151     $ 560     $ 24,058  
 
 
11

 
 
Interest income on impaired loans other than nonaccrual loans is recognized on an accrual basis.  Interest income on nonaccrual loans is recognized only as collected.  For the quarter ended March 31, 2011, interest income recognized on nonaccrual loans was $77,542.  If the nonaccrual loans had been accruing interest at their original contracted rates, related income would have been $284,480 for quarter ended March 31, 2011.

A summary of current, past due and nonaccrual loans as of March 31, 2011 was as follows:
 
   
Past Due
   
Past Due Over 90 days
                   
    30-89    
and
   
Non-
   
Total
         
Total
 
(Dollars in Thousands)
 
Days
   
Accruing
   
Accruing
   
Past Due
   
Current
   
Loans
 
Real estate
                                     
Construction
  $ -     $ 1,569     $ 14,230     $ 15,799     $ 42,614     $ 58,413  
Residential
    1,226       -       2,854       4,080       85,494       89,574  
Nonresidential
    1,881       -       5,618       7,499       137,781       145,280  
Total real estate loans
    3,107       1,569       22,702       27,378       265,889       293,267  
Commercial
    469       -       751       1,220       38,399       39,619  
Consumer and other
    8       -       5       13       8,032       8,045  
                                                 
Totals
  $ 3,584     $ 1,569     $ 23,458     $ 28,611     $ 312,320     $ 340,931  

A summary of current, past due and nonaccrual loans as of December 31, 2010 was as follows:
 
   
Past Due
   
Past Due Over 90 days
                   
    30-89    
and
   
Non-
   
Total
         
Total
 
(Dollars in Thousands)
 
Days
   
Accruing
   
Accruing
   
Past Due
   
Current
   
Loans
 
Real estate
                                     
Construction
  $ 1,896     $ 1,546     $ 14,796     $ 18,238     $ 44,397     $ 62,635  
Residential
    1,102       -       3,310       4,412       87,783       92,195  
Nonresidential
    5,993       335       1,001       7,329       144,849       152,178  
Total real estate loans
    8,991       1,881       19,107       29,979       277,029       307,008  
Commercial
    776       29       753       1,558       39,299       40,857  
Consumer and other
    49       -       6       55       6,408       6,463  
                                                 
Totals
  $ 9,816     $ 1,910     $ 19,866     $ 31,592     $ 322,736     $ 354,328  

At March 31, 2011 and December 31, 2010 loans past due 90 days and still accruing interest totaled $1,569,099 and $1,910,413, respectively.
 
Restructured loans (loans which had been renegotiated at below-market interest rates or for which other concessions were granted, but are accruing interest) were $2,616,974 and $2,183,635 at March 31, 2011 and December 31, 2010, respectively.  At March 31, 2011, all restructured loans were performing as agreed.

 
12

 
 
Credit Indicators
 
Loans are categorized into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The following definitions are utilized for risk ratings, which are consistent with the definitions used in supervisory guidance:
 
Special Mention - Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
 
Substandard - Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
Doubtful - Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
 
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.

As of March 31, 2011, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non -
   
Estate
         
Consumer
 
   
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
(Dollars in Thousands)
                                         
Pass
  $ 259,703     $ 28,821     $ 75,621     $ 112,701     $ 217,143     $ 34,762     $ 7,798  
Special mention
    40,229       11,534       7,003       18,891       37,428       2,623       178  
Substandard
    40,999       18,058       6,950       13,688       38,696       2,234       69  
Doubtful
    -       -       -       -       -       -       -  
                                                         
Totals
  $ 340,931     $ 58,413     $ 89,574     $ 145,280     $ 293,267     $ 39,619     $ 8,045  
 
As of December 31, 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
                           
Total
             
         
Real Estate Loans
   
Real
             
                     
Non -
   
Estate
         
Consumer
 
   
Total
   
Construction
   
Residential
   
Residential
   
Loans
   
Commercial
   
and Other
 
(Dollars in Thousands)
                                         
Pass
  $ 270,154     $ 31,067     $ 76,299     $ 120,429     $ 227,795     $ 36,233     $ 6,126  
Special mention
    43,386       12,743       7,481       20,822       41,046       2,149       191  
Substandard
    40,788       18,825       8,415       10,927       38,167       2,475       146  
Doubtful
    -       -       -       -       -       -       -  
                                                         
Totals
  $ 354,328     $ 62,635     $ 92,195     $ 152,178     $ 307,008     $ 40,857     $ 6,463  

The Company enters into financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments consist of commitments to extend credit and standby letters of credit.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.  The Company’s exposure to credit loss in the event of nonperformance by the other parties to the instrument is represented by the contractual notional amount of the instrument. Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Company uses the same credit policies in making commitments to extend credit as it does for on-balance-sheet instruments.  Letters of credit are conditional commitments issued to guarantee a customer’s performance to a third party and have essentially the same credit risk as other lending facilities.

 
13

 
 
Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties.

The following table summarizes the Company’s off-balance sheet financial instruments whose contract amounts represent credit risk:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Commitments to extend credit
  $ 32,707,260     $ 32,932,922  
Standby letters of credit
    2,206,379       2,102,497  
 
Note 7 – Other Real Estate Owned

Transactions in other real estate owned for the three months and year ended March 31, 2011 and December 31, 2010 are summarized below:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Beginning balance
  $ 14,669,051     $ 8,954,214  
Additions
    4,357,723       12,010,459  
Improvements made to properties
    29,350       180,475  
Sales
    (1,204,044 )     (6,273,435 )
Write downs
    -       (202,662 )
                 
Ending balance
  $ 17,852,080     $ 14,669,051  

The Company recognized a net loss of $43,444 and a net gain of $242,122 on the sale of other real estate owned for the three months ended March 31, 2011 and 2010, respectively.

Other real estate owned expense for the three months ended March 31, 2011 and 2010 was $476,224 and $290,726, respectively, which includes gains and losses on sales.

Note 8 – Shareholders’ Equity

Common StockThe following is a summary of the changes in common shares outstanding for the three months ended March 31, 2011 and 2010.
 
   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Common shares outstanding at beginning of the period
    4,115,903       3,582,691  
Issuance of common stock
    334       -  
Issuance of non-vested restricted shares
    -       120,684  
Forfeiture of restricted shares
    (17,981 )     -  
Common shares outstanding at end of the period
    4,098,256       3,703,375  

Note 9 – Net Income (Loss) Per Share

Net income (loss) available to common shareholders represents net income (loss) adjusted for preferred dividends including dividends declared, accretions of discounts and amortization of premiums on preferred stock issuances and cumulative dividends related to the current dividend period that have not been declared as of period end.

 
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The following is a summary of the net income (loss) per common share calculations for the three months ended March 31, 2011 and 2010.
 
   
March 31,
 
   
2011
   
2010
 
Net income (loss) available to common shareholders
           
Net income
  $ 114,670     $ 530,134  
Preferred stock dividends
    249,248       204,574  
Deemed dividends on preferred stock resulting from net accretion of discount and amortization of premium
    43,900       43,900  
                 
Net income (loss) available to common shareholders
  $ (178,478 )   $ 281,660  
Basic net income (loss) per common share:
               
Net income (loss) available to common shareholders
  $ (178,478 )   $ 281,660  
Average common shares outstanding – basic
    4,110,477       3,584,032  
                 
Basic net income (loss) per common share
  $ (0.04 )   $ 0.08  
                 
Diluted net income (loss) per common share:
               
Net income (loss) available to common shareholders
  $ (178,478 )   $ 281,660  
                 
Average common shares outstanding – basic
    4,110,477       3,584,032  
                 
Dilutive potential common shares
    -       -  
                 
Average common shares outstanding - diluted
    4,110,477       3,584,032  
                 
Diluted income (loss) per common share
  $ (0.04 )   $ 0.08  

Due to the net loss, common shares equivalents were not included in loss per share calculations as their effect would be anti-dilutive.

Note 10 - Equity Incentive Plan

On January 19, 2006, the Company adopted the 2006 Equity Incentive Plan, which provides for the granting of dividend equivalent rights options, performance unit awards, phantom shares, stock appreciation rights and stock awards, each of which shall be subject to such conditions based upon continued employment, passage of time or satisfaction of performance criteria or other criteria as permitted by the plan. The plan, as amended on September 17, 2010, allows the Company, subject to approval by the Board of Directors, up to 950,000 shares of stock, to officers, employees, and directors, consultants and service providers of the Company or its affiliates.  Awards may be granted for a term of up to ten years from the effective date of grant. Under this Plan, our Board of Directors has sole discretion as to the exercise date of any awards granted.  The per-share exercise price of incentive stock awards may not be less than the market value of a share of common stock on the date the award is granted.  Any awards that expire unexercised or are canceled become available for re-issuance.

The Company can issue the restricted shares as of the grant date either by the issuance of share certificate(s) evidencing restricted shares or by documenting the issuance in uncertificated or book entry form on the Company’s stock records. Except as provided by the Plan, the employee does not have the right to make or permit to exist any transfer or hypothecation of any restricted shares. When restricted shares vest, the employee must either pay the Company within two business days the amount of all tax withholding obligations imposed on the Company or make an election pursuant to Section 83(b) of the Internal Revenue Code to pay taxes at grant date.

Restricted shares may be subject to one or more objective employment, performance or other forfeiture conditions as established by the Plan Committee at the time of grant.  The restricted shares will not vest unless the Company’s retained earnings at the end of the fiscal quarter preceding the third anniversary of the restricted share award date are greater than the award value of the restricted shares.  Any shares of restricted stock that are forfeited will again become available for issuance under the Plan.  An employee or director has the right to vote the shares of restricted stock after grant until they are forfeited or vested.  Compensation cost for restricted stock is equal to the market value of the shares at the date of the award and is amortized to compensation expense over the vesting period.  Dividends, if any, will be paid on awarded but unvested stock.

During the three months ended March 31, 2011 and 2010 the Company issued 0 and 120,684 shares, respectively, of restricted stock pursuant to the 2006 Equity Incentive Plan.  The shares issued in 2010 cliff vest in three years and are fully vested in 2013, subject to meeting the performance criteria of the Plan.  The weighted-average fair value of restricted stock issued during the three months ended March 31, 2010 was $3.50 per share.  Compensation cost associated with the issuance for 2010 was $422,394 to be amortized over 3 years.  During the first quarter of 2011, 17,981 shares were forfeited having a weighted average price of $3.59.   No shares were forfeited during the first quarter of 2010.  Deferred compensation expense of $58,369 and $30,473, relating to restricted stock, was amortized to income during three months ended March 31, 2011 and 2010, respectively.
 
 
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The 2006 Equity Incentive Plan allows for the issuance of Stock Appreciation Rights (“SARs”).  The SARs entitle the participant to receive the excess of (1) the market value of a specified or determinable number of shares of the stock at the exercise date over the fair value at grant date or (2) a specified or determinable price which may not in any event be less than the fair market value of the stock at the time of the award.  Upon exercise, the Company can elect to settle the awards using either Company stock or cash. The shares start vesting after five years and vest at 20% per year until fully vested.  Compensation cost for SARs is amortized to compensation expense over the vesting period.

The SARs compensation expense for the quarters ended March 31, 2011 and 2010 was $15,853 and $18,356, respectively.

A summary of the status of the Company’s SARs as of March 31, 2011 and 2010 and changes during the period then ended is presented below.
 
   
2011
    2010
   
Shares
 
Weighted-
Average
Exercise
Price
   
Shares
   
Weighted-
Average
Exercise
Price
Outstanding at beginning of year
    88,499     $ 14.95     $ 89,293       14.95  
Forfeited
    -               (794 )     15.00  
Outstanding at end of period
    88,499     $ 14.95     $ 88,499       14.95  
 
Note 11 – Fair Value Measurements

The following methods and assumptions were used to estimate the fair value of significant financial instruments:

Cash and Due from Banks and Interest-bearing Deposits with Other Banks - The carrying amount is a reasonable estimate of fair value.

Time Deposits in other Banks - The carrying amount is a reasonable estimate of fair value.

Securities Available-for-Sale - The fair values of securities available-for-sale equal the carrying amounts, which are the quoted market prices.  If quoted market prices are not available, fair values are based on quoted market prices of comparable securities.

Nonmarketable Equity Securities - The carrying amount of nonmarketable equity securities is a reasonable estimate of fair value since no ready market exists for these securities.

Loans Held-for-Sale - The carrying amount of loans held for sale is a reasonable estimate of fair value.

Loans Receivable – For certain categories of loans, such as variable rate loans which are repriced frequently and have no significant change in credit risk, fair values are based on the carrying amounts.  The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Deposits - The fair value of demand deposits, savings, and money market accounts is the amount payable on demand at the reporting date.  The fair values of certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates to a schedule of aggregated expected maturities.

Securities Sold Under Agreements to Repurchase - The carrying amount is a reasonable estimate of fair value because these instruments typically have terms of one day.

Advances From Federal Home Loan Bank - The fair values of fixed rate borrowings are estimated using a discounted cash flow calculation that applies the Company’s current borrowing rate from the Federal Home Loan Bank.  The carrying amounts of variable rate borrowings are reasonable estimates of fair value because they can be repriced frequently.

Junior Subordinated Debentures - The carrying value of the junior subordinated debentures approximates their fair value since they were issued at a floating rate.
 
 
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Accrued Interest Receivable and Payable - The carrying value of these instruments is a reasonable estimate of fair value.

Off-Balance Sheet Financial Instruments - Fair values of off-balance sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

The carrying values and estimated fair values of the Company’s financial instruments were as follows:
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
Carrying
   
Estimated Fair
   
Carrying
   
Estimated Fair
 
   
Amount
   
Value
   
Amount
   
Value
 
Financial Assets:
                       
Cash and due from banks
  $ 1,648,976     $ 1,648,976     $ 1,806,512     $ 1,806,512  
Interest-bearing deposits with other banks
    35,436,975       35,436,975       23,863,781       23,863,781  
Time deposits in other banks
    100,000       100,000       100,000       100,000  
Securities available-for-sale
    83,738,531       83,738,531       84,472,553       84,472,553  
Nonmarketable equity securities
    4,357,300       4,357,300       4,357,300       4,357,300  
Loans, including loans held for sale
    341,904,328       345,417,000       355,513,545       356,465,000  
Accrued interest receivable
    2,093,616       2,093,616       2,417,134       2,417,134  
                                 
Financial Liabilities:
                               
Demand deposit, interest-bearing
                               
transaction, and savings accounts
  $ 202,735,885     $ 202,735,885     $ 191,818,861     $ 191,818,861  
Certificates of deposit
    245,597,516       252,153,000       263,431,604       266,448,000  
Securities sold under agreements to repurchase
    396,883       396,883       476,522       476,522  
Advances from Federal Home Loan Bank
    20,000,000       20,075,385       13,000,000       13,049,000  
Junior subordinated debentures
    10,310,000       10,310,000       10,310,000       10,310,000  
Accrued interest payable
    471,128       471,128       547,222       547,222  
 
   
Notional
   
Notional
 
   
Amount
   
Amount
 
Off-Balance Sheet Financial Instruments:
           
Commitments to extend credit
  $ 32,707,260     $ 32,932,922  
Standby letters of credit
    2,206,379       2,102,497  
 
Generally accepted accounting principles (GAAP) provide a framework for measuring and disclosing fair value which requires disclosures about the fair value of assets and liabilities recognized in the balance sheet, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).

Fair value is defined as the exchange in price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These levels are:
 
Level 1 —
 
Valuation is based upon quoted prices for identical instruments traded in active markets.
     
Level 2 —
 
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
 
 
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Level 3 —
 
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Securities Available for Sale - Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the counter markets and money market funds. Level 2 securities include mortgage backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans - The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At March 31, 2011 and December 31, 2010, substantially all of the impaired loans were evaluated based upon the fair value of the collateral. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3.

Other Real Estate Owned - Foreclosed assets are adjusted to fair value upon transfer of the loans to other real estate owned. Real estate acquired in settlement of loans is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional allowances, which are charges to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis by level within the hierarchy.
 
 
March 31, 2011
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Available for-sale-securities:
                       
U.S. Government agencies
  $ 2,966     $ -     $ 2,966     $ -  
Mortgage-backed securities
    35,470,823       -       35,470,823       -  
Municipals
    48,234,917       -       48,234,917       -  
Other
    29,825       -       29,825       -  
      83,738,531       -       83,738,531       -  
Mortgage loans held for sale (1)
    973,477       -       973,477       -  
    $ 84,712,008     $ -     $ 84,712,008     $ -  
 
December 31, 2010
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Available for-sale-securities:
                       
U.S. Government agencies
  $ 5,178     $ -     $ 5,178     $ -  
Mortgage-backed securities
    35,769,713       -       35,769,713       -  
Municipals
    48,657,162       -       48,657,162       -  
Other
    40,500       -       40,500       -  
      84,472,553       -       84,472,553       -  
Mortgage loans held for sale (1)
    1,185,576       -       1,185,576       -  
    $ 85,658,129     $ -     $ 85,658,129     $ -  
 

(1) Carried at the lower of cost or market.
 
 
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There were no liabilities measured at fair value on a recurring basis at March 31, 2011 and December 31, 2010.

Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).  The following table presents the assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2011 and December 31, 2010, aggregated by level in the fair value hierarchy within which those measurements fall.
 
 
March 31, 2011
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Impaired loans receivable
  $ 28,055,749     $ -     $ 28,055,749     $ -  
Other real estate owned
    17,852,080       -       17,852,080       -  
Total assets at fair value
  $ 45,907,829     $ -     $ 45,907,829     $ -  
                                 
December 31, 2010
                               
Impaired loans receivable
  $ 18,742,006     $ -     $ 18,742,006     $ -  
Other real estate owned
    14,669,051       -       14,669,051       -  
Total assets at fair value
  $ 33,411,057     $ -     $ 33,411,057     $ -  
 
There were no liabilities measured at fair value on a nonrecurring basis at March 31, 2011 and December 31, 2010.
 
Impaired loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying value of $28,554,893 at March 31, 2011 with a valuation allowance of $499,144.  Impaired loans had a carrying value of $19,301,570 at December 31, 2010 with a valuation allowance of $559,564.
 
Other real estate owned, which is measured at the lower of carrying amount or fair value less costs to sell, had a net carrying value of $17,852,080 and $14,669,051 at March 31, 2011 and December 31, 2010, respectively.  Write downs of other real estate owned for the three months ended March 31, 2011 and for the year ended December 31, 2010 were $0 and $202,662, respectively.

The Company has no assets or liabilities whose fair values are measured using level 3 inputs.

Note 12 - Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.  Unrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.  Management has reviewed events occurring through the date the financial statements were issued and no subsequent events occurred that require accrual or disclosure.

 
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The following discussion reviews our results of operations and assesses our financial condition.  You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunction with the discussion of forward-looking statements, the financial statements and the related notes and the other statistical information included in this report.

Cautionary Note Regarding Forward-Looking Statements

The statements contained in this report on Form 10-Q that are not historical facts are forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995.  We caution readers of this report that such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of us to be materially different from those expressed or implied by such forward-looking statements.

Although we believe that our expectations of future performance are based on reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results will not differ materially from our expectations.

These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors, including, but not limited to the following:
 
 
deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;
 
 
changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;
 
 
the failure of assumptions underlying the establishment of reserves for possible loan losses;
 
 
changes in political and economic conditions, including the political and economic effects of the current economic downturn and other major developments, including the ongoing war on terrorism and political unrest in the Middle East;
 
 
changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts its operations, including, without limitation, reduced rates of business formation and growth, commercial and residential real estate development, and real estate prices;
 
 
the Company’s ability to comply with any requirements imposed on it or the Bank by their respective regulators, and the potential negative consequences that may result;
 
 
fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;
 
 
governmental monetary and fiscal policies, as well as legislative and regulatory changes;
 
 
the Company’s participation or lack of participation in governmental programs implemented under the Emergency Economic Stabilization Act (the “EESA”) and the American Recovery and Reinvestment Act (the “ARRA”), including, without limitation, the CPP administered under the Troubled Asset Relief Program, and the Temporary Liquidity Guarantee Program (the “TLGP”) and the impact of such programs and related regulations on the Company and on international, national, and local economic and financial markets and conditions;
 
 
the Company’s lack of participation in a “stress test” under the Federal Reserve’s Supervisory Capital Assessment Program; the diagnostic and stress testing we conducted differs from that administered under the Supervisory Capital Assessment Program, and the results of our test may be inaccurate; and
 
 
the impact of the EESA and the ARRA and related rules and regulations on the business operations and competitiveness of the Company and other participating American financial institutions, including the impact of the executive compensation limits of these acts, which may impact the ability of the Company to retain and recruit executives and other personnel necessary for their businesses and competitiveness.

Forward-looking statements speak only as of the date on which they are made.  We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made to reflect the occurrence of unanticipated events.
 
 
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Overview

The following discussion describes our results of operation for the quarter ended March 31, 2011 as compared to the quarter ended March 31, 2010 and also analyzes our financial condition as of March 31, 2011 as compared to December 31, 2010.

Like most community bank holding companies, we derive the majority of our income from interest received on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We maintain this allowance by charging a provision for loan losses against our operating earnings for each period.  We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers.  We have also included a discussion of the various components of this non-interest income, as well as our non-interest expense.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the SEC.

Critical Accounting Policies

We have adopted various accounting policies, which govern the application of accounting principles generally accepted in the United States in the preparation of our financial statements.  Our significant accounting policies are described in the notes to the consolidated financial statements at December 31, 2010 as filed on our annual report on Form 10-K.  Certain accounting policies involve significant judgments and assumptions by us, which have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgments and assumptions we use are based on the historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates which could have a major impact on our carrying values of assets and liabilities and our results of operations.

We believe the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for description of our processes and methodology for determining our allowance for loan losses.

Regulatory Matters

Following an examination of the Bank by the Federal Deposit Insurance Corporation (the “FDIC”) during the first quarter of 2010, the Bank’s Board of Directors agreed to enter into a Memorandum of Understanding (the “Bank MOU”) with the FDIC and South Carolina Commissioner of Banks (“SC State Board”), that became effective August 19, 2010.  Among other things, the Bank MOU provides for the Bank to (i) review and formulate objectives relative to liquidity and growth, including a reduction in reliance on volatile liabilities, (ii) formulate plans for the reduction and improvement in adversely classified assets, (iii) maintain a Tier 1 leverage capital ratio of 8% and continue to be “well capitalized” for regulatory purposes, (iv) continue to maintain an adequate allowance for loan and lease losses, (v) not pay any dividend to the Bank’s parent holding company without the approval of the regulators, (vi) review officer performance and consider additional staffing needs, and (vii) provide progress reports and submit various other information to the regulators.

In addition, on the basis of the same examination by the FDIC and the SC State Board, the Federal Reserve Bank of Richmond (the “Federal Reserve Bank”) requested that the Company enter into a separate Memorandum of Understanding, which the Company entered into in December 2010 (the “Company MOU”).  While this agreement provides for many of the same measures suggested by the Memorandum already in place for the Bank, the Company MOU requires that the Company seek pre-approval from the Federal Reserve Bank prior to the declaration or payment of dividends or other interest payments relating to its securities.  As a result, until the Company is no longer subject to the Company MOU, it will be required to seek regulatory approval prior to paying scheduled dividends on its preferred stock and trust preferred securities, including the Series A Preferred Stock and Series B Preferred Stock issued to the Treasury as part of our participation in the TARP CPP, as well as the Series C Preferred Stock issued as part of a private offering earlier this year.  This provision will also apply to the Company’s common stock, although, to date, the Company has not elected to pay a cash dividend on its shares of common stock.  The Federal Reserve Bank approved the scheduled payment of dividends on the Company’s preferred stock and interest payments on the Company’s trust preferred securities for the first and second quarter of 2011.  However, no assurance can be given as to the ability of the Company to obtain approval from the Federal Reserve Bank to declare and pay such dividends and interest in future quarters while the Company MOU remains in effect.
 
 
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In response to these Regulatory Matters, the Bank and the Company have taken various actions over the past year designed to improve our lending procedures, nonperforming assets, liquidity and capital position and other conditions related to our operations, which are more fully described in turn as part of this discussion.  We believe that the successful completion of these initiatives will result in full compliance with our regulatory obligations with the FDIC, the SC State Board and the Federal Reserve and position us well for stability and growth over the long term.
 
Effect of Economic Trends

Economic conditions, competition and federal monetary and fiscal policies also affect financial institutions. Lending activities are also influenced by regional and local economic factors, such as housing supply and demand, competition among lenders, customer preferences and levels of personal income and savings in our primary market area.

Results of Operations

Our net income (loss) available to common shareholder for the first quarter of 2011 was $460,138 less than our net income (loss) available to common shareholders for the first quarter of 2010.  We incurred a net loss available to common shareholders of $178,478 for the quarter ended March 31, 2011 compared to net income available to common shareholders of $281,660 for the quarter ended March 31, 2010.  This resulted in basic and diluted loss per share of $0.04 for 2011, compared to basic and diluted income per share of $0.08 for 2010.  The primary reason for the decline in our net income (loss) available to common shareholders is attributable to the increase of $426,439 in other noninterest expense, which resulted from an increase in costs related to our increased holdings of other real estate owned and an increase in insurance premiums relating to our deposit insurance assessment.  See “Noninterest Expense” below for a more detailed discussion.

Income Statement Review

Net Interest Income

The largest component of our net income is net interest income, which is the difference between the income earned on assets and interest paid on deposits and on the borrowings used to support such assets.  Net interest income is determined by the yields earned on our interest-earning assets and the rates paid on interest-bearing liabilities, the relative amounts of interest-earning assets and interest-bearing liabilities, and the degree of mismatch and the maturity and repricing characteristics of its interest-earning assets and interest-bearing liabilities.  Total interest-earning assets yield less total interest-bearing liabilities rate represents our net interest rate spread.

Net interest income decreased $163,776, or 3.86%, to $4,079,305 for the quarter ended March 31, 2011, from $4,243,081 for the comparable period of 2010.  Comparing the first quarter of 2011 with the first quarter of 2010 our average interest earning assets declined more than our interest-bearing liabilities, which is the main reason for the decline in our net interest income.  See “Rate/Volume Analysis” below for a more detailed discussion.

For the first quarter of 2011, average-earning assets totaled $463,245,072 with an annualized average yield of 5.19% compared to $565,972,425, and 5.38%, respectively, for the first quarter of 2010.  Average interest-bearing liabilities totaled $430,491,297 with an annualized average cost of 1.75% for first quarter of 2011 compared to $527,745,383 and 2.51%, respectively, for the first quarter of 2010.

Our net interest margin and net interest spread were 3.57% and 3.44%, respectively, for the first quarter of 2011 compared to 3.04% and 2.87%, respectively, for the first quarter of 2010.

Because loans often provide a higher yield than other types of earning assets, one of our goals is to maintain our loan portfolio as the largest component of total earning assets.  Loans comprised 75.03% and 71.24% of average earning assets at March 31, 2011 and 2010, respectively.  Loan interest income for the three months ended March 31, 2011 and 2010 was $5,070,274 and $6,213,086, respectively.  The annualized average yield on loans was 5.92% and 6.25% for the first quarter of 2011 and 2010, respectively.  Average balances of loans decreased to $347,550,126 during the first quarter of 2011, a decrease of $55,683,610 from the average of $403,233,736 during first quarter of 2010.  Our loan income for the first quarter of 2011 continued to be negatively impacted by the depressed local real estate market and the high volume of our nonperforming loans.
 
 
22

 
 
Available-for-sale investment securities averaged $82,795,452, or 17.87% of average earning assets, for the first quarter of 2011 compared to $121,661,899, or 21.50% of average earning assets for the first quarter of 2010.  Interest earned on investment securities amounted to $839,617 for the quarter ended March 31, 2011, compared to $1,262,892 for the same period last year.  With the relatively low yield available on our securities portfolio, we chose to instead reduce our securities position proportionally with a reduction in higher cost deposits as part of our effort to reduce interest expense.  The annualized average yield on available-for-sale investment securities was 4.11% and 4.21% for the first quarter of 2011 and 2010, respectively.

Our average interest-bearing deposits were $401,283,399 and $488,882,534 for the first quarter of 2011 and 2010, respectively. This represented a decrease of $87,599,135, or 17.92%.  Total interest paid on deposits for first quarter of 2011 and 2010 was $1,776,064 and $2,872,971, respectively.  The annualized average cost of deposits was 1.79% and 2.38% for the three months ended March 31, 2011 and 2010, respectively.  As our loan demand declined, we concurrently lowered our rates paid for deposits, especially for time deposits, which is the primary reason why our average time deposits declined by $94,142,691, or 27.18 %, from March 31, 2011 to March 31, 2010.

The average balance of other interest-bearing liabilities was $29,207,898 and $38,862,849 for the first quarter of 2011 and 2010, respectively.  This represented a decrease of $9,654,951, or 24.84%.  The decrease is partially attributable to the decrease of $9,258,978, in our average borrowings from the Federal Home Loan Bank.  With the weakness in loan demand we experienced during the past year, we became less reliant on borrowings from the Federal Home Loan Bank to meet our funding needs.

The following table sets forth, for the period indicated, certain information related to our average balance sheet and our average yields on assets and average costs of liabilities.  Such yields are derived by dividing income or expense by the average balance of the corresponding assets or liabilities.  Average balances have been derived from the daily balances throughout the periods indicated.
 
    Average Balances, Income and Expenses, and Rates  
Three Months Ended March 31,
  2011     2010     2009  
(Dollars in
 
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield /
 
thousands)
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Assets
                                                     
Earning assets:
                                                     
Loans (1)
  $ 347,550     $ 5,070       5.92 %   $ 403,234     $ 6,213       6.25 %   $ 487,879     $ 6,968       5.79 %
Securities, taxable
    34,822       305       3.55       61,135       610       4.05       46,575       531       4.63  
Securities, nontaxable
    47,973       534       4.51       60,526       653       4.38       29,067       313       4.37  
Other earning assets
    32,899       24       0.30       41,077       29       0.29       7,532       11       0.57  
Total earning assets
    463,244       5,933       5.19       565,972       7,505       5.38       571,053       7,823       5.56  
Non earning assets
    63,167                       54,180                       54,765                  
Total assets
  $ 526,411                     $ 620,152                     $ 625,818                  
                                                                         
Liabilities and Shareholders’ Equity
                                                                       
Interest-bearing deposits:
                                                                       
Transaction accounts
  $ 38,350     $ 52       0.55 %   $ 41,354     $ 44       0.43 %   $ 34,086     $ 50       0.59 %
Savings and money market accounts
    110,685       213       0.78       101,138       337       1.35       99,194       370       1.51  
Time deposits
    252,248       1,512       2.43       346,391       2,493       2.92       299,383       2,465       3.25  
Total interest-bearing deposits
    401,283       1,777       1.80       488,883       2,874       2.38       432,663       2,885       2.64  
 
 
23

 
 
    Average Balances, Income and Expenses, and Rates  
Three Months Ended March 31,
  2011     2010     2009  
(Dollars in
 
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield /
 
thousands)
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Other interest-bearing liabilities:
                                                     
Federal Home Loan Bank borrowing
    18,522       68       1.49 %     27,780       235       3.43       82,045       667       3.29  
Junior subordinated debentures
    10,310       11       0.11       10,310       153       6.02       10,310       152       5.99  
Other
    376       -               772       -       -       11,815       36       2.35  
Total other interest-bearing liabilities
    29,208       79       1.10       38,862       388       4.05       104,170       855       3.33  
                                                                         
Total interest-bearing liabilities
    430,491       1,856       1.75       527,745       3,262       2.51       536,833       3,739       2.82  
Noninterest-bearing deposits
    45,109                       43,367                       47,575                  
Other liabilities
    2,473                       3,412                       1,507                  
Shareholders’ equity
    48,338                       45,628                       39,903                  
                                                                         
Total liabilities and equity
  $ 526,411                     $ 620,152                     $ 625,818                  
                                                                         
Net interest income/interest spread
          $ 4,077       3.44 %           $ 4,243       2.87 %           $ 4,084       2.74 %
Net yield on earning assets
                    3.57 %                     3.04 %                     2.90 %
 

(1)  
Includes mortgage loans held for sale and nonaccruing loans

 
24

 
 
Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume.  The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.
 
Three Months Ended March 31,
 
2011 Compared to 2010
   
2010 Compared to 2009
 
   
Due to increase (decrease) in
   
Due to increase (decrease) in
 
(Dollars in thousands)
 
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
Interest income:
                                   
Loans
  $ (827 )   $ (316 )   $ (1,143 )   $ (1,277 )   $ 522     $ (755 )
Securities, taxable
    (237 )     (68 )     (305 )     151       (72 )     79  
Securities, tax exempt
    (141 )     22       (119 )     339       -       339  
Other earning assets
    (5 )     1       (4 )     26       (7 )     19  
Total interest income
    (1,210 )     (361 )     (1,571 )     (761 )     443       (318 )
                                                 
Interest expense:
                                               
Interest-bearing deposits
                                               
Interest-bearing transaction accounts
    (3 )     11       8       9       (15 )     (6 )
Savings and money market accounts
    29       (153 )     (124 )     7       (40 )     (33 )
Time deposits
    (606 )     (374 )     (980 )     359       (332 )     27  
Total interest-bearing deposits
    (580 )     (516 )     (1,096 )     375       (387 )     (12 )
                                                 
Other interest-bearing liabilities
                                               
Federal Home Loan Bank borrowings
    (63 )     (106 )     (169 )     (460 )     29       (431 )
Junior subordinated debentures
    -       (142 )     (142 )     -       -       -  
Other
    -       -       -       (19 )     (15 )     (34 )
Total other interest-bearing liabilities
    (63 )     (248 )     (311 )     (479 )     14       (465 )
                                                 
Total interest expense
    (643 )     (764 )     (1,407 )     (104 )     (373 )     (477 )
                                                 
Net interest income
  $ (567 )   $ 403     $ (164 )   $ (657 )   $ 816     $ 159  

Provision and Allowance for Loan Losses

We have developed policies and procedures for evaluating the overall quality of our credit portfolio and the timely identification of potential problem credits.  On a quarterly basis, our Board of Directors reviews and approves the appropriate level for the allowance for loan losses based upon management’s recommendations, the results of our internal monitoring and reporting system, and an analysis of economic conditions in our market.  The objective of management has been to fund the allowance for loan losses at a level greater than or equal to our internal risk measurement system for loan risk.

 
25

 
 
Additions to the allowance for loan losses, which are expensed as the provision for loan losses on our statement of operations, are made periodically to maintain the allowance at an appropriate level based on management’s analysis of the potential risk in the loan portfolio.  Loan losses and recoveries are charged or credited directly to the allowance.  The amount of the provision is a function of the level of loans outstanding, the level of nonperforming loans, historical loan loss experience, the amount of loan losses actually charged against the reserve during a given period, and current and anticipated economic conditions.

The allowance represents an amount which management believes will be adequate to absorb inherent losses on existing loans that may become uncollectible.  Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate. Our determination of the allowance for loan losses is based on regular evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical loan loss experience, and a review of specific problem loans. We also consider subjective issues such as changes in our lending policies and procedures, changes in the local and national economy, changes in volume or type of credits, changes in the volume or severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons.

More specifically, in determining our allowance for loan losses, we regularly review loans for specific and impaired reserves based on the appropriate impairment assessment methodology. Pooled reserves are determined using historical loss trends measured over a four quarter average applied to risk rated loans grouped by Federal Financial Examination Council (“FFIEC”) call code and segmented by impairment status. The pooled reserves are calculated by applying the appropriate historical loss ratio to the loan categories. Impaired loans greater than a minimum threshold established by management are excluded from this analysis. The sum of all such amounts determines our pooled reserves.  Management undertook a thorough statistical review of our recognized loss history during the 2010 calendar year.  This analysis revealed that over 80% of our losses were concentrated in the coastal markets.  Management has strategically decided to reduce the Bank’s portfolio exposure to the coastal markets due to this and other factors.  Accordingly, we modified our loss history calculation to segment our losses by geography.  We now calculate a loss factor for each geographic region, then weight the overall loss factor by the geographic weight remaining in the overall portfolio.  Over time we expect this to have a material impact on our required allowance level as we continue to reduce our exposure to problematic markets.  We have also shortened the period over which we review historical losses from eight quarters to four in response to industry trends and conditions; the shorter loss history window is more in line with our peer group.

We track our portfolio and analyze loans grouped by FFIEC call code categories. The first step in this process is to risk grade each and every loan in the portfolio based on one common set of parameters. These parameters include items like debt-to-worth ratio, liquidity of the borrower, net worth, experience in a particular field and other factors such as underwriting exceptions. Weight is also given to the relative strength of any guarantors on the loan.

After risk grading each loan, we then segment the portfolio by FFIEC call code groupings, separating out substandard or impaired loans.  The remaining loans are grouped into “performing loan pools.”  The loss history for each performing loan pool is measured over a specific period of time to create a loss factor for each geographic region.  The overall loss factor is then calculated by weighting each geographic region within the overall portfolio.  The relevant look back period is determined by the Bank, regulatory guidance, and current market events.  The loss factor is then applied to the pool balance and the reserve per pool calculated.  Loans deemed to be substandard but not impaired are segregated and a loss factor is applied to this pool as well.  Loans are segmented based upon sizes as smaller impaired loans are pooled and a loss factor applied, while larger impaired loans are assessed individually using the appropriate impairment measuring methodology.  Finally, five qualitative factors are utilized to assess economic and other trends not currently reflected in the loss history. These factors include concentration of credit across the portfolio, the experience level of management and staff, effects of changes in risk selection and underwriting practice, industry conditions and the current economic and business environment.  A quantitative value is assigned to each of the five factors, which is then applied to the performing loan pools. Negative trends in the loan portfolio increase the quantitative values assigned to each of the qualitative factors and, therefore, increase the reserve.  For example, as general economic and business conditions decline, this qualitative factor’s quantitative value will increase, which will increase the reserve requirement for this factor.  Similarly, positive trends in the loan portfolio, such as improvement in general economic and business conditions, will decrease the quantitative value assigned to this qualitative factor, thereby decreasing the reserve requirement for this factor.  These factors are reviewed and updated by our risk management committee on a regular basis to arrive at a consensus for our qualitative adjustments.

Periodically, we adjust the amount of the allowance based on changing circumstances. We recognize loan losses to the allowance and add subsequent recoveries back to the allowance for loan losses. In addition, on a quarterly basis, we informally compare our allowance for loan losses to various peer institutions; however, we recognize that allowances will vary as financial institutions are unique in the make-up of their loan portfolios and customers, which necessarily creates different risk profiles for the institutions. We would only consider further adjustments to our allowance for loan losses based on this peer review if our allowance was significantly different from our peer group. To date, we have not made any such adjustment. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period, especially considering the overall weakness in the economic environment in our market areas.

 
26

 
 
Various regulatory agencies review our allowance for loan losses through their periodic examinations, and they may require additions to the allowance for loan losses based on their judgment and assumptions about the economic condition of our market and the loan portfolio available to them at the time of their examinations. Our losses will undoubtedly vary from our estimates, and it is possible that charge-offs in future periods will exceed the allowance for loan losses as estimated at any point in time.

As of March 31, 2011 and 2010, the allowance for loan losses was $5,697,858 and $6,725,174, respectively, a decrease of $1,027,316, or 15.28%, from the 2010 allowance.  However, as a percentage of total loans, the allowance for loan losses was 1.67% and 1.71% at March 31, 2011 and 2010, respectively.  The decrease in the allowance for loan losses was driven primarily by the significant reduction in the size of our loan portfolio, particularly the segment of the portfolio located in coastal South Carolina.  At March 31, 2011 compared to March 31, 2010, our loan portfolio was $51,261,885 or 13.07% lower.  For 2011 compared to 2010 the average volume of our loans was $55,683,610 or 13.81% lower.   See “Nonperforming Assets” below for additional information regarding our asset quality and loan portfolio.

For the first quarter of 2011 and 2010, the provision for loan losses was $241,114 and $186,089, respectively

We believe the allowance for loan losses at March 31, 2011, is adequate to meet potential loan losses inherent in the loan portfolio, and, as described earlier, to maintain the flexibility to adjust the allowance should our local economy and loan portfolio either improve or decline in the future.

Noninterest Income

The following is a summary of noninterest income for the three months ended March 31, 2011 and 2010.
 
   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Service fees on deposit accounts
  $ 445,562     $ 468,220  
Gain on sale of mortgage loans
    123,045       210,043  
Other income
    438,086       364,022  
Total noninterest income
  $ 1,006,693     $ 1,042,285  
 
Noninterest income decreased $35,592, or 3.41%, to $1,006,693 for the first quarter of 2011 from $1,042,285 for the first quarter of 2010.  Due to the weak demand for mortgage loans and the bottoming out of residential mortgages being refinanced because of low interest rates our gain on the sale of mortgage loans was $86,998, or 41.42%, lower for the three months ended March 31, 2011 compared to the comparable 2010 period.

Noninterest Expense

For the quarter ended March 31, 2011, noninterest expense totaled $5,023,900, which is $388,525, or 8.38%, higher than our noninterest expense for the quarter ended March 31, 2010.

The primary reason for the increase in our noninterest expense is attributable to the increase in the following expense items:

1.  
Other real estate owned expense increased $185,498 as a result of the significant increase in the volume in other real estate owned.  At March 31, 2011, our other real estate owned totaled $17,852,080 compared to $7,249,401 at March 31, 2010.

2.  
Professional fees and service expense was $44,274 higher as a result of the increase in professional fees relating to certain legal expenses related to foreclosures and troubled loans, as well as mortgage-related litigation insurance claims.

3.  
Supervisory fees and assessment expense increased by $60,336 due to an increase in our FDIC assessment rates largely relating to efforts by the FDIC to replenish the Deposit Insurance Fund (DIF) in light of the difficult current banking environment.

Our income tax provision for the quarters ended March 31, 2011 and 2010 consists of a tax benefit of $293,686 and $66,232, respectively.  The increase in the tax benefit is attributable to the relationship of our non-taxable income generated from investments in bank-owned life insurance and tax-exempt municipal bonds to our net income (loss) before income taxes.

 
27

 
 
Balance Sheet Review
 
General
 
At March 31, 2011, we had total assets of $530.2 million, consisting principally of $340.9 million in loans, $88.1 million in investments, and $37.1 million in cash and due from banks.  Our liabilities at March 31, 2011, totaled $481.6 million, which consisted principally of $448.3 million in deposits, $20.0 million in FHLB advances, and $10.7 million in other borrowings.  At March 31, 2011, our shareholders’ equity was $48.7 million.

At December 31, 2010, we had total assets of $530.1 million, consisting principally of $354.3 million in loans, $88.8 million in investments, and $25.7 million in cash and due from banks.  Our liabilities at December 31, 2010 totaled $481.5 million, consisting principally of $455.3 million in deposits, $13.0 million in FHLB advances, and $10.8 million in other borrowings.  At December 31, 2010, our shareholders’ equity was $48.6 million.

Investment Securities

The investment securities portfolio, which is also a component of our total earning assets, consists of securities available-for-sale and nonmarketable equity securities.

At March 31, 2011 our investment in available-for sale securities was $83,738,531, this is $734,022, or 0.87%, lower than our investment of $84,472,553 in available-for-sale securities at December 31, 2010.

The amortized costs and the fair value of our securities available-for-sale at March 31, 2011 and December 31, 2010 are shown in the following table.
 
   
March 31, 2011
   
December 31,2010
 
   
Amortized
   
Estimated
   
Amortized
   
Estimated
 
   
Cost
   
Fair Value
   
Cost
   
Fair Value
 
Government sponsored enterprises
  $ 2,911     $ 2,966     $ 5,031     $ 5,178  
Mortgage-backed securities
    35,366,442       35,470,823       35,361,686       35,769,713  
Municipal securities
    48,828,388       48,234,917       49,804,336       48,657,162  
Other
    200,000       29,825       200,000       40,500  
    $ 84,397,741     $ 83,738,531     $ 85,371,053     $ 84,472,553  

At March 31, 2011, securities classified as available-for-sale are recorded at fair market value.  Approximately 38.54% of the unrealized losses, or five individual securities, consisted of securities in a continuous loss position for twelve months or more.  We do not intend to sell these securities in the near future and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost. We believe, based on industry analyst reports and credit ratings, that the deterioration in value is attributable to changes in market interest rates and is not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary.

Securities Available-for-sale Maturity Distribution and Yields

Contractual maturities and yields on our available for sale securities at March 31, 2011 are shown in the following table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
   
After One But
   
After Five But
                         
March 31, 2011
 
Within Five Years
   
Within Ten Years
   
After Ten Years
   
Total
 
(Dollars in thousands)
 
Amount
   
Yield
   
Amount
   
Yield
   
Amount
   
Yield
   
Amount
   
Yield
 
U.S. government agencies and corporations
  $ 3       6.34 %   $ -       - %   $ -       - %   $ 3       6.34 %
Municipals
    6,583       4.04       17,233       4.32       24,419       4.44       48,235       4.34  
Total securities (1)
  $ 6,586       4.04 %   $ 17,233       4.32 %   $ 24,419       4.44 %   $ 48,238       4.34 %
 

(1)  
Excludes mortgage-backed securities totaling $35,470,823 with a yield of 4.00 % and other securities totaling $29,825.
 
 
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During the first quarter of 2011, we sold approximately $10,500,000 of available-for-sale securities and replaced them with higher investor-rated securities.

At March 31, 2011 and December 31, 2010, nonmarketable equity securities totaled $4,357,300 consisting of Federal Home Loan Bank and Community Bankers Bank stock, which are recorded at their original cost of $4,299,200 and $58,100, respectively.

Loans

Loans, including loans held for sale, are the largest category of earning assets and typically provide higher yields than the other types of earning assets.  Associated with the higher loan yields are the inherent credit and liquidity risks which, we attempt to control and counterbalance.  Loans averaged $347,550,126 during the first quarter of 2011 compared to $403,233,736 during the first quarter of 2010, a decrease of $55,683,610, or 13.81%.  At March 31, 2011, total loans were $341,904,328 compared to $355,513,545 at December 31, 2010, a decrease of $13,609,217, or 3.83%.  Excluding loans held for sale, loans were $340,930,851 at March 31, 2011, compared to $354,327,969 at December 31, 2010, which equated to a decrease of $13,397,118, or 3.78%. This decrease is the result of the economic downturn in our markets that caused the volume of new loan customers to decrease.

The following table summarizes the composition of our loan portfolio March 31, 2011 and December 31, 2010.
 
   
March 31,
   
% of
   
December 31,
   
% of
 
   
2011
   
Total
   
2010
   
Total
 
Mortgage loans on real estate
                       
Construction
  $ 58,413,807       17.14 %   $ 62,635,354       17.68 %
Residential 1-4 family
    49,702,946       14.58       50,085,085       14.13  
Multifamily
    8,572,050       2.51       9,337,285       2.64  
Second mortgages
    4,662,649       1.37       4,782,583       1.35  
Equity lines of credit
    26,635,843       7.81       27,989,649       7.90  
Commercial
    145,279,680       42.61       152,178,318       42.95  
Total mortgage loans
    293,266,975       86.02       307,008,274       86.65  
Commercial and industrial
    39,619,169       11.62       40,856,292       11.53  
Consumer
    6,806,996       2.00       6,057,089       1.71  
Other, net
    1,237,711       0.36       406,314       0.11  
Total loans
  $ 340,930,851       100.00 %   $ 354,327,969       100.00 %

In the context of this discussion, a “real estate mortgage loan” is defined as any loan, other than a loan for construction purposes, secured by real estate, regardless of the purpose of the loan.  It is common practice for financial institutions in our market area to obtain a mortgage on the Borrower’s real estate when possible, in addition to any other available collateral.  This collateral is taken to reinforce the likelihood of the ultimate repayment of the loan and tends to increase management’s willingness to make real estate loans and, to that extent, also tends to increase the magnitude of the real estate loan portfolio component.

The largest component of our loan portfolio is real estate mortgage loans.  At March 31, 2011, real estate mortgage loans totaled $234,853,168 and represented 68.89% of the total loan portfolio, compared to $244,372,921, or 68.97%, at December 31, 2010.

Residential mortgage loans totaled $89,573,488 at March 31, 2011, and represented 26.27% of the total loan portfolio, compared to $92,194,602 and 26.02%, respectively, at December 31, 2010.  Residential real estate loans consist of first and second mortgages on single or multi-family residential dwellings.  Nonresidential mortgage loans, which include commercial loans and other loans secured by multi-family properties and farmland, totaled $145,279,680 at March 31, 2011, compared to $152,178,318 at December 31, 2010.  This represents a decrease of $6,898,638, or 4.53%, from the December 31, 2010 balance.  Real estate construction loans were $58,413,807 and $62,635,354 at March 31, 2011 and December 31, 2010, respectively, and represented 17.14% and 17.68% of the total loan portfolio, respectively.  Currently, the demand for all types of real estate mortgage loans in our market area is very weak, largely because of the general economic downturn that has affected many businesses and individuals in our market area.

Commercial and industrial loans decreased $1,237,123, or 3.03%, to $39,619,169 at March 31, 2011, from $40,856,292 at December 31, 2010.  The decrease is mainly due to the economic downturn in our markets that caused the demand for these types of loans to decrease.  At March 31, 2011 and December 31, 2010, commercial and industrial loans represented 11.62% and 11.53%, respectively, of the total loan portfolio.
 
 
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Our loan portfolio is also comprised of consumer and other loans that totaled $8,044,707 and $6,463,403 at March 31, 2011 and December 31, 2010, respectively.  At March 31, 2011 and December 31, 2010, these loans represented 2.36% and 1.82%, respectively, of the total loan portfolio.

Our loan portfolio reflects the diversity of our markets.  The economies of our markets contain elements of medium and light manufacturing, higher education, regional health care, and distribution facilities. We expect the local economy to remain stable; however due to the current economic challenges facing our markets, we do not expect any material growth in our loan portfolio in the near future.  We do not engage in foreign lending.

Maturities and Sensitivity of Loans to Changes in Interest Rates
 
The information in the following tables is based on the contractual maturities of individual loans, including loans, which may be subject to renewal at their contractual maturity.  Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity.  Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

The following table summarizes the loan maturity distribution by type and related interest rate characteristics at March 31, 2011.

Loan Maturity Schedule and Sensitivity to Changes in Interest Rates
 
March 31, 2011
       
Over
             
(Dollars in thousands)
       
One Year
             
   
One Year or
   
Through
   
Over Five
       
   
Less
   
Five Years
   
Years
   
Total
 
Commercial and industrial
  $ 115     $ 33,512     $ 5,992     $ 39,619  
Real estate
    5,334       214,708       73,225       293,267  
Consumer and other
    435       4,313       3,297       8,045  
    $ 5,884     $ 252,533     $ 82,514     $ 340,931  
Loans maturing after one year with:
                               
Fixed interest rates
                          $ 171,340  
Floating interest rates
                            163,707  
                            $ 335,047  
 
Activity in the Allowance for Loan Losses

The following table summarizes the activity related to our allowance for loan losses for the three months ended March 31, 2011 and 2010.
 
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
Balance, January 1
  $ 6,271     $ 9,801  
Loans charged off:
               
Real estate – construction
    261       2,351  
Real estate – mortgage
    555       1,345  
Commercial and industrial
    305       108  
Consumer and other
    9       24  
Total loan losses
    1,130       3,828  
Recoveries of previous loan losses:
               
Real estate – construction
    216       40  
Real estate – mortgage
    97       76  
Commercial and industrial
    3       359  
Consumer and other
    -       91  
Total recoveries
    316       566  
Net charge-offs
    814       3,262  
Provision for loan losses
    241       186  
Balance, March 31
  $ 5,698     $ 6,725  
Total loans outstanding, end of period
  $ 340,931     $ 392,193  
Allowance for loan losses to loans outstanding
    1.67 %     1.71 %
 
 
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Risk Elements in the Loan Portfolio

The following table shows the nonperforming assets, percentages of net charge-offs, and the related percentage of allowance for loan losses for the three months ended March 31, 2011 and 2010.
 
(Dollars in thousands)
 
2011
   
2010
 
Loans over 90 days past due and still accruing
  $ 1,569     $ 1  
Loans on nonaccrual:
               
Real Estate Construction
    14,230       15,103  
Real Estate Mortgage
    8,472       8,668  
Commercial
    751       1,004  
Consumer
    5       12  
Total nonaccrual loans
    23,458       24,787  
Total of nonperforming loans
    25,027       24,788  
Other nonperforming assets
    17,852       7,249  
Total nonperforming assets
  $ 42,879     $ 32,037  
 
Percentage of nonperforming assets to total assets
    8.09 %     5.20 %
Percentage of nonperforming loans to total loans
    7.34 %     6.32 %
Allowance for loan losses as a percentage of non-performing loans
    22.77 %     27.13 %
 
Nonaccruing loans – At March 31, 2011 and 2010, loans totaling $23,457,852 and $24,787,204, respectively, were in nonaccrual status.  Generally, loans are placed on nonaccrual status if principal or interest payments become 90 days past due and/or we deem the collectibility of the principal and/or interest to be doubtful.  Once a loan is placed in nonaccrual status, all previously accrued and uncollected interest is reversed against interest income.  Interest income on nonaccrual loans is recognized on a cash basis when the ultimate collectability is no longer considered doubtful.  Loans are returned to accrual status when the principal and interest amounts contractually due are brought current and future payments are reasonably assured.  If interest on our loans classified as nonaccrual at March 31, 2011 and 2010 had been recognized on a fully accruing basis, we would have recorded approximately $207,000 and $170,000 of additional interest income for the quarters ended March 31, 2011 and 2010, respectively.  All nonaccruing loans at March 31, 2011 and 2010 were included in our classification of impaired loans at those dates.

Loans over 90 days past due and still accruing – As of March 31, 2011 and 2010, we had loans totaling $1,569,049 and $635, respectively, that were past due over 90 days and still accruing interest.   All loans are secured by real estate and included in our impaired loan classification at March 31, 2011 and 2010.

Restructured Loans - In situations where, for economic or legal reasons related to a borrower’s financial difficulties, a concession to the borrower is granted that we would not otherwise consider, the related loan is classified as a troubled debt restructuring.  The restructuring of a loan may include the transfer of real estate collateral, either through the pledge of additional properties by the borrower or through a transfer to the Bank in lieu of foreclosures.  Restructured loans may also include the borrower transferring to the Bank receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan, a modification of the loan terms, or a combination of the above.

At March 31, 2011, we had restructured loans totaling $2,616,974 consisting of eight borrowers.  All loans were secured by real estate and included in our classification of impaired loans at March 31, 2011.  These loans were performing and generally renegotiated for lower interest rates.  In most cases, these restructured loans were made as a result of the general economic downturn and its effect on depressing real estate sales and purchases and other economic activity in our market area.  Restructures loans totaled $337,000 at March 31, 2010.  All restructured loans at March 31, 2011 and 2010 were included in our classification of impaired loans.

Impaired loans - At March 31, 2011, we had impaired loans totaling $28,554,893, as compared to $24,787,204 at March 31, 2010.  Included in the impaired loans at March 31, 2011 were 10 borrowers that accounted for approximately 68.64% of the total amount of the impaired loans at that date.  These loans were primarily commercial real estate loans located in coastal South Carolina.  Impaired loans, as a percentage of total loans, were 8.38% at March 31, 2011 as compared to 6.32% at March 31, 2010.
 
 
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During the quarter ended March 31, 2011, the average investment in impaired loans was $26,619,700 as compared to $34,862,181 during the quarter ended March 31, 2010.  Impaired loans with a specific allocation of the allowance for loan losses totaled $10,669,918 and $2,817,993 at March 31, 2011 and 2010, respectively.  The amount of the specific allocation at March 31, 2011 and 2010 was $499,144 and $221,738, respectively.

The downturn in the real estate market that began in 2008 has resulted in an increase in loan delinquencies, defaults and foreclosures; however, we believe these trends are stabilizing as the liquidation prices for our other real estate owned have stabilized for vertical construction, indicating some stabilization of demand for that product.  In some cases, the current economic downturn has resulted in a significant impairment to the value of our collateral and limits our ability to sell the collateral upon foreclosure at its appraised value. There is also risk that downward trends could continue at a higher pace.  If real estate values further decline, it is also more likely that we would be required to increase our allowance for loan losses.

On a quarterly basis, we analyze each loan that is classified as impaired during the period to determine the potential for possible loan losses.  This analysis is focused upon determining the then current estimated value of the collateral, local market condition, and estimated costs to foreclose, repair and resell the property.  The net realizable value of the property is then computed and compared to the loan balance to determine the appropriate amount of specific reserve for each loan.

Other nonperforming assets – Other nonperforming assets consist of other real estate owned (“OREO”) that was acquired through foreclosure.  Other real estate owned is carried at fair market value minus estimated costs to sell.  Current appraisals are obtained at time of foreclosure and write-downs, if any, charged to the allowance for loan losses as of the date of foreclosure.  On a regular basis, we reevaluate our OREO properties for impairment.  Along with gains and losses on disposal, expenses to maintain such assets and subsequent changes in the valuation allowance are included in other noninterest expense.

As of March 31, 2011, we had OREO properties totaling $17,852,080 geographically located in the following South Carolina areas - 71% in the Coastal area, 17% in the Columbia area and 12% in the Florence area.  The combined nature of these properties is 91% commercial and 9% residential and other.  While we are diligently trying to dispose of our OREO properties, the currently depressed real estate market affects our ability to do so in a timely manner without experiencing additional losses.  Additionally, there can be no assurance that these properties can be sold for their carrying values.

Deposits and Other Interest-Bearing Liabilities

Average interest-bearing liabilities decreased $97,254,086 or 18.43%, to $430,491,297 for the first quarter of 2011, from $527,745,383 for the comparable 2010 period.  Deposits declined as a part of the Company’s effort to shrink the loan portfolio and to reduce interest expense.

Deposits - For the quarter ended March 31, 2011 and 2010, average total deposits were $446,392,747 and $532,249,647, respectively, which is a decrease of $85,856,900, or 16.13%.  At March 31, 2011 and December 31, 2010, total deposits were $448,333,401 and $455,250,465, respectively, a decrease of $6,917,064, or 1.52%.

Average interest-bearing deposits decreased $87,599,135, or 17.92%, to $401,283,399 for the quarter ended March 31, 2011, from $488,882,534 for the quarter ended March 31, 2010.

The average balance of non-interest bearing deposits increased $1,742,235, or 4.02%, to $45,109,348 for the three months ended March 31, 2011, from $43,367,113 for the three months ended March 31, 2010.

The following table shows the average balance amounts and the average rates paid on deposits held by us for the three months ended March 31, 2011 and 2010. 
 
      2011    
2010
 
   
Average
Amount
   
Average
Rate
   
Average
Amount
   
Average
Rate
 
Noninterest bearing demand deposits
  $ 45,109,348       0.00 %   $ 43,367,113       0.00 %
Interest bearing demand deposits
    38,349,978       0.55       41,354,002       0.43  
Savings accounts
    110,685,338       0.78       101,137,758       1.35  
Time deposits
    252,248,083       2.43       346,390,774       2.92  
    $ 446,392,747       1.61 %   $ 532,249,647       2.19 %
 
 
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Core deposits, which exclude time deposits of $100,000 or more, provide a relatively stable funding source for our loan portfolio and other earning assets.  Our core deposits were $309,124,174 and $297,769,985 at March 31, 2011 and December 31, 2010, respectively.  This equates to an increase of $11,354,189, or 3.81%, which is the result of our continued focus to replace wholesale deposits and other borrowings with core deposits.

Included in time deposits of $100,000 and over, at March 31, 2011 and December 31, 2010 are brokered time deposits of $97,929,000 and $111,929,000, respectively, equating to a decrease of $14,000,000.  In accordance with our asset/liability management strategy, we do not intend to renew or replace the outstanding brokered deposits at March 31, 2011, when they mature.

Deposits, and particularly core deposits, have been our primary source of funding and have enabled us to meet successfully both our short-term and long-term liquidity needs.  We anticipate that such deposits will continue to be our primary source of funding in the future.  Our loan-to-deposit ratio was 76.04% and 77.83% on March 31, 2011 and December 31, 2010, respectively.

The maturity distribution of our time deposits of $100,000 or more at March 31, 2011, is set forth in the following table:

   
March 31,
2011
 
Three months or less
  $ 25,255,009  
Over three through twelve months
    18,637,488  
Over one year through three years
    77,281,525  
Over three years
    18,035,205  
Total
  $ 139,209,227  
 
Approximately 31.53% of our time deposits of $100,000 or more had scheduled maturities within one year.  Large certificate of deposit customers tend to be extremely sensitive to interest rate levels, making these deposits less reliable sources of funding for liquidity planning purposes than core deposits.  We expect most certificates of deposits with maturities less than one year to be renewed upon maturity. However, there is the possibility that some certificates may not be renewed.  We believe that, should these certificates of deposit not be renewed, the impact would be minimal on our operations and liquidity due to the availability of other funding sources.

Other Borrowings – Other borrowings at March 31, 2011 and December 31, 2010, consist of the following:

   
March 31,
2011
   
December 31,
2010
 
Securities sold under agreement to repurchase
  $ 396,883     $ 476,522  
Advances from the Federal Home Loan Bank
    20,000,000       13,000,000  
Junior subordinated debentures
    10,310,000       10,310,000  
 
Securities sold under agreements to repurchase mature on a one to seven day basis.  These agreements are secured by U.S. government agencies.  Advances from Federal Home Loan Bank mature at different periods and are secured by our one to four family residential mortgage loans and our investment in Federal Home Loan Bank stock.  The new advances of $7,000,000 from the Federal Home Loan Bank were used to repay brokered deposits that matured during the first quarter of 2011.

Capital Resources

Total shareholders’ equity at March 31, 2011 and December 31, 2010 was $48,674,385 and $48,591,844, respectively.  The $82,541 increase during the first three months of 2011 resulted primarily from the increase in accumulated other comprehensive income of $157,932, net income of $114,670, reduction in restricted stock, and offset by preferred stock dividends.

The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the three months ended March 31, 2011 and 2010.  While the Company has not paid a cash dividend on our common stock since our inception, the Company has declared and paid dividends on its outstanding shares of preferred stock, and made quarterly interest payments on its trust-preferred securities as agreed.  Under the terms of the Company MOU, the terms of which are more fully described as part of “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Regulatory Matters”, the Company must request prior approval from the Federal Reserve prior to declaring or paying dividends on our common stock or preferred stock, or making scheduled interest payments on our trust-preferred securities.
 
   
March 31,
 
   
2011
   
2010
 
Return on average assets
    0.09 %     0.35 %
Return on average equity
    0.96       4.71  
Average equity to average assets ratio
    9.18       7.36  
 
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s consolidated financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Company’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  Currently, the Bank MOU requires that the Bank maintain a Tier 1 leverage ratio of 8%, and our other regulatory capital ratios at such levels so as to be considered well capitalized for regulatory purposes.  We continue to be in full compliance with this requirement of the Bank MOU.  Additional discussion of the Bank MOU is included above as part of “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Regulatory Matters.”

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance-sheet exposures, adjusted for risk weights ranging from 0% to 100%.  Tier 1 capital of the Company consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets.  The Company’s Tier 2 capital consists of the allowance for loan losses subject to certain limitations.  Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 capital and 8% for total risk-based capital; under the provisions of the Memorandum the Bank will be required to maintain a Tier 1 leverage ratio of 8% and a total risk-based capital ratio of 10%.

The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.  Only the strongest banks are allowed to maintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios 1% to 2% above the minimum.

The following table sets forth the holding company’s and the bank’s various capital ratios at March 31, 2011 and at December 31, 2010.  For both periods, the bank was considered “well capitalized” and the holding company met or exceeded its applicable regulatory capital requirements.

 
   
March 31, 2011
   
December 31, 2010
 
   
Holding
Company
   
Bank
   
Holding
Company
   
Bank
 
Tier 1 capital (to risk-weighted assets)
    13.70 %     12.23 %     13.34 %     11.87 %
Total capital (to risk-weighted assets)
    14.95 %     13.48 %     14.59 %     13.13 %
Leverage or Tier 1 capital (to total average assets)
    10.63 %     9.58 %     9.99 %     8.94 %
 
Effect of Inflation and Changing Prices
 
The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements.  Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature.  Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general.  In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude.  As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Off-Balance Sheet Risk
Through our operations, we have made contractual commitments to extend credit in the ordinary course of its business activities.  These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time.  At March 31, 2011 we had issued commitments to extend credit of $32.7 million and standby letters of credit of $2.2 million through various types of commercial lending arrangements. Approximately $29.88 million of these commitments to extend credit had variable rates.
 
 
33

 
 
The following table sets forth the length of time until maturity for unused commitments to extend credit and standby letters of credit at March 31, 2011:
 
(Dollars in thousands)
 
Within One Month
   
After One
Through
Three Months
   
After Three Through Twelve Months
   
Within One
Year
   
Greater
Than One Year
   
Total
 
Unused commitments to extend credit
  $ 1,431     $ 2     $ 829     $ 2,262     $ 30,445 $       32,707  
Standby letters of credit
    75       -       1,502       1,577       629       2,206  
Totals
  $ 1,506     $ 2     $ 2,331     $ 3,839     $ 31,074 $       34,913  
 
Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates and principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities.  Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.  Our finance committee monitors and considers methods of managing exposure to interest rate risk.  We have both an internal finance committee consisting of senior management and directors that meets at various times during each quarter and a management finance committee that meets weekly as needed.  The finance committees are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.

We actively monitor and manage our interest rate risk exposure principally by measuring our interest sensitivity “gap,” which is the positive or negative dollar difference between assets and liabilities that are subject to interest rate repricing within a given period of time.  Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available for sale, replacing an asset or liability at maturity, or adjusting the interest rate during the life of an asset or liability.  Managing the amount of assets and liabilities repricing in this same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates.  We generally would benefit from increasing market rates of interest when we have an asset-sensitive gap position and generally would benefit from decreasing market rates of interest when we are liability-sensitive.

We were liability sensitive during the year ended December 31, 2010 and during the three months ended March 31, 2011.  As of March 31, 2011, we expect to be liability sensitive for the next nine months because a majority of our deposits reprice over a 12-month period.  Approximately 51% of our loans were variable rate loans at March 31, 2011.  The ratio of cumulative gap to total earning assets after 12 months was (15.714%) because $73.1 million more liabilities will reprice in a 12 month period than assets.   However, our gap analysis is not a precise indicator of our interest sensitivity position.  The analysis presents only a static view of the timing of maturities and repricing opportunities, without taking into consideration that changes in interest rates do not affect all assets and liabilities equally.  For example, rates paid on a substantial portion of core deposits may change contractually within a relatively short time frame, but those rates are viewed by us as significantly less interest-sensitive than market-based rates such as those paid on noncore deposits.  Net interest income may be affected by other significant factors in a given interest rate environment, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities.

Liquidity and Interest Rate Sensitivity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities.  Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits.  Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control.  For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made.  However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

At March 31, 2011, our liquid assets, consisting of cash and cash equivalents amounted to $37.1 million, or 6.99% of total assets.  Our investment securities, excluding nonmarketable securities, at March 31, 2011 amounted to $83.7 million, or 15.79% of total assets.  Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.  However, $10.9 million of these securities were pledged as collateral to secure public deposits and borrowings as of March 31, 2011.  At December 31, 2010, our liquid assets, consisting of cash and cash equivalents amounted to $25.6 million, or 4.84% of total assets.  Our investment securities, excluding nonmarketable securities, at December 31, 2010 amounted to $84.5 million, or 15.94% of total assets.  Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.  However, $84.4 million of these securities were pledged as collateral to secure public deposits and borrowings as of December 31, 2010.
 
 
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Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity.  For the near future, it is our intention to reduce the use of wholesale funding to fund loan demand.  We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, and from additional borrowings.  In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities.  At March 31, 2011, we had two federal funds purchased lines of credit with correspondent banks giving us credit availability totaling approximately $5.0 million for which there were no outstanding borrowings.  In addition, at March 31, 2011, we had sufficient unpledged securities that would have allow us to borrow up to $72.8 million from the Federal Reserve Bank.  Also, we are a member of the Federal Home Loan Bank of Atlanta, (the “FHLB”) from which applications for borrowings can be made for leverage purposes.  The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the bank be pledged to secure any advances from the FHLB. We have an available line to borrow funds from the Federal Home Loan Bank up to 30% of the Bank’s total assets, which provide additional available funds of $159.1 million at March 31, 2011.  At March 31, 2011 the bank had $20 million outstanding in FHLB advances.  We believe that sources described above will be sufficient to meet our future liquidity needs.

The Company is largely dependent upon dividends from the Bank as a source of cash.  The Bank MOU restricts the ability of the Bank to declare and pay dividends to the Company.  The Company MOU requires the Company to obtain approval of the Federal Reserve Bank prior to declaring dividends.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Regulatory Matters” for additional information relating to the Company MOU.

Asset/liability management is the process by which we monitor and control the mix and maturities of our assets and liabilities. The essential purposes of asset/liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. We have both an internal finance committee consisting of senior management that meets at various times during each quarter and a management finance committee that meets weekly as needed.  The finance committees are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.

Interest Sensitivity Analysis

The following table sets forth information regarding our rate sensitivity as of March 31, 2011, for each of the time intervals indicated. The information in the table may not be indicative of our rate sensitivity position at other points in time.  In addition, the maturity distribution indicated in the table may differ from the contractual maturities of the earning assets and interest-bearing liabilities presented due to consideration of prepayment speeds under various interest rate change scenarios in the application of the interest rate sensitivity methods described above.

March 31, 2011
 
(Dollars in thousands)
 
Within One Month
   
After One Through
Three Months
   
Three Through Twelve Months
   
Within One
Year
   
Greater Than One Year or
Non-Sensitive
   
Total
 
Assets
                                   
Interest-earning assets
                                   
Interest-bearing deposits in other banks
  $ 35,437     $ -     $ -     $ 35,437     $ -     $ 35,437  
Loans (1)
    70,628       20,725       79,211       170,564       171,340       341,904  
Securities, taxable
    -       -       -       -       35,504       35,504  
Securities, nontaxable
    -       -       -       -       48,235       48,235  
Nonmarketable securities
    4,357       -       -       4,357       -       4,357  
Time Deposits in other banks
                    100       100       -       100  
Total earning assets
    110,422       20,725       79,311       210,458       255,079       465,537  
 
 
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March 31, 2011
 
(Dollars in thousands)
 
Within One Month
   
After One Through
Three Months
   
Three Through Twelve Months
   
Within One
Year
   
Greater Than One Year or
Non-Sensitive
   
Total
 
Liabilities
                                   
Interest-bearing liabilities
                                   
Interest-bearing deposits:
                                   
Demand deposits
    37,666       -       -       37,666       -       37,666  
Savings deposits
    118,492       -       -       118,492       -       118,492  
Time deposits
    23,819       29,028       67,208       120,055       125,543       245,598  
Total interest-bearing deposits
    179,977       29,028       67,208       276,213       125,543       401,756  
Federal Home Loan Bank Advances
    -       -       7,000       7,000       13,000       20,000  
Junior subordinated debentures
    -       -       -       -       10,310       10,310  
Repurchase agreements
    397       -       -       397       -       397  
Total interest-bearing liabilities
    180,374       29,028       74,208       283,610       148,853       432,463  
                                                 
Period gap
  $ (69,952 )   $ (8,303 )   $ 5,103     $ (73,152 )   $ 106,226          
                                                 
Cumulative gap
  $ (69,952 )   $ (78,255 )   $ (73,152 )   $ (73,152 )   $ 33,074          
                                                 
Ratio of cumulative gap to total earning assets
    (15.03 )%     (16.81 )%     (15.71 )%     (15.71 )%     7.10 %        
 

(1)
Including mortgage loans held for sale.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

See “Market Risk” and “Liquidity and Interest Rate Sensitivity” in Item 2, Management Discussion and Analysis of Financial Condition and Results of Operations for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.

Item 4.  Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (“Disclosure Controls”).  Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.  Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Based upon their controls evaluation, our CEO and CFO have concluded that our Disclosure Controls are effective at a reasonable assurance level.

There have been no changes in our internal controls over financial reporting during our second fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 
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Part II - Other Information

Item 1.  Legal Proceedings

There are no material, pending legal proceedings to which the Company or its subsidiary is a party or of which any of their property is the subject.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
(a)
 
Not applicable.

(b)
 
The following stock repurchases were made during the period covered by this report in connection with administration of the Company’s employee stock ownership plan.
 
Period
 
Total Number of Shares Purchased
   
Average Price Paid per Share
   
Total Number
of Shares
Purchased as
Part of Publicly
Announced Plans
or Programs
   
Maximum
Number of
Shares that
May Yet Be
Purchased
Under the Plans
or Programs
 
January 1, 2011 – January 31, 2011
    -     $ -       -       -  
February 1, 2011 - February 28, 2011
    62     $ 2.97       -       -  
March 1, 2011 – March 31, 2011
    -     $ -       -       -  
      62     $ 2.97       -       -  
 
Item 3.  Defaults Upon Senior Securities

Not applicable.

Item 6. Exhibits
 
Exhibit Number
 
Exhibit
31.1
 
Certification pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended.
31.2
 
Certification pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended.
32.1
 
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
 
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
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SIGNATURE

In accordance with the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
FIRST RELIANCE BANCSHARES, INC.
 
       
Date:  May 13, 2011
By: 
/s/ F.R. SAUNDERS, JR.   
    F. R. Saunders, Jr.  
   
President & Chief Executive Officer
 
       

Date:  May 13, 2011
By: 
/s/ JEFFERY A. PAOLUCCI  
    Jeffery A. Paolucci  
    Senior Vice President and Chief Financial Officer
       

 
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