Attached files

file filename
EX-31.1 - EX-31.1 - Independence Bancshares, Inc.d28765_ex31-1.htm
EX-31.2 - EX-31.2 - Independence Bancshares, Inc.d28765_ex31-2.htm
EXCEL - IDEA: XBRL DOCUMENT - Independence Bancshares, Inc.Financial_Report.xls
EX-32 - EX-32 - Independence Bancshares, Inc.d28765_ex32.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q



x

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


For the Quarterly Period ended September 30, 2011


OR



o

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


For the Transition Period from _________to_________


Commission File No. 000-51907


Independence Bancshares, Inc.

(Exact name of registrant as specified in its charter)



South Carolina

20-1734180

(State or other jurisdiction of incorporation)

(I.R.S. Employer Identification No.)

 

 

500 East Washington Street

Greenville, South Carolina 29601

(Address of principal executive offices)


(864) 672-1776

(Registrant's telephone number, including area code)

________________________________________________


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.  Yes  x  No  o


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  x  No  o


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act).


Large accelerated filer o     Accelerated filer o     Non-accelerated o     Smaller reporting company x


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


Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 2,085,010 shares of common stock, $.01 par value per share, were issued and outstanding as of November 4, 2011.





Independence Bancshares, Inc.

Part I – Financial Information

Item 1. Financial Statements

Consolidated Balance Sheets

        September 30, 2011     December 31, 2010
        (unaudited)     (audited)
Assets
                                     
   Cash and due from banks
              $ 3,372,437          $ 2,993,102   
   Federal funds sold
                 10,115,000             7,700,000   
   Investment securities available for sale
                 9,095,417             10,652,733   
   Non-marketable equity securities
                 1,047,850             1,400,350   
   Loans, net of allowance for loan losses of $2,350,886 and $3,062,492, respectively
                 80,366,791             91,402,749   
   Accrued interest receivable
                 268,713             291,499   
   Property and equipment, net
                 3,550,347             3,687,386   
   Other real estate owned and repossessed assets
                 3,846,965             2,537,259   
   Other assets
                 1,435,370             1,145,890   
       Total assets
              $ 113,098,890          $ 121,810,968   
 
Liabilities
                                     
   Deposits:
                                     
   Noninterest bearing
              $ 6,573,442          $ 5,710,240   
   Interest bearing
                 89,982,078             98,370,429   
     Total deposits
                 96,555,520             104,080,669   
 
   Borrowings
                 7,079,297             7,065,479   
   Accrued interest payable
                 56,512             69,473   
   Accounts payable and accrued expenses
                 234,821             144,003   
       Total liabilities
                 103,926,150             111,359,624   
 
Commitments and contingencies
                                       
 
Shareholders’ equity
                                      
   Preferred stock, par value $.01 per share; 10,000,000 shares authorized; no shares issued
                                 
   Common stock, par value $.01 per share; 100,000,000 shares authorized; 2,085,010 shares issued
      and outstanding
                 20,850             20,850   
   Additional paid-in capital
                 21,102,085             21,095,485   
   Accumulated other comprehensive income
                 158,606             34,725   
   Accumulated deficit
                 (12,108,801 )            (10,699,716 )  
     Total shareholders’ equity
                 9,172,740             10,451,344   
     Total liabilities and shareholders’ equity
              $ 113,098,890          $ 121,810,968   
 

The accompanying notes are an integral part of these consolidated financial statements.

2



Independence Bancshares, Inc.

Consolidated Statements of Operations
(unaudited)

        Three Months Ended
September 30,
    Nine Months Ended
September 30,
   
        2011     2010     2011     2010
Interest income
                                                                   
   Loans
              $  1,171,051          $ 1,181,010          $ 3,349,379          $ 3,655,015   
   Investment securities
                 60,118             73,057             210,390             201,507   
   Federal funds sold and other
                 11,027             12,921             35,060             38,624   
       Total interest income
                 1,242,196             1,266,988             3,594,829             3,895,146   
 
Interest expense
                                                                   
   Deposits
                 303,562             487,490             1,041,425             1,590,619   
   Borrowings
                 53,449             80,249             158,825             322,259   
       Total interest expense
                 357,011             567,739             1,200,250             1,912,878   
 
       Net interest income
                 885,185             699,249             2,394,579             1,982,268   
 
Provision for loan losses
                 (80,000 )            1,220,000             730,000             2,055,000   
 
       Net interest income (expense) after provision for loan losses
                 965,185             (520,751 )            1,664,579             (72,732 )  
 
Noninterest income
                 73,916             76,004             169,999             188,418   
 
Noninterest expenses
                                                                   
   Compensation and benefits
              $ 439,738          $ 484,498          $ 1,271,971          $ 1,488,624   
   Net changes in fair value and (gains) losses on other real estate owned
       and repossessed assets
                 7,165             318,131             246,382             692,290   
   Occupancy and equipment
                 147,001             142,763             433,984             432,282   
   Insurance
                 63,685             125,818             316,935             383,876   
   Data processing and related costs
                 72,026             70,085             223,130             215,666   
   Professional fees
                 66,556             92,848             225,326             226,272   
   Marketing
                 14,515             18,727             56,052             79,458   
   Telephone and supplies
                 16,023             12,724             51,008             45,227   
   Other
                 172,867             80,716             418,875             221,540   
       Total noninterest expenses
                 999,576             1,346,310             3,243,663             3,785,235   
 
       Income (loss) before income tax expense
                 39,525             (1,791,057 )            (1,409,085 )            (3,669,549 )  
 
Income tax expense
                              1,374,937                          1,374,937   
       Net income (loss)
              $ 39,525          $ (3,165,994 )         $ (1,409,085 )         $ (5,044,486 )  
Income (loss) per common share – basic and diluted
              $ 0.02          $ (1.52 )         $ (0.68 )         $ (2.42 )  
 
Weighted average common shares outstanding – basic and diluted
                 2,085,010             2,085,010             2,085,010             2,085,010   
 

The accompanying notes are an integral part of these consolidated financial statements.

3



Independence Bancshares, Inc.
Consolidated Statements of Changes
In Shareholders’ Equity and Comprehensive Income (Loss)
(unaudited)

                 Accumulated          
              other          
   Common Stock    Additional    comprehensive    Accumulated   
   Shares
  
Amount
  
paid-in capital
  
income
  
deficit
  
Total
December 31, 2009
                 2,085,010          $ 20,850          $ 20,997,135          $ 23,052          $ (4,354,170 )         $ 16,686,867   
Compensation expense related to stock options granted
                                           80,400                                       80,400   
Net loss
                                                                     (5,044,486 )            (5,044,486 )  
Unrealized gain on investment securities available for sale, net of tax
                                                        94,076                          94,076   
Total comprehensive loss
                                                                                  (4,950,410 )  
September 30, 2010
                 2,085,010          $ 20,850          $ 21,077,535          $ 117,128          $ (9,398,656 )         $ 11,816,857   
 
December 31, 2010
                 2,085,010          $ 20,850          $ 21,095,485          $ 34,725          $ (10,699,716 )         $ 10,451,344   
Compensation expense related to stock options granted
                                           6,600                                       6,600   
Net loss
                                                                     (1,409,085 )            (1,409,085 )  
Unrealized gain on investment securities available for sale, net of tax
                                                        123,881                          123,881   
Total comprehensive loss
                                                                                  (1,285,204 )  
September 30, 2011
                 2,085,010          $ 20,850          $ 21,102,085          $ 158,606          $ (12,108,801 )         $ 9,172,740   
 

The accompanying notes are an integral part of these consolidated financial statements.

4



Independence Bancshares, Inc.

Consolidated Statements of Cash Flows
(unaudited)

        Nine Months Ended
September 30,
   
        2011     2010
Operating activities
                                     
   Net loss
              $ (1,409,085 )         $ (5,044,486 )  
   Adjustments to reconcile net loss to cash used in operating activities
                                       
     Provision for loan losses
                 730,000             2,055,000   
     Depreciation
                 147,828             145,308   
     Amortization of investment securities premiums, net
                 21,145             40,716   
     Compensation expense related to stock options granted
                 6,600             80,400   
     Net changes in fair value and losses on other real estate owned and repossessed assets
                 246,382             692,290   
     (Increase) decrease in other assets, net
                 (299,209 )            1,615,801   
     Increase (decrease) in other liabilities, net
                 14,040             (6,627 )  
       Net cash used in operating activities
                 (542,299 )            (421,598 )  
 
Investing activities
                                     
   Repayments of loans, net
                 7,648,204             8,895,930   
   Purchase of investment securities available for sale
                 (4,595,698 )            (6,000,000 )  
   Maturities and sales of investment securities available for sale
                 5,524,374             3,000,000   
   Repayments of investment securities available for sale
                 827,708             1,258,926   
   Redemption of non-marketable equity securities, net
                 352,500             107,250   
   Purchase of property and equipment, net
                 (10,789 )            (53,339 )  
   Sale of other real estate owned and repossessed assets
                 1,101,666             942,936   
       Net cash provided by investing activities
                 10,847,965             8,151,703   
 
Financing activities
                                       
   Increase (decrease) in deposits, net
                 (7,525,149 )            590,197   
   Increase (decrease) in borrowings
                 13,818             (7,108,066 )  
       Net cash used in financing activities
                 (7,511,331 )            (6,517,869 )  
 
Net increase in cash and cash equivalents
                 2,794,335             1,212,236   
 
Cash and cash equivalents at beginning of the period
                 10,693,102             10,224,360   
 
Cash and cash equivalents at end of the period
              $ 13,487,437          $ 11,436,596   
 
Supplemental information:
                                       
     Cash paid for
                                      
       Interest
              $ 1,213,211          $ 1,975,331   
     Schedule of non-cash transactions
                                       
       Change in unrealized gain on securities, net of tax
              $ 123,881          $ 94,076   
       Transfers between loans and other real estate owned
              $ 2,657,754          $ 2,173,188   
 

The accompanying notes are an integral part of these consolidated financial statements.

5



Notes to Unaudited Consolidated Financial Statements

NOTE 1 – NATURE OF BUSINESS AND BASIS OF PRESENTATION

Independence Bancshares, Inc. (the “Company”) is a South Carolina corporation organized to operate as a bank holding company pursuant to the federal Bank Holding Company Act of 1956 and the South Carolina Bank Holding Company Act, and to own and control all of the capital stock of Independence National Bank (the “Bank”). The Bank is a national association organized under the laws of the United States to conduct general banking business in Greenville, South Carolina.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.

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. Non-recognized 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 performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date, and concluded that no subsequent events had occurred requiring accrual or disclosure through the date of this filing.

Recent Regulatory Developments

On January 20, 2010, the Bank entered into a Formal Agreement (the “Formal Agreement”) with its primary regulator, the Office of the Comptroller of the Currency (the “OCC”). The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management. In addition, the OCC has established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks. The Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%. The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam that led to the Formal Agreement and will continue to work to comply with all the requirements of the Formal Agreement. As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital. As of September 30, 2011, total risk-based capital was 11.0% compared to the required 12%, Tier 1 capital was 9.7% compared to the required 10%, and leverage ratio was 7.9% compared to the required 9%. However, as of September 30, 2011, the Bank was still considered to be well capitalized by the OCC because the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives. For additional information on the Formal Agreement, including actions the Bank has taken in response to the Formal Agreement, see “Management’s Discussion and Analysis – Recent Regulatory Developments” and “Management’s Discussion and Analysis – Results of Operations – Capital Resources.”

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A summary of significant accounting policies is included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2010. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.

6



Cash and Cash Equivalents – For purposes of reporting cash flows, cash and cash equivalents include cash, amounts due from banks and federal funds sold. Generally, federal funds are sold for one-day periods. Due to the short term nature of cash and cash equivalents, the carrying amount of these instruments is deemed to be a reasonable estimate of fair value.

Income (Loss) per Share – Basic income (loss) per share represents net income (loss) divided by the weighted average number of common shares outstanding during the period. Diluted income (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method. For the three month period ended September 30, 2011, all of the potential common shares were considered anti-dilutive due to the average trading price of the Company’s common stock which was well below the exercise price of all outstanding options and warrants. For the three month period ended September 30, 2010 and the nine month periods ended September 30, 2011 and 2010, as a result of the Company’s net loss, all of the potential common shares were considered anti-dilutive.

Fair Value Measurements – The Company determines the fair market values of its financial instruments based on the fair value hierarchy established in FASB ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”), which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, 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).

ASC Topic 820 defines fair value as the exchange 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. ASC Topic 820 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 standard describes three levels of inputs that may be used to measure fair value:

Level 1 – Valuations are based on quoted prices in active markets for identical assets or liabilities.

Level 2 – Valuations are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Valuations include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Income Taxes – The Company accounts for income taxes in accordance with FASB ASC Topic 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.

We did not recognize any income tax benefit or expense for the three and nine month periods ended September 30, 2011. However, we did recognize income tax expense of $1,374,937 for the three and nine month periods ended September 30, 2010 based on the following requirements. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. During our September 30, 2010 quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned, and we recorded a 100% valuation allowance against the deferred tax asset. We will continue to analyze our deferred tax assets and related valuation allowance each quarter taking into account performance compared to forecast and current

7



economic or internal information that would impact forecasted earnings. No expense was recognized on net income for the quarter ended September 30, 2011 due to the Company’s large cumulative net operating loss carry-forward position as well as the 100% valuation allowance on our deferred tax assets. The net income for the quarter ended September 30, 2011 does not represent a trend toward sustained profitability.

The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities, and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flows. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to ASC 740, “Income Taxes”.

Recently Issued Accounting Pronouncements – The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:

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 its interim and annual financial statements. See Note 4, Loans, for applicable disclosures.

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, the 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 are required beginning with this quarter ended September 30, 2011. See Note 4, Loans, for applicable disclosures.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity. The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively.

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.

8



NOTE 3 – INVESTMENT SECURITIES

Investment securities classified as “Available for Sale” are carried at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity (net of estimated tax effects). Realized gains or losses on the sale of investments are based on the specific identification method. The amortized costs and fair values of investment securities available for sale are as follows:

        September 30, 2011
   
            Gross Unrealized        
        Amortized
Cost
    Gains
    Losses
    Fair
Value
Government-sponsored enterprises
              $ 3,000,000          $ 5,277          $      —           $ 3,005,277   
Mortgage-backed securities
                 5,482,129             209,569                          5,691,698   
Municipals, taxable
                 372,977             25,465                          398,442   
 
   Total investment securities
              $  8,855,106          $ 240,311          $           $  9,095,417   
 
        December 31, 2010
   
            Gross Unrealized        
        Amortized
Cost
    Gains
    Losses
    Fair
Value
Government-sponsored enterprises
              $ 5,000,000          $ 12,723          $ (37,007 )         $ 4,975,716   
Mortgage-backed securities
                 5,226,829             87,186             (24,588 )            5,289,427   
Municipals, taxable
                 373,291             14,299                          387,590   
 
   Total investment securities
              $ 10,600,120          $ 114,208          $ (61,595 )         $ 10,652,733   
 

At September 30, 2011, the investment portfolio included an unrealized gain of $240,311. At September 30, 2011, the investment portfolio included no securities in a loss position. At December 31, 2010, the investment portfolio included five securities with a fair value of $4,978,136 and an amortized cost of $5,039,731 that had been in an unrealized loss position for less than twelve months and no securities in a loss position for more than twelve months. The Company believes, based on industry analyst reports and credit ratings, that the deterioration in the fair value of these investment securities available for sale is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary. The Company has the ability and intent to hold these securities until such time as the value recovers or the securities mature.

NOTE 4 – LOANS

At September 30, 2011, our gross loan portfolio consisted primarily of $53.6 million of commercial real estate loans, $11.8 million of commercial business loans, and $17.4 million of consumer and home equity loans. Other than continued purposeful reduction in our commercial real estate concentration, our current loan portfolio composition is not materially different than the loan portfolio composition disclosed in the footnotes to the consolidated financial statements included in our Annual Report on Form 10-K for 2010 as filed with the SEC.

Certain credit quality statistics related to our loan portfolio have improved over the past quarter, including reductions of in-migration of nonaccrual loans and reductions in the aggregate level of nonperforming assets. To the extent such improvement continues, we may continue to reduce our allowance for loan losses in future periods based on our assessment of the inherent risk in the loan portfolio at those future reporting dates. A reduction in the allowance for loan losses would result in a lower provision for loans losses being recorded in future periods. Conversely, there can be no assurance that loan losses in future periods will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required. Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting our business, financial condition, results of operations, and cash flows.

9



Loan Performance and Asset Quality

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectibility of principal or interest based on current available information or as evidenced by sufficient payment history, generally six monhts.

The following table summarizes delinquencies and nonaccruals, by portfolio class, as of September 30, 2011 and December 31, 2010.

        Single and
multifamily
residential
real estate
  
Construction
and
development
  
Commercial
real estate –
other
  
Commercial
business
  
Consumer
  
Total
September 30, 2011
30-59 days past due
              $ 847,078          $ 104,641          $           $           $           $ 951,719   
60-89 days past due
                                                                                     
Nonaccrual
                 1,794,986             3,309,379             1,320,411             92,265                          6,517,041   
Total past due and nonaccrual
                 2,642,064             3,414,020             1,320,411             92,265                          7,468,760   
Current
                 22,184,904             10,282,649             29,520,242             11,712,381             1,628,660             75,328,448   
   Total loans
              $ 24,826,968          $ 13,696,669          $ 30,840,653          $ 11,804,646          $ 1,628,660          $ 82,797,596   
 
        Single and
multifamily
residential
real estate
  
Construction
and
development
  
Commercial
real estate –
other
  
Commercial
business
  
Consumer
  
Total
December 31, 2010
30-59 days past due
              $ 16,902          $           $ 428,273          $ 1,409          $ 7,576          $ 454,160   
60-89 days past due
                              145,718             97,680                                       243,398   
Nonaccrual
                 3,098,499             8,069,557             861,432                                       12,029,488   
Total past due and nonaccrual
                 3,115,401             8,215,275             1,387,385             1,409             7,576             12,727,046   
Current
                 24,292,606             10,994,198             32,630,608             12,260,814             1,651,994             81,830,220   
   Total loans
              $ 27,408,007          $ 19,209,473          $ 34,017,993          $ 12,262,223          $ 1,659,570          $ 94,557,266   
 

At September 30, 2011 and December 31, 2010, there were nonaccrual loans of $6.5 million and $12.0 million, respectively. Foregone interest income related to nonaccrual loans equaled $428,582 and $550,761 for the nine months ended September 30, 2011 and 2010, respectively. No interest income was recognized on nonaccrual loans during for the nine months ended September 30, 2011 and 2010. At both September 30, 2011 and December 31, 2010, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.

As part of the loan review process, loans are given individual credit grades, representing the risk the Company believes is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade.

10



The following table summarizes management’s internal credit risk grades, by portfolio class, as of September 30, 2011 and December 31, 2010.

September 30, 2011
        Single and
multifamily
residential
real estate
  
Construction
and
development
  
Commercial
real estate –
other
  
Commercial
business
  
Consumer
  
Total
Pass Loans
              $ 14,482,666          $ 757,771          $ 37,951          $           $ 1,554,187          $ 16,832,575   
Grade 1 - Prime
                                                        65,429                          65,429   
Grade 2 - Good
                                           485,952             125,250                          611,202   
Grade 3 - Acceptable
                 2,143,418             399,431             14,526,175             5,927,238                          22,996,262   
Grade 4 - Acceptable w/ Care
                 5,291,710             5,454,417             12,300,594             5,492,964                          28,539,685   
Grade 5 - Special Mention
                 1,114,188             104,641             330,394             101,500                          1,650,723   
Grade 6 - Substandard
                 1,794,986             6,980,409             3,159,587                          74,473             12,009,455   
Grade 7 - Doubtful
                                                        92,265                          92,265   
Total loans
              $ 24,826,968          $ 13,696,669          $ 30,840,653          $ 11,804,646          $ 1,628,660          $ 82,797,596   
 
December 31, 2010


  
Single and
multifamily
residential
real estate
  
Construction
and
development
  
Commercial
real estate –
other
  
Commercial
business
  
Consumer
  
Total
Pass Loans
              $ 15,304,972          $ 937,399          $           $           $ 1,585,097          $ 17,827,468   
Grade 1 - Prime
                                                        65,429                          65,429   
Grade 2 - Good
                 44,312             323,784             253,851             130,628                          752,575   
Grade 3 - Acceptable
                 1,936,575             1,429,714             16,769,211             5,964,501                          26,100,001   
Grade 4 - Acceptable w/Care
                 5,488,792             4,547,604             14,142,081             5,884,011                          30,062,488   
Grade 5 - Special Mention
                 1,534,857             3,755,697             1,381,947             217,654                          6,890,155   
Grade 6 - Substandard
                 3,098,499             8,215,275             1,470,903                          74,473             12,859,150   
Grade 7 - Doubtful
                                                                                     
   Total loans
              $ 27,408,007          $ 19,209,473          $ 34,017,993          $ 12,262,223          $ 1,659,570          $ 94,557,266   
 

Loans graded one through four are considered “pass” credits. As of September 30, 2011, approximately 62% of the loan portfolio had a credit grade of Acceptable or Acceptable with Care. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

As of September 30, 2011, we had loans totaling $1.7 million classified as special mention. This classification is utilized when an initial concern is identified about the financial health of a borrower. Loans are designated as such in order to be monitored more closely than other credits in the loan portfolio. At September 30, 2011, substandard loans totaled $12.0 million, with all but one loan being collateralized by real estate. Substandard credits are evaluated for impairment on a quarterly basis.

The Company identifies impaired loans through its normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans on the Company’s problem loan watch list are considered potentially impaired loans. Impairment is measured on a loan-by-loan basis based on the determination of the most probable source of repayment which is usually liquidation of the underlying collateral, but may also include discounted future cash flows, or in rare cases, the market value of the loan itself.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

11



At September 30, 2011, impaired loans totaled $10.2 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. As of September 30, 2011, we had loans totaling approximately $1.9 million that were classified in accordance with our loan rating policies but were not considered impaired. The following table summarizes information relative to impaired loans, by portfolio class, at September 30, 2011 and December 31, 2010.

        Unpaid
principal
balance
  
Recorded
investment
  
Related
allowance
  
Average
impaired
investment
  
Year to date
interest
income
September 30, 2011
With no related allowance recorded:
   Single and multifamily residential real estate
              $ 92,677          $ 91,025          $           $ 110,136          $    
   Construction and development
                 2,201,030             2,201,030                          1,834,659             42,102   
   Commercial real estate-other
                 1,313,326             1,229,411                          886,408             9,907   
   Commercial business
                                                                        
With related allowance recorded:
                                                                                       
   Single and multifamily residential real estate
                 1,916,929             1,703,962             173,962             2,123,071                
   Construction and development
                 6,039,513             4,779,378             421,756             6,448,650             76,199   
   Commercial real estate-other
                 99,512             91,000             61,500             506,145                
   Commercial business
                 92,265             92,265                          46,132                
Total:
                                                                                  
   Single and multifamily residential real estate
                 2,009,606             1,794,986             173,962             2,233,207                
   Construction and development
                 8,240,543             6,980,408             421,756             8,283,309             118,301   
   Commercial real estate-other
                 1,412,838             1,320,411             61,500             1,392,553             9,907   
   Commercial business
                 92,265             92,265                          46,132                
 
              $ 11,758,501          $ 10,188,070          $ 657,218          $ 11,955,201          $ 128,208   
December 31, 2010
With no related allowance recorded:
   Single and multifamily residential real estate
              $ 102,083          $ 102,083          $           $ 248,045          $    
   Construction and development
                 453,000             453,000                          2,800,727                
   Commercial real estate-other
                 290,377             290,377                          58,075                
   Commercial business
                                                        5,743                
With related allowance recorded:
   Single and multifamily residential real estate
                 3,413,462             2,996,415             551,415             1,862,302             13,222   
   Construction and development
                 8,415,920             7,762,275             768,358             5,141,497             8,584   
   Commercial real estate-other
                 1,218,225             1,180,526             251,971             453,294             10,152   
   Commercial business
                 -                                        8,818             441    
Total:
                                                                                       
   Single and multifamily residential real estate
                 3,515,545             3,098,498             551,415             2,110,347             13,222   
   Construction and development
                 8,868,920             8,215,275             768,358             7,942,224             8,584   
   Commercial real estate-other
                 1,508,602             1,470,903             251,971             511,369             10,152   
   Commercial business
                                                        14,561             441    
 
              $ 13,893,067          $ 12,784,676          $ 1,571,744          $ 10,578,501          $ 32,399   
 

As a result of adopting the amendments in ASU 2011-02, we reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are TDRs under the amended guidance. We did not identify any new TDRs during our assessment. As noted below, all outstanding TDRs as of September 30, 2011 were restructured prior to the adoption of ASU 2011-02.

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.

12



At September 30, 2011, the principal balance of TDRs totaled $1.3 million. All TDRs were considered classified, impaired, and in nonaccrual status at September 30, 2011. No TDRs went into default during either the nine months or the quarter ended September 30, 2011. A TDR can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.

Provision and Allowance for Loan Losses

An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of both a specific and a general component. The specific component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. For such loans, an allowance is established when either the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors.

13



The following table summarizes activity related to our allowance for loan losses for the nine months ended September 30, 2011, by portfolio segment.

        Single and
multifamily
residential
real estate
  
Construction
and
development
  
Commercial
real estate –
other
  
Commercial
business
  
Consumer
  
Total
September 30, 2011
Allowance for loan losses:
Balance, beginning of period
              $ 859,255          $ 1,365,914          $ 473,504          $ 306,791          $ 57,028          $ 3,062,492   
Provision for loan losses
                 186,224             626,379             4,153             (96,612 )            9,856             730,000   
Loan charge-offs
                 (390,069 )            (1,232,202 )            (25,706 )            (764 )            (6,979 )            (1,655,720 )  
Loan recoveries
                                                        214,114                          214,114   
   Net loans (charged-off)
       recovered
                 (390,069 )            (1,232,202 )            (25,706 )            213,350             (6,979 )            (1,441,606 )  
Balance, end of period
              $ 655,410          $ 760,091          $ 451,951          $ 423,529          $ 59,905          $ 2,350,886   
 
Individually reviewed for impairment
              $ 173,962             421,756          $ 61,500                       $           $ 657,218   
Collectively reviewed for impairment
                 481,448             338,335             390,451             423,529             59,905             1,693,668   
Total allowance for loan losses
              $ 655,410             760,091          $ 451,951          $ 423,529          $ 59,905          $ 2,350,886   
 
Gross loans, end of period:
Individually reviewed for impairment
              $ 1,794,986             6,980,408          $ 1,320,411          $ 92,265          $           $ 10,188,070   
Collectively reviewed for impairment
                 23,031,982             6,716,261             29,520,242             11,712,381             1,628,660             72,609,526   
Total gross loans
              $ 24,826,968          $ 13,696,669          $ 30,840,653          $ 11,804,646          $ 1,628,660          $ 82,797,596   
 

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charged-off. Beginning first quarter 2011, we began using our own historical charge-off history versus that of our peers. As a result, there were small decreases in the commercial real estate and consumer segments which were offset by increases in the other real estate segments. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. 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.

14



NOTE 5 – FAIR VALUE

Assets and Liabilities Measured at Fair Value

Fair value is defined as the exchange 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. The Company determines the fair values of its financial instruments based on the 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 three levels of inputs that may be used to measure fair value are detailed in Note 1.

Available-for-sale investment securities ($9.1 million at September 30, 2011) are carried at fair value and measured on a recurring basis using Level 2 inputs (other observable inputs). Fair values are estimated by using bid prices and quoted prices of pools or tranches of securities with similar characteristics.

We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and a specific reserve within the allowance for loan losses is established or the loan is charged down to the fair value less costs to sell. At September 30, 2011, all impaired loans were evaluated on a nonrecurring basis based on the market value of the underlying collateral. Market values are generally obtained using independent appraisals or other market data, which the Company considers to be Level 2 inputs (other observable inputs). The aggregate carrying amount, net of specific reserves, of impaired loans carried at fair value at September 30, 2011 was $5.9 million.

Other real estate owned and repossessed assets, consisting of properties or other collateral obtained through foreclosure or in satisfaction of loans, are carried at fair value and measured on a nonrecurring basis. Market values are generally obtained using independent appraisals or other current market information, including but not limited to offers received on a property, which the Company considers to be Level 2 inputs (other observable inputs). The carrying amount of other real estate owned and repossessed assets carried at fair value at September 30, 2011 was $3.8 million.

The Company has no assets whose fair values are measured using Level 1 or Level 3 inputs. The Company also has no liabilities carried at fair value or measured at fair value.

Disclosures about Fair Value of Financial Instruments

FASB ASC Topic 825, “Financial Instruments” requires disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. FASB ASC Topic 825 defines a financial instrument as cash, evidence of an ownership interest in an entity or contractual obligations which require the exchange of cash or other financial instruments. Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, property and equipment and other assets and liabilities.

Fair value approximates carrying value for the following financial instruments due to the short-term nature of the instrument: cash and due from banks, federal funds sold, and securities sold under agreements to repurchase. Investment securities are valued using quoted market prices. No ready market exists for non-marketable equity securities, and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value. Fair value of loans is based on the discounted present value of the estimated future cash flows. Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality.

Fair value for demand deposit accounts and interest bearing accounts with no fixed maturity date is equal to the carrying value. Fair value of certificate of deposit accounts are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments. Fair value for FHLB advances is based on discounted cash flows using the Company’s current incremental borrowing rate.

The Company has used management’s best estimate of fair value based on the above assumptions. Thus, the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair value presented.

15



The estimated fair values of the Company’s financial instruments at September 30, 2011 and December 31, 2010 are as follows:

        September 30, 2011
    December 31, 2010
   
        Carrying
Amount
    Fair
Value
    Carrying
Amount
    Fair
Value
Financial Assets:
   Cash and due from banks
              $ 3,372,437          $ 3,372,437          $ 2,993,102          $ 2,993,102   
   Federal funds sold
                 10,115,000             10,115,000             7,700,000             7,700,000   
   Investment securities available for sale
                 9,095,417             9,095,417             10,652,733             10,652,733   
   Non-marketable equity securities
                 1,047,850             1,047,850             1,400,350             1,400,350   
   Loans, net
                 80,366,791             79,331,820             91,402,749             90,410,864   
 
Financial Liabilities:
   Deposits
                 96,555,520             96,824,734             104,080,669             104,657,280   
   Federal Home Loan Bank advances
                 7,000,000             7,327,393             7,000,000             7,325,072   
   Securities sold under agreements to repurchase
                 79,297             79,297             65,479             65,479   
 

16



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

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.

DISCUSSION OF FORWARD-LOOKING STATEMENTS

This report contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may relate to our financial condition, results of operations, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in our forward-looking statements include, but are not limited, to the following:

•   
  our ability to comply with our Formal Agreement and potential regulatory actions if we fail to comply;
•   
  our ability to comply with our higher individual minimum capital ratios and potential regulatory actions if we fail to comply;
•   
  general economic conditions, either nationally or regionally and especially in our primary service area, being less favorable than expected, resulting in, among other things, a deterioration in credit quality;
•   
  greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;
•   
  greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;
•   
  the amount of our loan portfolio collateralized by real estate and weakness in the real estate market;
•   
  the rate of delinquencies and amount of loans charged-off;
•   
  the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
•   
  the rate of loan growth in recent years and the lack of seasoning of our loan portfolio;
•   
  our ability to attract and retain key personnel;
•   
  our ability to retain our existing customers, including our deposit relationships;
•   
  significant increases in competitive pressure in the banking and financial services industries;
•   
  adverse changes in asset quality and resulting credit risk related losses and expenses;
•   
  changes in the interest rate environment which could reduce anticipated or actual margins;
•   
  changes in political conditions or the legislative or regulatory environment, including the effect of recent financial reform legislation on the banking and financial services industries;
•   
  changes occurring in business conditions and inflation;
•   
  increased funding costs due to market illiquidity, increased competition for funding, and/or increased regulatory requirements with regard to funding;
•   
  changes in deposit flows;
•   
  changes in technology;
•   
  changes in monetary and tax policies;
•   
  changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;
•   
  loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions; and
•   
  other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

17



These risks are exacerbated by the developments over the last three years in local, national and international financial markets, and we are unable to predict what effect these uncertain market conditions will continue to have on our Company. Beginning in 2008 and continuing through the third quarter of 2011, the capital and credit markets experienced unprecedented levels of extended volatility and disruption. During the first half of 2011, there was a general expectation within the economic and business community that conditions, while slow by historical standards, were stabilizing and were expected to show continued improvement. However, as a result of U.S. government fiscal challenges and resulting downgrade of the U.S. government debt by Standard & Poor’s, continued volatility in European sovereign and bank debt, little to no improvement in domestic employment conditions, and the economic and monetary policy statements by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) during the third quarter of 2011, an increasing number of economists began predicting more negative economic forecasts and the possibility of a “double-dip” recession. There can be no assurance that these unprecedented negative developments will not continue to materially and adversely impact the U.S. economy in general, the banking industry, and our business, financial condition and results of operations, as well as our ability to maintain sufficient capital or other funding for liquidity and business purposes.

All forward-looking statements in this report are based on information available to us as of the date of this report. Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee you that these expectations will be achieved. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2010, as filed in our Annual Report on Form 10-K.

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

Allowance for Loan Losses

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Other Real Estate Owned and Repossessed Assets

Real estate and other property acquired in settlement of loans is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis when acquired. Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell. Recoveries of value are recorded only to the extent of previous write-downs on the property in accordance with FASB ASC Topic 360 “Property, Plant, and Equipment”. Write-downs or recoveries of value resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.

18



Income Taxes

We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in our consolidated financial statements and income tax returns, and income tax benefit or expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets. These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized. No assurance can be given that either the tax returns submitted by us or the income tax reported on the financial statements will not be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service. We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.

Overview

The following discussion describes our results of operations for the three and nine month periods ended September 30, 2011 and 2010 and also analyzes our financial condition as of September 30, 2011.

Like most community banks, we derive the majority of our income from interest we receive 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.

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 establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section we have included a detailed discussion of this process.

In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this noninterest income, as well as our noninterest expenses, in the following discussion.

Markets in the United States and elsewhere have experienced extreme volatility and disruption over the past three plus years. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. Dramatic slowdowns in the housing industry, due in part to falling home prices and increasing foreclosures and unemployment, have created strains on financial institutions. Many borrowers are now unable to repay their loans, and the collateral securing these loans has, in some cases, declined below the loan balance. In response to the challenges facing the financial services sector, beginning in 2008 a multitude of new regulatory and governmental actions have been announced including the Emergency Economic Stabilization Act, approved by Congress and signed by President Bush on October 3, 2008, and the American Recovery and Reinvestment Act on February 17, 2009, among others. Some of the more recent actions include:

19



•   
 
On July 21, 2010, the U.S. President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), a comprehensive regulatory framework that will likely result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates. Implementation of the Dodd-Frank Act will require many new rules to be made by various federal regulatory agencies over the next several years. Uncertainty remains as to the ultimate impact of the Dodd-Frank Act until final rulemaking is complete, which could have a material adverse impact either on the financial services industry as a whole or on our business, financial condition, results of operations, and cash flows. Provisions in the legislation that affect consumer financial protection regulations, deposit insurance assessments, payment of interest on demand deposits, and interchange fees could increase the costs associated with deposits and place limitations on certain revenues those deposits may generate. The Dodd-Frank Act includes provisions that, among other things, will:

○      
 
Centralize responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, responsible for implementing, examining, and enforcing compliance with federal consumer financial laws;

○      
 
Create the Financial Stability Oversight Council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity;

○      
 
Provide mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions;

○      
 
Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (“DIF”), and increase the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion;

○      
 
Make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until December 31, 2012 for noninterest-bearing demand transaction accounts at all insured depository institutions;

○      
 
Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, which apply to all public companies, not just financial institutions;

○      
 
Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transactions and other accounts;

○      
 
Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer;

○      
 
Eliminate the Office of Thrift Supervision (“OTS”) on July 21, 2011. The Office of the Comptroller of the Currency (“OCC”), which is the primary federal regulator for national banks, now has become the primary federal regulator for federal thrifts. In addition, the Federal Reserve now supervises and regulates all savings and loan holding companies that were formerly regulated by the OTS.

20



•   
 
On September 27, 2010, the U.S. President signed into law the Small Business Jobs Act of 2010 (the “Act”). The Small Business Lending Fund (the “SBLF”), which was enacted as part of the Act, is a $30 billion fund that encourages lending to small businesses by providing Tier 1 capital to qualified community banks with assets of less than $10 billion. On December 21, 2010, the U.S. Treasury published the application form, term sheet and other guidance for participation in the SBLF. Under the terms of the SBLF, the Treasury will purchase shares of senior preferred stock from banks, bank holding companies, and other financial institutions that will qualify as Tier 1 capital for regulatory purposes and rank senior to a participating institution’s common stock. The application deadline for participating in the SBLF was May 16, 2011. We did not participate in the SBLF.

•   
 
Internationally, both the Basel Committee on Banking Supervision (the “Basel Committee”) and the Financial Stability Board (established in April 2009 by the Group of Twenty (“G-20”) Finance Ministers and Central Bank Governors to take action to strengthen regulation and supervision of the financial system with greater international consistency, cooperation, and transparency) have committed to raise capital standards and liquidity buffers within the banking system (“Basel III”). On September 12, 2010, the Group of Governors and Heads of Supervision agreed to the calibration and phase-in of the Basel III minimum capital requirements (raising the minimum Tier 1 common equity ratio to 4.5% and minimum Tier 1 equity ratio to 6.0%, with full implementation by January 2015) and introducing a capital conservation buffer of common equity of an additional 2.5% with full implementation by January 2019. The U.S. federal banking agencies support this agreement. In December 2010, the Basel Committee issued the Basel III rules text, outlining the details and time-lines of global regulatory standards on bank capital adequacy and liquidity. According to the Basel Committee, the framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build-up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.

•   
 
In November 2010, the Federal Reserve’s monetary policymaking committee, the Federal Open Market Committee (“FOMC”), decided that further support to the economy was needed. With short-term interest rates already nearing 0%, the FOMC agreed to deliver that support by committing to purchase additional longer-term Treasury securities, as it had in 2008 and 2009. The FOMC announced that it intended to purchase an additional $600 billion of longer-term U.S. Treasury securities by the end of the second quarter of 2011, at a pace of about $75 billion per month. In addition, the FOMC stated that it would maintain its existing policy of reinvesting principal payments from its securities holdings.

•   
 
In November 2010, the FDIC approved two proposals that amend the deposit insurance assessment regulations. The first proposal implements a provision in the Dodd-Frank Act that changes the assessment base from one based on domestic deposits (as it has been since 1935) to one based on assets. The assessment base changes from adjusted domestic deposits to average consolidated total assets minus average tangible equity. The second proposal changes the deposit insurance assessment system for large institutions in conjunction with the guidance given in the Dodd-Frank Act. In February 2011, the FDIC approved the final rules that change the assessment base from domestic deposits to average assets minus average tangible equity, adopt a new scorecard-based assessment system for financial institutions with more than $10 billion in assets, and finalize the designated reserve ratio target size at 2.0% of insured deposits. We elected to voluntarily participate in the unlimited deposit insurance component of the Treasury’s Transaction Account Guarantee Program (“TAGP”) through December 31, 2010. Coverage under the program was in addition to and separate from the basic coverage available under the FDIC’s general deposit insurance rules. As a result of the Dodd-Frank Act that was signed into law on July 21, 2010, the program ended on December 31, 2010, and all institutions are now required to provide full deposit insurance on noninterest-bearing transaction accounts until December 31, 2012. There will not be a separate assessment for this as there was for institutions participating in the deposit insurance component of the TAGP.

21



•   
 
In June 2011, the Federal Reserve approved a final debit card interchange rule in accordance with the Dodd-Frank Act. The final rule caps an issuer’s base fee at $0.21 per transaction and allows an additional 5 basis point charge per transaction to help cover fraud losses. Though the rule technically does not apply to institutions with less than $10 billion in assets, such as the Bank, there is concern that the price controls may harm community banks, which could be pressured by the marketplace to lower their own interchange rates. The Federal Reserve also adopted requirements for issuers to include two unaffiliated networks for debit card transactions — one signature-based and one PIN-based. The effective date for the final rules on the pricing and routing restrictions was October 1, 2011. The results of these final rules may impact our interchange income from debit card transactions in the future.

•   
 
On September 21, 2011, the FOMC announced that, in order to support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with its statutory mandate, it had decided to extend the average maturity of its holdings of securities. In addition, the FOMC announced that it intended to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 3 years or less in order to put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. Further, to help support conditions in mortgage markets, the FOMC intends to now reinvest in agency mortgage-backed securities the principal payments from its holdings of agency debt and agency mortgage-backed securities.

Although it is likely that further regulatory actions will arise as the Federal government attempts to address the economic situation, we cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.

Recent Regulatory Developments

On January 20, 2010, the Bank entered into a Formal Agreement (the “Formal Agreement”) with its primary regulator, the OCC. The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management. In response, the Bank formed a Compliance Committee of its Board of Directors (the “Compliance Committee”) to oversee management’s response to all sections of the Formal Agreement. The Compliance Committee also monitors adherence to deadlines for submission to the OCC of information required under the Formal Agreement. The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam and will continue to work to comply with all the requirements of the Formal Agreement. A summary of the requirements of the Formal Agreement and the Bank’s status on complying with the Formal Agreement is as follows:


Requirements of the Formal Agreement

Responsive Actions
Article II. Establish, within 30 days from the effective date of the Formal Agreement, a Compliance Committee of at least five directors to be responsible for monitoring and coordinating the Bank’s adherence to the provisions of the Formal Agreement. The Compliance Committee is required to meet at least monthly to receive written progress reports from management on the results and status of actions needed to achieve full compliance with each article of the Formal Agreement.

The Compliance Committee was formed in January 2010 and has met monthly to review written progress reports provided by management.




Article III. Complete, within 60 days of the effective date of the Formal Agreement, a thorough review and assessment of the Bank’s Board of Directors and management supervision, management structure and staffing requirements.
The Compliance Committee completed this review and assessment, including obtaining Board approval of the findings and recommendations, in April and June 2010, and submitted its report to the OCC immediately thereafter.

 

22




Requirements of the Formal Agreement

Responsive Actions
Article IV. Adopt and implement, within 45 days of the effective date of the Formal Agreement, an updated written strategic plan for the Bank covering at least a three-year period including an updated three year capital program to strengthen the Bank’s capital structure.

The Board adopted the Bank’s strategic plan, including the required capital program, on March 3, 2010 which was submitted to the OCC on March 8, 2010. The Bank has also taken steps to implement this strategic plan and capital program. Management revised the capital program based on the OCC’s review. The revised plan was resubmitted to the OCC on November 1, 2010.

Management continues to submit capital updates to the OCC on a regular basis. We believe the OCC will not consider the Bank compliant with this requirement until our capital levels are at or above our individual minimum capital ratios.

Article V. Develop and implement, within 45 days of the effective date of the Formal Agreement, an updated written profit plan to improve and sustain the earnings of the Bank.

The Board adopted the Bank’s profit plan in November 2010 which was submitted to the OCC on December 14, 2010.

Article VI (4) and (5). Review the Bank’s liquidity on a monthly basis and provide the full Board of Directors with a written report of the results of this review to ensure adequate sources of liquidity in relation to the Bank’s needs.

Throughout 2010 and thus far in 2011, management has actively monitored liquidity and has provided detailed monthly reports to the Asset Liability Committee and the full Board of Directors for review.

Article VII. Adopt and implement, within 60 days of the effective date of the Formal Agreement, an updated written interest rate risk policy addressing management reports used for decision-making, interest rate risk tolerance, tools used to measure and monitor the Bank’s overall interest rate risk profile, and model validation and back-testing procedures.

The Bank’s Interest Rate Risk Policy, which addresses management reports, interest rate risk tolerance, measuring and monitoring the Bank’s risk profile and model validation and back-testing, was reviewed and approved by the Bank’s Board of Directors on March 3, 2010 and was submitted to the OCC on March 8, 2010.

Article VIII. Improve, within 90 days of the effective date of the Formal Agreement, the Bank’s liquidity position and maintain adequate sources of stable funding given the Bank’s anticipated liquidity and funding needs by reducing wholesale or credit sensitive liabilities and/or increasing liquid assets.

As of September 30, 2011, the Bank has increased its liquidity position to 20.0% from 13.6% as of December 31, 2009. In addition, the Bank decreased wholesale funding reliance by $19.9 million in 2010 and an additional $12.4 million in the first nine months of 2011.

 

23



 


Requirements of the Formal Agreement

Responsive Actions
Article IX. Accept, renew or rollover brokered deposits for deposit at the Bank only after obtaining a prior written determination of no supervisory objection from the OCC.

The Bank has obtained required written approvals from the OCC for all new and renewed brokered deposits accepted by the Bank since the effective date of the Formal Agreement.

Article X (7). Extend credit, including renewals or extensions, to a borrower whose loans or other extensions of credit exceed $300,000 and are criticized by the OCC or any other bank examiner, only after the Board or designated committee finds that the extension of additional credit is necessary to promote the best interests of the Bank.

All extensions of credit or modifications related to a criticized borrower have been properly approved by the Board.

Article XI. Adopt and implement, within 60 days of the effective date of the Formal Agreement, an updated and comprehensive policy for determining the adequacy of the Bank’s allowance for loan losses, which must provide for a review of the Bank’s allowance for loan losses by the Board at least once each calendar quarter.

The Bank’s Allowance for Loan Losses methodology and model was reviewed and approved by the Bank’s Board of Directors on April 28, 2010 and was submitted to the OCC on May 3, 2010. Management revised the Allowance for Loan Losses methodology and model based on the OCC’s review. Management resubmitted this information to the OCC in December 2010 and updated the written policy to reflect these revisions. The updated policy was submitted on May 4, 2011.

Article XII (1). Develop and implement, within 60 days of the effective date of the Formal Agreement, an updated written program to improve the Bank’s loan portfolio management including a pricing policy, guidelines for loans to insiders, guidelines on concentrations of credit, lending procedures, underwriting, documentation, exception tracking, re-appraisal guidelines and a comprehensive loan review process.

The Bank’s General Loan Policy, which addresses loans to insiders, guidelines on concentrations of credit, lending procedures, underwriting, documentation, exception tracking, and re-appraisals, was reviewed and approved by the Bank’s Board of Directors on April 28, 2010 and was submitted to the OCC on May 3, 2010.

Article XII (3). Develop and implement, within 60 days of the effective date of the Formal Agreement, updated systems which provide for effective monitoring of early problem loan identification and sources of problem loans by various factors, previously charged-off assets and their recovery potential, compliance with the Bank’s lending policies and laws, rules, and regulations pertaining to the Bank’s lending function, adequacy of credit and collateral documentation, and concentrations of credit.

Since the effective date of the Formal Agreement, the Bank has developed new loan tracking reports, has engaged a third party to perform loan portfolio stress testing, and has increased the scope of external quarterly loan review procedures.

 

24




Requirements of the Formal Agreement

Responsive Actions
Article XII (4). Provide to the Board of Directors, within 60 days of the effective date of the Formal Agreement, written reports on a monthly basis, including problem loans, delinquent loans, documentation exceptions, regulatory violations, concentrations of credit, significant economic factors, and general conditions and their impact on the credit quality of the Bank’s loan and lease portfolios, loans to insiders, and policy exceptions.

Throughout 2010 and thus far in 2011, management has provided detailed monthly reports to the Board of Directors detailing information required in this provision of the Formal Agreement.

Article XIII. Adopt and implement, within 60 days of the effective date of the Formal Agreement, a written asset diversification program including policies and procedures to control and monitor concentrations of credit and an action plan to reduce the risk of current concentrations of credit.

The Board of Directors has approved the updated General Loan Policy and has adopted a Commercial Real Estate Action Plan to ensure a reduction in the Bank’s commercial real estate portfolio. The General Loan Policy and Commercial Real Estate Action Plan were reviewed and approved by the Bank’s Board of Directors on April 28, 2010 and were submitted to the OCC on May 3, 2010.

Article XIV (1). Obtain, within 90 days of the effective date of the Formal Agreement, current and satisfactory credit information on all loans lacking such information, including those criticized by the OCC or any other bank examiner.

Since the effective date of the Formal Agreement, the Bank has obtained current and satisfactory credit information on all loans.

Article XIV (2). Ensure, within 60 days of the effective date of the Formal Agreement, proper collateral documentation is maintained on all loans and correct each collateral exception listed by the OCC or any other bank examiner.

Since the effective date of the Formal Agreement, the Bank has ensured proper collateral documentation is maintained and corrected each collateral exception that arose.

Article XIV (3). Effective immediately, the Bank may grant, extend, renew, alter or restructure any loan or other extension of credit only after: (1) documenting the specific reason or purpose for the extension of credit; (2) identifying the expected source of repayment in writing; (3) structuring the repayment terms to coincide with the expected source of repayment; (4) obtaining and analyzing current and satisfactory credit information, including cash flow analysis, where loans are to be repaid from operations; and (5) documenting, with adequate supporting material, the value of collateral and properly perfecting the Bank’s lien on it where applicable.

Since the effective date of the Formal Agreement, the Bank has sought to ensure that it has only granted, extended, renewed, altered or restructured any loan or other extension of credit after taking the steps outlined in Article XIV of the Formal Agreement.

Article XV. Adopt and implement, within 90 days of the effective date of the Formal Agreement, an updated written, comprehensive conflict of interest policy applicable to the Bank’s and the Bank holding company’s directors, principal shareholders, executive officers, affiliates, and employees (“Insiders”) and related interests of such Insiders.

The Bank’s Conflict of Interest and Code of Ethics Policy was reviewed and approved by the Bank’s Board of Directors on December 9, 2009 and was submitted to the OCC on March 8, 2010.

 

25




Requirements of the Formal Agreement

Responsive Actions
Article XVI. Within 30 days of the effective date of the Formal Agreement, the Board of Directors must reduce to conforming amounts all loans or other extensions of credit which exceed the Bank’s legal lending limit. The Board is also required to establish, implement, and thereafter ensure Bank adherence to written procedures to prevent future violations.

The Bank is in the process of reducing non-conforming loan relationships at the time of each renewal through the requirement of principal reductions or payoff. The Bank is regularly reporting to the OCC the status of its progress related to this provision of the Formal Agreement.

 

We are seeking to take all actions necessary to enable the Bank to comply with the requirements of the Formal Agreement. We have taken significant steps as noted above in an effort to comply with the provisions of the Formal Agreement and are continuing to work toward full compliance. Since the effective date of the Formal Agreement, management and the Board of Directors have adjusted a number of policies and initiated many actions. However, primarily because additional time is needed to show compliance with established policies and to see new initiatives result in increased capital levels and earnings, the OCC has deemed us not to be in compliance with Articles III, IV, V, VI, VII, VIII, X, XII, XIII, XIV, XVI of the Formal Agreement. Consequently, we anticipate that the OCC will impose an additional enforcement action with even more stringent requirements against us. There can be no assurances that the Bank will be able to fully comply with this new enforcement action and failure to meet its requirements could result in regulators taking additional enforcement actions against the Bank.

In addition, the OCC has established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks. Specifically, the Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%. As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital. As of September 30, 2011, total risk-based capital was 11% compared to the required 12%, Tier 1 capital was 9.7% compared to the required 10%, and leverage ratio was 7.9% compared to the required 9%. However, as of September 30, 2011 the Bank was still considered to be well capitalized by the OCC because the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives. The OCC instructed the Bank to achieve individual minimum capital ratio levels by June 30, 2011 which did not occur. We believe noncompliance with these ratio levels will result in the Bank becoming subject to a formal capital directive. The Bank is currently working with several advisors and consultants regarding strategies to increase capital. In addition, to facilitate its capital raising efforts the Company amended its Articles of Incorporation on August 12, 2011 to increase in the number of authorized shares of the Company’s common stock from 10,000,000 shares to 100,000,000 shares. See “Management’s Discussion and Analysis — Results of Operations — Capital Resources” for more discussion.

Currently, the Company also has to obtain the prior written approval of the Federal Reserve Bank of Richmond before (1) declaring or paying any dividends, (2) directly or indirectly accepting dividends or any other form of payment representing a reduction in capital from the Bank, (3) making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, (4) directly or indirectly, incurring, increasing or guaranteeing any debt, and (5) directly or indirectly, purchasing or redeeming any shares of its stock. Pursuant to our plans to preserve capital, the Company has no plans to undertake any of the foregoing activities.

Results of Operations

Three months ended September 30, 2011 and 2010

We recorded net income of $39,525, or $0.02 per diluted share, for the quarter ended September 30, 2011, an increase of $3.2 million, or 101%, compared to a net loss of $3.2 million, or $1.52 per diluted share, for the quarter ended September 30, 2010. This change from a net loss to a net income position between comparable quarters was primarily driven by decreases in income tax expense and provisions for loan losses and net changes in fair value and losses on other real estate owned. Each of these components is discussed in greater detail below.

26



The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the three months ended September 30, 2011 and 2010. We derived these yields by dividing annualized income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. The net amount of capitalized loan fees are amortized into interest income on loans.

        For the Three Months Ended September 30,    
        2011
    2010
   
        Average
Balance
  
Income/
Expense
  
Yield/
Rate
  
Average
Balance
  
Income/
Expense
  
Yield/
Rate
Federal funds sold and other
              $ 9,302,900          $ 11,027             0.47 %         $ 10,038,217          $ 12,921             0.51 %  
Investment securities (1)
                 8,236,429             60,118             2.90             9,649,805             73,057             3.00   
Loans (2)
                 83,418,652             1,171,051             5.57             96,573,968             1,181,010             4.85   
Total interest-earning assets
              $ 100,957,981          $ 1,242,196             4.88 %         $ 116,261,990          $ 1,266,988             4.32 %  
 
NOW accounts
              $ 5,789,429          $ 9,595             0.66 %         $ 6,187,086          $ 11,884             0.76 %  
Savings & money market
                 35,739,066             92,978             1.03             35,712,345             141,151             1.57   
Time deposits (excluding brokered time deposits)
                 32,505,156             114,448             1.40             28,700,939             135,446             1.87   
Brokered time deposits
                 17,112,586             86,541             2.01             30,385,324             199,009             2.60   
Total interest-bearing deposits
                 91,146,237             303,562             1.32             100,985,694             487,490             1.92   
Borrowings
                 7,174,162             53,449             2.96             7,742,892             80,249             4.11   
Total interest-bearing liabilities
              $ 98,320,399          $ 357,011             1.44 %         $ 108,728,586          $ 567,739             2.07 %  
 
Net interest spread
                                               3.44 %                                          2.25 %  
Net interest income/ margin
                             $ 885,185             3.48 %                        $ 699,249             2.39 %  
 
 
(1)    
  The average balances for investment securities exclude the unrealized gain recorded for available for sale securities.
(2)    
  Nonaccrual loans are included in average balances for yield computations.

For the three months ended September 30, 2011, we recognized $1.2 million in interest income and $357,011 in interest expense, resulting in net interest income of $885,185, an increase of $185,936, or 27%, over the same period in 2010. Average earning assets decreased to $101.0 million for the three months ended September 30, 2011 from $116.3 million for the three months ended September 30, 2010, a decrease of $15.3 million, or 13%. This decrease in earning assets was primarily due to a $13.2 million decrease in average loans between periods as well as a $1.4 million decrease in investment securities. Average interest bearing liabilities decreased to $98.3 million for the three months ended September 30, 2011 from $108.7 million for the three months ended September 30, 2010, a decrease of $10.4 million, or 10%. During 2009, we adopted measures to promote the long term stability of the Bank. These measures included restructuring the balance sheet to focus on credit quality and management of our funding sources to increase liquidity and the net interest margin. As a result, average loans decreased between periods, with funds from net loan payoffs used to repay FHLB advances and brokered time deposits as well as to strengthen our liquidity position through cash and the investment securities portfolio. Net interest margin, calculated as annualized net interest income divided by average earning assets, increased from 2.39% for the quarter ended September 30, 2010 to 3.48% for the quarter ended September 30, 2011, primarily due to an increase in yield on earning assets from 4.32% to 4.88% between periods, as well as a decrease in cost of funds from 2.07% to 1.44% between periods, due to the mix of liabilities and the timing of their repricing. The increase in yield on earning assets was impacted by the return of three loans to accrual status, based on accounting guidance and our loan policies, resulting in an increase in interest income of approximately $115,000 accounting for 45 basis points in net interest margin.

27



We recovered $80,000 in provision for loan losses for the quarter ended September 30, 2011, representing a decrease of $1.3 million, or 107%, compared to the expense of $1.2 million for the quarter ended September 30, 2010. The allowance as a percentage of gross loans decreased to 2.84% as of September 30, 2011 compared to 3.24% at December 31, 2010. Specific reserves were approximately $657,000 on impaired loans of $10.2 million as of September 30, 2011 compared to specific reserves of approximately $1.6 million on impaired loans of $12.8 million as of December 31, 2010. As of September 30, 2011, the general reserve allocation was 2.33% of gross loans not impaired compared to 1.82% as of December 31, 2010. The sharp decrease in provision for loan losses for the current quarter is due to the significant decrease in loan balances between the comparable periods combined with a lack of new required specific reserves. We did decrease one qualitative loss factor utilized in our allowance for loan losses model relative to staffing which resulted in lower required general reserves of approximately $17,000. No other loss factors in our allowance for loan losses model were adjusted. For the quarter ended September 30, 2010, the large provision expense was a result of a large increase in impaired and nonaccrual loans, and their related specific reserves, in addition to an increase in the general allowance allocation due to declining economic conditions and increased charge-off levels. Though we continue to have elevated levels of non-performing loans, we did not experience a sharp increase in non-performing loans during the quarter ended September 30, 2011 as we did during the quarter ended September 30, 2010. The provision for loan losses is discussed further below under “Provision and Allowance for Loan Losses.”

For the three months ended September 30, 2011, noninterest income was $73,916 compared to $76,004 for the three months ended September 30, 2010, a decrease of $2,088, or 3%, between comparable periods. Noninterest income for the three months ended September 30, 2011 and 2010 was derived from service charges on deposits, customer service fees, rental income, gains on investment securities sales, and mortgage origination income. Mortgage origination income decreased by approximately $31,000 for the quarter ended September 30, 2011 compared to the quarter ended September 30, 2010. Offsetting this decrease was a gain of approximately $32,500 on the sale of three small mortgage backed securities available for sale.

During the current quarter, we incurred noninterest expenses of $999,576, compared to noninterest expenses of $1.3 million for the quarter ended September 30, 2010, a decrease of $346,734, or 26%. This decrease in noninterest expenses for the three month period ended September 30, 2011 primarily resulted from a decrease of $310,966, or 98%, in net changes in fair value and (gains) losses on other real estate owned and repossessed assets. This decrease was primarily attributable to a property which was written down by approximately $278,000 during the quarter ended September 30, 2010 based on an appraisal received in that year. Write-downs or recoveries and gains or losses are charged against income, if necessary, as a result of our regular review of the fair value of repossessed property. Compensation and benefits also decreased $44,760 due to a decrease in salaries and stock-based compensation, and insurance decreased $62,133 primarily due to a decrease in FDIC assessments due to the revised assessment calculation. In addition, professional fees decreased $26,292 primarily due to a decrease in legal expense. Offsetting these decreases was an increase in other noninterest expenses of $92,151 due to increased expenses related to other real estate owned, such as taxes, maintenance and utilities.

We did not recognize any income tax benefit or expense for the three months ended September 30, 2011. However, we did recognize income tax expense of $1.4 million for the quarter ended September 30, 2010 based on the following requirements. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. During our September 30, 2010 quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned, and booked a 100% valuation allowance against the deferred tax asset. We will continue to analyze our deferred tax assets and related valuation allowance each quarter taking into account performance compared to forecast and current economic or internal information that would impact forecasted earnings. No expense was recognized on net income for the quarter ended September 30, 2011 due to the Company’s large cumulative net operating loss carry-forward position as well as the 100% valuation allowance on our deferred tax assets. The net income for the quarter ended September 30, 2011 does not represent a trend toward sustained profitability.

28



Nine months ended September 30, 2011 and 2010

We incurred a net loss of $1.4 million, or $0.68 per diluted share, for the nine months ended September 30, 2011, a decrease in net loss of $3.6 million or 72%, compared to a net loss of $5.0 million, or $2.42 per diluted share, for the nine months ended September 30, 2010. This decrease in net loss between comparable periods was primarily driven by an increase in net interest income coupled with decreases in several expense areas including provisions for loan losses, salaries and benefits expense, as well as net changes in fair value and gains or losses on sale of other real estate owned. Each of these components is discussed in greater detail below.

The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the nine months ended September 30, 2011 and 2010. We derived these yields by dividing annualized income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. The net amount of capitalized loan fees are amortized into interest income on loans.

        For the Nine Months Ended September 30,    
        2011
    2010
   
        Average
Balance
  
Income/
Expense
  
Yield/
Rate
  
Average
Balance
  
Income/
Expense
  
Yield/
Rate
Federal funds sold and other
              $ 9,397,543          $ 35,060             0.50 %         $ 10,833,056          $ 38,624             0.48 %  
Investment securities (1)
                 9,562,051             210,390             2.94             8,608,399             201,507             3.13   
Loans (2)
                 88,105,894             3,349,379             5.08             101,537,328             3,655,015             4.81   
Total interest-earning assets
              $ 107,065,488          $ 3,594,829             4.49 %         $ 120,978,783          $ 3,895,146             4.30 %  
 
NOW accounts
              $ 5,990,791          $ 30,468             0.68 %         $ 5,607,114          $ 28,675             0.68 %  
Savings & money market
                 34,891,870             290,054             1.11             32,064,244             414,694             1.73   
Time deposits (excluding brokered time deposits)
                 32,996,890             379,815             1.54             29,364,941             452,216             2.06   
Brokered time deposits
                 21,071,174             341,088             2.16             34,426,433             695,034             2.70   
Total interest-bearing deposits
                 94,950,725             1,041,425             1.47             101,462,732             1,590,619             2.10   
Borrowings
                 7,121,766             158,825             2.98             11,024,597             322,259             3.91   
Total interest-bearing liabilities
              $ 102,072,491          $ 1,200,250             1.57 %         $ 112,487,329          $ 1,912,878             2.27 %  
 
Net interest spread
                                               2.92 %                                          2.03 %  
Net interest income/ margin
                             $ 2,394,579             2.99 %                        $ 1,982,268             2.19 %  
 
(1)    
  The average balances for investment securities exclude the unrealized gain recorded for available for sale securities.
(2)    
  Nonaccrual loans are included in average balances for yield computations.

For the nine months ended September 30, 2011, we recognized $3.6 million in interest income and $1.2 million in interest expense, resulting in net interest income of $2.4 million, an increase of $412,311, or 21%, over the same period in 2010. Average earning assets decreased to $107.1 million for the nine months ended September 30, 2011 from $121.0 million for the nine months ended September 30, 2010, a decrease of $13.9 million, or 12%. This decrease in earning assets was due to a $13.4 million decrease in average loans between periods as well as a $1.4 million decrease in average federal funds sold and other, partially offset by a $953,562 increase in average investment securities. Average interest bearing liabilities decreased to $102.1 million for the nine months ended September 30, 2011 from $112.5 million for the nine months ended September 30, 2010, a decrease of $10.4 million, or 9%. During 2009, we adopted measures to promote the long term stability of the Bank. These measures included restructuring the balance sheet to focus on credit quality and management of our funding sources to increase liquidity and the net interest margin. As a result, average loans decreased between periods, with funds from net loan payoffs used to repay FHLB advances and brokered time deposits as well as to strengthen our liquidity position through cash and the investment securities portfolio. Net interest margin, calculated as annualized net interest income divided by average earning assets, increased from 2.19% for the nine months ended September 30, 2010 to 2.99% for the nine months ended September 30, 2011, primarily due to a decrease in cost of funds from 2.27% to 1.57% between periods due to the mix of liabilities and the timing of their repricing.

29



Provision for loan losses was $730,000 for the nine months ended September 30, 2011 representing a decrease of $1.3 million, or 65%, compared to the expense of $2,055,000 for the nine months ended September 30, 2010. The large decrease in provision for loan losses for the current nine months is due to the decrease in average loans between comparable periods combined with a lack of new required specific reserves and an overall decrease in non-performing loans. During 2010, we increased our allowance for loan losses as a result of a significant overall increase in impaired and nonaccrual loans due to declining economic conditions and increased charge-off levels. The allowance as a percentage of gross loans decreased to 2.84% as of September 30, 2011 compared to 3.24% at December 31, 2010. This decline is due to charge-offs taken against specific reserves as well as payoffs in our commercial real estate portfolio which carries a higher historical loss ratio and consequently a higher reserve factor within our allowance model. Specific reserves were approximately $657,000 on impaired loans of $10.2 million as of September 30, 2011 compared to specific reserves of approximately $1.6 million on impaired loans of $12.8 million as of December 31, 2010. As of September 30, 2011, the general reserve allocation was 2.33% of gross loans not impaired compared to 1.82% as of December 31, 2010. The provision for loan losses is discussed further below under “Provision and Allowance for Loan Losses.”

For the nine months ended September 30, 2011, noninterest income was $169,999 compared to $188,418 for the nine months ended September 30, 2010, a decrease of $18,419, or 10%, between comparable periods. This decrease is primarily due to a decrease in mortgage origination income of approximately $45,000 between comparable periods offset by a gain of approximately $32,500 on the sale of three small mortgage backed securities available for sale. Noninterest income for the nine months ended September 30, 2011 and 2010 was derived from service charges on deposits, customer service fees, rental income, gains on investment securities sales, and mortgage origination income.

During the current nine months, we incurred noninterest expenses of $3.2 million, compared to noninterest expenses of $3.8 million for the nine months ended September 30, 2010, a decrease of $541,572, or 14%. This decrease in noninterest expenses for the nine month period ended September 30, 2011 primarily resulted from a decrease of $445,908 in net changes in fair value and (gains) losses on other real estate owned and repossessed assets due to several significant write-downs in 2010. In addition, there was a decrease of $216,653, or 15%, in compensation and benefits due to decreased salaries and stock option expense as well as the discontinuation of our 401(k) match beginning April 1, 2010. Insurance decreased $66,941 due to the drop in FDIC assessment charges due to the revised assessment calculation. Offsetting these decreases was an increase in other noninterest expenses of $197,335 due to increased expenses related to other real estate owned, such as taxes, maintenance and legal fees.

We did not recognize any income tax benefit or expense for the nine months ended September 30, 2011. However, we did recognize income tax expense of $1.4 million for the nine months ended September 30, 2010 based on the following requirements. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. During our September 30, 2010 quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned, and booked a 100% valuation allowance against the deferred tax asset. We will continue to analyze our deferred tax assets and related valuation allowance each quarter taking into account performance compared to forecast and current economic or internal information that would impact forecasted earnings.

30



Assets and Liabilities

General

Total assets as of September 30, 2011 were $113.1 million, representing a decrease of $8.7 million, or 7%, compared to December 31, 2010. The decrease in assets is due to an $11.0 million decrease in net loans, which is the result of $7.6 million of net loan payoffs, $2.7 million in transfers between loans and other real estate owned and net charge-offs of $1.4 million offset by provision for loan losses of $730,000. Other real estate owned increased due to the repossession of six properties offset by the sale of four properties as well as net write-downs taken during the nine months ended September 30, 2011. Investment securities decreased due to mortgage-backed securities repayments of approximately $828,000 and sales and maturities, net of purchases, of approximately $929,000. These decreases were offset by an increase in cash and cash equivalents of $2.8 million. At September 30, 2011, our total assets consisted principally of $13.5 million in cash and due from banks, $9.1 million in investment securities, $80.4 million in net loans, $3.6 million in property and equipment and $3.8 million in other real estate owned and repossessed assets. Our management closely monitors and seeks to maintain appropriate levels of interest-earning assets and interest-bearing liabilities so that maturities of assets are such that adequate funds are provided to meet customer withdrawals and demand.

Liabilities at September 30, 2011 totaled $103.9 million, representing a decrease of $7.4 million, or 7%, compared to December 31, 2010, and consisted principally of $96.6 million in deposits and $7.1 million in borrowings. Our borrowings consisted of FHLB advances and customer repurchase agreements. At September 30, 2011, shareholders’ equity was $9.2 million compared to $10.5 million at December 31, 2010. The decrease in shareholders’ equity was primarily due to the net loss of $1.4 million for the nine months ended September 30, 2011.

Loans

Since loans typically provide higher interest yields than other types of interest-earning assets, we invest a substantial percentage of our earning assets in our loan portfolio. At September 30, 2011, our gross loan portfolio consisted primarily of $53.6 million of commercial real estate loans, $11.8 million of commercial business loans, and $17.4 million of consumer and home equity loans. Other than continued purposeful reduction in our commercial real estate concentration, our current loan portfolio composition is not materially different than the loan portfolio composition disclosed in the footnotes to the consolidated financial statements included in our Annual Report on Form 10-K for 2010 as filed with the SEC. We experienced net payoffs of $7.6 million during the nine months ended September 30, 2011 due to low market demand, careful consideration of liquidity needs and credit risk management.

Loan Performance and Asset Quality

The downturn in general economic conditions over the past three years has resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declining real estate market has had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, in our current market the value of the collateral has deteriorated during the time the credit is extended. There is a risk that this trend will continue, which could result in additional loss of earnings, increases in our provision for loan losses and loan charge-offs.

Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees. Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal.

31



Refer to Note 4, Loans, for a table summarizing delinquencies and nonaccruals, by portfolio class, as of September 30, 2011 and December 31, 2010. Total delinquent and nonaccrual loans decreased from $12.7 million at December 31, 2010 to $7.5 million at September 30, 2011, a decrease of $5.3 million or 41%. This decrease was a result of movement in nonaccrual loans, which decreased by $5.5 million, or 46%, during the nine months ended September 30, 2011. Nonaccrual decreases were seen in single and multifamily residential real estate as well as construction and development loans due to reposessions of property in satisfaction of these loans in addition to the return of three loans to accrual status based on a long satisfactory payment history and current financial information of the borrowers as well as the collateral. These decreases were offset by an increase in other commercial real estate loans as a result of detailed review of relationships within these portfolio classes, loan payment history and the current economic environment. At September 30, 2011, nonaccrual loans represented 7.9% of gross loans compared to 12.7% of gross loans as of December 31, 2010. Loans past due 30-89 days are considered potential problem loans and amounted to $951,719 at September 30, 2011 compared to $697,558 at December 31, 2010.

Another method used to monitor the loan portfolio is credit grading. As part of the loan review process, loans are given individual credit grades, representing the risk we believe is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. Refer to Note 4, Loans, for a table summarizing management’s internal credit risk grades, by portfolio class, as of September 30, 2011 and December 31, 2010.

Loans graded one through four are considered “pass” credits. As of September 30, 2011, approximately 62% of the loan portfolio had a credit grade of Acceptable or Acceptable with Care. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

Loans with a credit grade of five are not considered classified; however they are categorized as a special mention or watch list credit, and are considered potential problem loans. This classification is utilized by us when we have an initial concern about the financial health of a borrower. These loans are designated as such in order to be monitored more closely than other credits in our portfolio. We then gather current financial information about the borrower and evaluate our current risk in the credit. We will then either reclassify the loan as “substandard” or back to its original risk rating after a review of the information. There are times when we may leave the loan on the watch list, if, in management’s opinion, there are risks that cannot be fully evaluated without the passage of time, and we determine to review the loan on a more regular basis. Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of September 30, 2011, we had loans totaling $1.7 million on the watch list compared to $6.9 million as of December 31, 2010, a decrease of $5.2 million or 76%. This decrease in watch list loans was primarily due to the downgrade of loans within this category to substandard due to receipt of additional information and continued analysis of credit deterioration in these credit relationships.

Loans graded six or greater are considered classified credits. At September 30, 2011 and December 31, 2010, classified loans totaled $12.1 million and $12.9 million, respectively. The decrease in this category of $757,430, or 6%, is due to the reclassification of watch list loans to substandard during the nine months ended September 30, 2011 offset by the repossession of collateral in satisfaction of several loans in this category. During 2011, we had nine loan relationships move out of substandard into other real estate owned at the time of collateral repossession. Classified credits are evaluated for impairment on a quarterly basis.

A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The resultant shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.

At September 30, 2011, impaired loans totaled $10.2 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. As of September 30, 2011, we had loans totaling approximately $1.9 million that were classified in accordance with our loan rating policies but were not considered impaired. Refer to Note 4, Loans, for a table summarizing information relative to impaired loans, by portfolio class, at September 30, 2011 and December 31, 2010.

32



As a result of adopting the amendments in ASU 2011-02, we reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are TDRs under the amended guidance. We did not identify any new TDRs during our assessment. As noted below, all outstanding TDRs as of September 30, 2011 were restructured prior to the adoption of ASU 2011-02.

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.

At September 30, 2011, the principal balance of TDRs totaled $1.3 million. All TDRs were considered classified, impaired, and in nonaccrual status at September 30, 2011. No TDRs went into default during either the nine months or the quarter ended September 30, 2011. A TDR can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.

Provision and Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged to expense on our consolidated statement of operations. At September 30, 2011, the allowance for loan losses was $2.4 million, or 2.84% of gross loans, compared to $3.1 million at December 31, 2010, or 3.24% of gross loans.

The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. We strive to follow a comprehensive, well-documented, and consistently applied analysis of our loan portfolio in determining an appropriate level for the allowance for loan losses. 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 what we believe are all significant factors that impact 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 lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and Board of Director oversight, concentrations of credit, and peer group comparisons.

Our allowance for loan losses consists of both specific and general reserve components. The specific reserve component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. Loans determined to be impaired are excluded from the general reserve calculation described below and evaluated individually for impairment. Impaired loans totaled $10.2 million at September 30, 2011, with an associated specific reserve of approximately $657,000. See Note 4, Loans, as well as the above discussion under “Loan Performance and Credit Quality” for additional information related to impaired loans.

The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors. Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio. The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.

33



Refer to Note 4, Loans, for a table summarizing activity related to our allowance for loan losses for the quarter and nine months ended September 30, 2011, by portfolio segment. As of September 30, 2011, the allowance for loan losses was $2.4 million, or 2.84% of gross loans, compared to $3.1 million, or 3.24% of gross loans, as of December 31, 2010 and $2.8 million, or 2.90% of gross loans, as of September 30, 2010. Provision for loan losses was a recovery of $80,000 for the three months ended September 30, 2011, a decrease of $1.3, or 107%, compared to the expense of $1.2 for the three months ended September 30, 2010. For the nine months ended September 30, 2011, provision expense for loan losses was $730,000, a decrease of $1.3 million, or 65%, compared to provision expense of $2.1 million for the nine months ended September 30, 2010. Net loan charge-offs decreased significantly during the quarter ended September 30, 2011, from $597,837 for the three months ended September 30, 2010 to $5,525 for the three months ended September 30, 2011, a decrease of $592,312 or 99%. Net charge-offs for the nine months ended September 30, 2011 were $1.4 million compared to $560,057 for the nine months ended September 30, 2010. This increase was due to the impact of the extended duration of this economic deterioration on our borrowers as well as declining asset quality trends in our loan portfolio. The vast majority of charge-offs thus far in 2011 were partial charge-offs taken on certain collateral-dependent loans within our real estate portfolio segments. Partial charge-offs were based on recent appraisals and evaluations on commercial real estate loans in the process of foreclosure. Loans with partial charge-offs are typically considered impaired loans and remain on nonaccrual status.

Other Real Estate Owned and Repossessed Assets

As of September 30, 2011, we had $3.8 million in other real estate owned and $39,457 in repossessed assets. This compares to $2.5 million in other real estate owned and $70,712 in repossessed assets as of December 31, 2010. During 2011, collateral was obtained from six loan relationships that went through the foreclosure process. We also completed the sale of four repossessed properties and one repossessed automobile. The following table summarizes changes in other real estate owned and repossessed assets for the nine months ended September 30, 2011:

        2011
Balance at beginning of period
              $ 2,537,259   
Repossessed property acquired in settlement of loans
                 4,738,064   
Sales of repossessed property financed by the Bank
                 (2,080,310 )  
Cash sales of repossessed property
                 (1,101,666 )  
Net changes in fair value and (gains) losses on other real estate owned and repossessed assets
                 (246,382 )  
Balance at end of period
              $ 3,846,965   
 

As of September 30, 2011, other real estate owned consisted of residential land lots valued at $1.2 million, a 1-4 family residential dwelling valued at $709,500, commercial land valued at $1.8 million and commercial office space valued at $117,500. Repossessed assets consisted of equipment valued at $39,457. These assets are being actively marketed with the primary objective of liquidating the collateral at a level which most accurately approximates fair value and allows recovery of as much of the unpaid principal loan balance as possible upon the sale of the asset within a reasonable period of time. Based on currently available valuation information, the carrying value of these assets is believed to be representative of their fair value less estimated costs to sell, although there can be no assurance that the ultimate proceeds from the sale of these assets will be equal to or greater than their carrying values, particularly in the current real estate environment and the continued downward trend in third party appraised values.

Deposits

Our primary source of funds for loans and investments is our deposits. At September 30, 2011, we had $96.6 million in deposits, representing a decrease of $7.5 million, or 7%, compared to December 31, 2010. Deposits at September 30, 2011 consisted primarily of $13.1 million in demand deposit accounts, $36.5 million in money market accounts and $46.5 million in time deposits. During the fourth quarter of 2006, we began obtaining deposits outside of our local market area in the form of brokered time deposits. Due to the interest rate environment in our market, as well as strong competition from other banking and financial services companies in gathering deposits, brokered time deposits allowed us to obtain funding in order to support loan growth. At September 30, 2011, we had $13.6 million in brokered time deposits, a decrease of $12.4 million compared to December 31, 2010.

34



Since January 20, 2010, we have had to obtain written approval from the OCC to accept, renew or rollover brokered time deposits pursuant to the terms of the Formal Agreement. Requests have been made to the OCC on a quarterly basis for permission to renew up to 90% of brokered time deposits maturing during each respective quarter. Approval was granted by the OCC for each request submitted in 2010; however due to strong customer deposit growth, we only renewed approximately 39% of brokered deposits maturing in 2010. During the first quarter of 2011, we renewed approximately 61% of maturing brokered deposits in order to ensure our liquidity position remained strong. Our most recent request to renew maturing brokered time deposits was denied by the OCC due to continuing credit quality issues which have led to increased net losses and declining capital. For the fourth quarter of 2011 we have $873,000 of brokered deposits maturing. During the first four months of 2012, we have $5.8 million of brokered deposits maturing. We believe we have adequate funding sources available to pay off brokered deposits as they mature. See additional discussion below under “Liquidity.”

Our strong customer deposit growth during 2010 and the decrease in the loan portfolio during the first nine months of 2011 has enabled us to maintain a strong liquidity position while decreasing our reliance on brokered deposits, thereby lowering our cost of interest-bearing liabilities. We will continue to reduce our reliance on brokered time deposits and other noncore funding sources, while focusing our efforts to gather core deposits in our local market. Our loan-to-deposit ratio was 85.8% and 90.8% at September 30, 2011 and December 31, 2010, respectively.

Borrowings

We use borrowings to fund growth of earning assets in excess of deposit growth. Borrowings totaled $7.1 million at September 30, 2011, compared to $7.1 million at December 31, 2010. FHLB advances accounted for $7.0 million of total borrowings as of September 30, 2011 and December 31, 2010. These advances are secured with approximately $54.8 million of first and second mortgage loans and $735,400 of stock in the FHLB. The remaining balance in borrowings represents customer repurchase agreements.

Liquidity

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of liabilities. The ongoing effects of the credit crisis have impacted liquidity for the banking industry. As a result, most of the sources of liquidity that we rely on have been significantly disrupted. We have reduced our reliance on the wholesale funding market for deposits by capitalizing on existing and new retail deposit opportunities through our network of full-service branches. We manage both assets and liabilities to achieve appropriate levels of liquidity. Cash and short-term investments are our primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment portfolio is our principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions and pledging agreements. Individual and commercial deposits, internet time deposits, and borrowings are our primary source of funds for credit activities. In addition, due to low market demand and careful consideration of liquidity needs and credit risk management, we have experienced an increase in loan payoffs which has also served as a source of funding. As brokered deposits or advances mature, we intend to replace these funds with new advances or other borrowings to the extent necessary after considering core deposit growth and loan payoffs, although overall we will seek to reduce our reliance on noncore funding sources.

We are a member of 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. At September 30, 2011, we had collateral that would support approximately $4.2 million in additional borrowings. Like all banks, we are subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. During the fourth quarter of 2010, the FHLB downgraded our credit risk rating, which resulted in decreased borrowing availability (total line reduced to 15% of total assets from 20% of total assets) and increased collateral requirements (moved to 125% of borrowings from 115%). Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.

We also pledge collateral to the Federal Reserve Bank’s Borrower-in-Custody of Collateral program, and our available credit under this program was approximately $8.5 million as of September 30, 2011. During the second quarter, we were informed by the Federal Reserve Bank that our available credit under the Borrower-in-Custody of Collateral program had been moved from Primary Credit to Secondary Credit, meaning borrowing requests have to be reviewed and approved in advance, and advances are to be short term in nature. This change also resulted in an increase in our collateral requirements and a corresponding decrease in our borrowing capacity with the Federal Reserve Bank.

35



We have a $2.0 million federal funds purchased line of credit through a correspondent bank that is secured by investment securities, but has not been utilized.

We believe our liquidity sources are adequate to meet our operating needs. However, we continue to carefully focus on liquidity management during 2011. Comprehensive weekly and monthly liquidity analyses serve management as vital decision-making tools by providing summaries of anticipated changes in loans, investments, core deposits, and wholesale funds. These internal funding reports provide management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan paydowns and amount and cost of available borrowing sources, including secured overnight federal funds lines with our various correspondent banks.

The level of liquidity is measured by the cash, cash equivalents, and investment securities available for sale to total assets ratio, which was at 20.0% at September 30, 2011 compared to 17.5% as of December 31, 2010. The increase in liquidity is due to net loan payoffs of $7.6 million, repayments and sales of mortgage-backed securities and the sale of four properties in other real estate owned during the nine months ended September 30, 2011.

Impact of Off-Balance Sheet Instruments

Through the operations of our Bank, we have made contractual commitments to extend credit in the ordinary course of our 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 September 30, 2011, we had issued commitments to extend credit of $11.5 million through various types of lending arrangements. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

Commitments and Contingencies

As of September 30, 2011, there were no significant firm commitments outstanding for capital expenditures.

Capital Resources

Total shareholders’ equity decreased to $9.1 million at September 30, 2011 from $10.5 million at December 31, 2010, primarily due to our net loss for the nine months of $1.4 million. We believe that our capital is sufficient to fund the activities of our Bank’s operations; however, the rate of net losses has deteriorated our capital base below our established individual minimum capital ratios as discussed in greater detail below. We have not been immune to the unprecedented levels of extended volatility and disruption in the capital and credit markets and can give no assurances with respect to our capital levels.

Our Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. However, the Federal Reserve guidelines contain an exemption from the capital requirements for “small bank holding companies,” which in 2006 were amended to cover most bank holding companies with less than $500 million in total assets that do not have a material amount of debt or equity securities outstanding registered with the SEC. Although our class of common stock is registered under Section 12 of the Securities Exchange Act, we believe that because our stock is not listed on any exchange or otherwise actively traded, the Federal Reserve Board will interpret its new guidelines to mean that we qualify as a small bank holding company. Nevertheless, our Bank remains subject to these capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s 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 Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

36



Quantitative measures established by regulation to ensure capital adequacy require the Bank 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 Bank consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, less certain intangible assets. The Bank’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.

The Bank is 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.

As previously discussed, on January 20, 2010, the Bank entered into the Formal Agreement with its primary regulator, the OCC. The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management.

In response, the Bank formed a Compliance Committee of its Board of Directors to oversee management’s response to all sections of the Formal Agreement. The Compliance Committee also monitors adherence to deadlines for submission to the OCC of information required under the Formal Agreement. The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam and will continue to work to comply with all the requirements of the Formal Agreement. For additional information on the Formal Agreement, including actions the Bank has taken in response to the Formal Agreement, see above under “Recent Regulatory Developments.”

In addition, the OCC established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks. The Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%. As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital. As of September 30, 2011, total risk-based capital was 11.0% compared to the required 12%, Tier 1 capital was 9.7% compared to the required 10%, and leverage ratio was 7.9% compared to the required 9%. However, as of September 30, 2011 the Bank was still considered to be well capitalized by the OCC because the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives. The OCC instructed the Bank to achieve individual minimum capital ratio levels by June 30, 2011 which did not occur. We believe noncompliance with these ratio levels will result in the Bank becoming subject to a formal capital directive. The Bank is currently working with several advisors and consultants regarding strategies to increase capital. In addition, to facilitate its capital raising efforts the Company amended its Articles of Incorporation on August 12, 2011 to increase in the number of authorized shares of the Company’s common stock from 10,000,000 shares to 100,000,000 shares.

37



The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements at September 30, 2011 and December 31, 2010.

(Dollars in thousands)

                Individual Minimum
Capital Ratio
    For capital
adequacy purposes
    To be well capitalized
under prompt
corrective
action provisions
   
        Actual     Minimum     Minimum     Minimum    
        Amount
    Ratio
    Amount
    Ratio
    Amount
    Ratio
    Amount
    Ratio
As of September 30, 2011
                                                                                                                               
Total Capital (to risk weighted assets)
              $ 10,149,000             11.0 %         $ 11,101,000             12.0 %         $ 7,401,000             8.0 %         $ 9,251,000             10.0 %  
Tier 1 Capital (to risk weighted assets)
                 8,978,000             9.7             9,251,000             10.0             3,700,000             4.0             5,551,000             6.0   
Tier 1 Capital (to average assets)
                 8,978,000             7.9             10,242,000             9.0             4,552,000             4.0             5,690,000             5.0   
 
As of December 31, 2010
                                                                                                                               
Total Capital (to risk weighted assets)
              $ 11,670,000             11.5 %         $ 12,169,000             12.0 %         $ 8,112,000             8.0 %         $ 10,141,000             10.0 %  
Tier 1 Capital (to risk weighted assets)
                 10,381,000             10.2             10,141,000             10.0             4,056,000             4.0             6,084,000             6.0   
Tier 1 Capital (to average assets)
                 10,381,000             8.4             11,137,000             9.0             4,950,000             4.0             6,187,000             5.0   
 

38



Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable

Item 4. Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e). Based upon that evaluation, our Chief Executive Officer and Acting Chief Financial Officer have concluded that our current disclosure controls and procedures are effective as of September 30, 2011. There have been no significant changes in our internal controls over financial reporting during the fiscal quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

Part II – Other Information

Item 1. Legal Proceedings

There are no material pending legal proceedings to which we are a party or of which any of our properties are the subject.

Item 1A. Risk Factors

Not applicable

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable

Item 3. Default Upon Senior Securities

Not applicable

Item 4. (Removed and Reserved.)

Item 5. Other Information

Not applicable

39



Item 6. Exhibits

10.1  
  Articles of Amendment to the Company’s Articles of Incorporation, dated August 12, 2011 (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed August 15, 2011).

31.1  
  Rule 13a-14(a) Certification of the Principal Executive Officer.

31.2  
  Rule 13a-14(a) Certification of the Principal Financial Officer.

32     
  Section 1350 Certifications.

101    The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, formatted in eXtensible Business Reporting Language (XBRL); (i) Consolidated Balance Sheets at September 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income (Loss) for the three and nine months ended September 30, 2011 and 2010, (iii) Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss) for the nine months ended September 30, 2011 and 2010, (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010, and (v) Notes to Consolidated Financial Statements*.

*   Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.


40



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date:   November 4, 2011
           
By: /s/ Lawrence R. Miller                       
Lawrence R. Miller
Chief Executive Officer (Principal Executive Officer)
 
Date:   November 4, 2011
           
By: /s/ Kimberly D. Barrs                         
Kimberly D. Barrs
Acting Chief Financial Officer
(Principal Financial and Accounting Officer)
 

41



EXHIBIT INDEX

Exhibit
Number
        Description
 
31.1
           
Rule 13a-14(a) Certification of the Principal Executive Officer.
 
31.2
           
Rule 13a-14(a) Certification of the Principal Financial Officer.
 
32
           
Section 1350 Certifications.
 

101    The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, formatted in eXtensible Business Reporting Language (XBRL); (i) Consolidated Balance Sheets at September 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income (Loss) for the three and nine months ended September 30, 2011 and 2010, (iii) Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss) for the nine months ended September 30, 2011 and 2010, (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010, and (v) Notes to Consolidated Financial Statements*.

*   Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.