COASTAL BANKING CO INC - FORM 10-Q

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EX-31.1 - CERTIFICATION - COASTAL BANKING CO INC	cbco_ex311.htm
EX-31.2 - CERTIFICATION - COASTAL BANKING CO INC	cbco_ex312.htm
EX-32.1 - CERTIFICATION - COASTAL BANKING CO INC	cbco_ex321.htm
EXCEL - IDEA: XBRL DOCUMENT - COASTAL BANKING CO INC	Financial_Report.xls
EX-32.2 - CERTIFICATION - COASTAL BANKING CO INC	cbco_ex322.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

þ QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period ended September 30, 2011

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the Transition Period from _________to_________

Commission File No. 000-28333

COASTAL BANKING COMPANY, INC.

(Exact name of registrant as specified in its charter)

South Carolina		58-2455445
(State or other jurisdiction		(I.R.S. Employer
of incorporation)		Identification No.)

36 Sea Island Parkway

Beaufort, SC 29907

(Address of principal executive

offices, including zip code)

(843) 522-1228

(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 of 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. YES þ 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company. See definition of “larger accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

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

State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 2,595,207 shares of common stock, $.01 par value, were issued and outstanding on November 14, 2011.

Index

		Page No.
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets – September 30, 2011 and December 31, 2010	3

	Consolidated Statements of Operations– Three Months and Nine Months Ended September 30, 2011 and 2010	4

	Consolidated Statements of Comprehensive Loss – Nine Months Ended September 30, 2011 and 2010	5

	Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2011 and 2010	6

	Notes to Consolidated Financial Statements	7

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	26

Item 3.	Quantitative and Qualitative Disclosure About Market Risk	41

Item 4.	Controls and Procedures	41

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	42

Item 1A.	Risk Factors	42

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42

Item 3.	Defaults Upon Senior Securities	42

Item 4.	Removed and Reserved	42

Item 5.	Other Information	42

Item 6.	Exhibits	43

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Coastal Banking Company

Consolidated Balance Sheets

September 30, 2011 and December 31, 2010

	September 30,			December 31,
	2011			2010
	(unaudited)			(audited)
Assets
Cash and due from banks	$	2,971,024		$	1,823,132
Interest-bearing deposits in banks		401,903			406,700
Federal funds sold		125,317			185,258
Securities available for sale, at fair value		29,810,135			37,720,495
Securities held to maturity, at cost		––			2,000,000
Restricted equity securities, at cost		4,242,200			4,472,500
Loans held for sale, at fair value		66,523,424			55,336,007

Loans, net of unearned income		260,789,176			267,600,402
Less allowance for loan losses		5,785,218			6,007,690
Loans, net		255,003,958			261,592,712

Premises and equipment, net		7,298,090			7,380,238
Cash surrender value of life insurance		1,954,434			1,894,971
Intangible assets		27,937			62,452
Other real estate owned		14,336,412			14,452,043
Loan sales receivable		50,409,855			31,505,783
Other assets		8,042,557			8,244,448
Total assets	$	441,147,246		$	427,076,739
Liabilities and Shareholders’ Equity
Deposits:
Noninterest-bearing	$	23,227,265		$	18,948,135
Interest-bearing		317,702,115			327,102,144
Total deposits		340,929,380			346,050,279

Federal funds purchased		3,487,000			––
Other borrowings		51,500,000			37,000,000
Junior subordinated debentures		7,217,000			7,217,000
Other liabilities		5,609,903			3,774,705
Total liabilities		408,743,283			394,041,984

Commitments and contingencies

Shareholders’ Equity:
Preferred stock, par value $.01; 10,000,000 shares authorized; 9,950 shares issued and outstanding at September 30, 2011 and December 31, 2010		9,633,759			9,581,703
Common stock, par value $.01; 10,000,000 shares authorized; 2,595,207 shares issued and outstanding at September 30, 2011; 2,588,707 shares issued and outstanding at December 31, 2010		25,952			25,887
Additional paid-in capital		41,359,009			41,247,995
Accumulated deficit		(19,260,622	)		(18,300,457	)
Accumulated other comprehensive income		645,865			479,627
Total shareholders’ equity		32,403,963			33,034,755
Total liabilities and shareholders’ equity	$	441,147,246		$	427,076,739

See accompanying notes to unaudited consolidated financial statements.

Coastal Banking Company

Consolidated Statements of Operations

For the Three Months and Nine Months Ended September 30, 2011 and 2010

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Interest income:
Interest and fees on loans	$	4,091,437		$	4,423,017		$	11,943,975		$	13,175,370
Interest on taxable securities		276,542			413,321			927,023			1,541,381
Interest on nontaxable securities		50,879			53,957			152,736			179,429
Interest on deposits in other banks		1,451			1,844			10,788			6,283
Interest on federal funds sold		471			472			2,174			4,362
Total interest income		4,420,780			4,892,611			13,036,696			14,906,825

Interest expense:
Interest on deposits		919,529			1,312,345			2,901,731			4,543,630
Interest on junior subordinated debentures		102,600			101,048			300,350			297,047
Interest on other borrowings		234,972			322,545			819,124			959,045
Total interest expense		1,257,101			1,735,938			4,021,205			5,799,722

Net interest income		3,163,679			3,156,673			9,015,491			9,107,103
Provision for loan losses		703,512			1,360,517			1,715,039			2,445,930
Net interest income after provision for loan losses		2,460,167			1,796,156			7,300,452			6,661,173

Non-interest income:
Service charges on deposit accounts		92,373			114,245			302,690			352,040
Other service charges, commissions and fees		75,976			69,379			228,332			197,961
SBA loan income		907,324			40,762			2,730,891			182,961
Mortgage banking income		4,580,706			2,978,591			7,705,377			4,719,527
Gain on sale of securities available for sale		––			––			16,823			939,385
Income from investment in life insurance contracts		19,604			16,184			59,463			49,318
Other income		42,442			305			100,955			22,728
Total other income		5,718,425			3,219,466			11,144,531			6,463,920

Non-interest expenses:
Salaries and employee benefits		3,963,246			2,611,922			9,090,458			5,978,277
Occupancy and equipment expense		488,413			392,840			1,216,125			1,053,592
Advertising fees		640,751			15,246			715,552			96,731
Amortization of intangible assets		11,505			20,841			34,515			62,523
Audit fees		94,403			96,434			299,998			292,443
Data processing fees		291,412			269,650			815,915			734,183
Director fees		30,300			36,200			104,500			128,350
FDIC insurance expense		147,578			204,028			481,758			621,445
Legal and other professional fees		192,833			194,528			684,555			484,556
OCC examination fees		41,964			43,846			129,480			135,679
Other real estate expenses		1,254,073			1,112,010			2,691,283			3,230,922
Other operating		1,100,211			852,783			2,457,941			1,785,030
Total other expenses		8,256,689			5,850,328			18,722,080			14,603,731

Loss before income tax (benefits)		(78,097	)		(834,706	)		(277,097	)		(1,478,638	)
Income tax expense (benefit)		290,806			(338,217	)		257,890			47,786
Net loss	$	(368,903	)	$	(496,489	)	$	(534,987	)	$	(1,526,424	)

Preferred stock dividends		141,980			140,979			425,178			422,217
Net loss available to common shareholders	$	(510,883	)	$	(637,468	)	$	(960,165	)	$	(1,948,641	)
Basic and diluted loss per common share	$	(.20	)	$	(.25	)	$	(.37	)	$	(.76	)

See accompanying notes to unaudited consolidated financial statements.

Coastal Banking Company

Consolidated Statements of Comprehensive Loss

For the Nine Months Ended September 30, 2011 and 2010

(Unaudited)

	2011			2010
Net loss	$	(534,987	)	$	(1,526,424	)
Other comprehensive income (loss), net of tax:
Net unrealized holding gains arising during period, net of tax of $91,357 and $133,185		177,341			258,537
Reclassification adjustment for gains included in net loss, net of tax of $5,720 and $319,391		(11,103	)		(619,994	)
Total other comprehensive income (loss)		166,238			(361,457	)
Comprehensive loss	$	(368,749	)	$	(1,887,881	)

See accompanying notes to unaudited consolidated financial statements.

Coastal Banking Company

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2011 and 2010

(Unaudited)

	2011			2010
Cash flows from operating activities:
Net loss	$	(534,987	)	$	(1,526,424	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation, amortization and accretion		452,375			509,219
Amortization of intangible assets		34,515			62,523
Stock-based compensation expense		111,079			94,919
Provision for loan losses		1,715,039			2,445,930
Gain on sale of securities available for sale		(16,823	)		(939,385	)
Net increase in loan sales receivable		(18,904,072	)		(24,566,901	)
Write downs and losses on sale of other real estate owned		2,357,168			2,775,872
Proceeds from sales of other real estate owned		6,603,001			6,888,353
Increase in cash value of life insurance		(59,463	)		(49,318	)
Originations of mortgage loans held for sale		(650,685,644	)		(671,037,270	)
Proceeds from sales of mortgage loans held for sale		647,203,604			688,324,281
Net decrease in interest receivable		214,155			210,242
Net increase (decrease) in interest payable		167,368			(82,277	)
SBA loan income		(2,730,891	)		(182,961	)
Mortgage banking income		(7,705,377	)		(4,719,527	)
Net other operating activities		3,983,437			4,220,819
Net cash provided by (used in) operating activities		(17,795,516	)		2,428,095

Cash flows from investing activities:
Net (increase) decrease in interest-bearing deposits in banks		4,797			(3,037,325	)
Net decrease in federal funds sold		59,941			163,506
Proceeds from maturities of securities held to maturity		2,000,000			—
Proceeds from maturities of securities available for sale		8,021,947			11,584,369
Proceeds from sale of securities available for sale		1,104,487			21,154,370
Purchases of securities available for sale		(1,094,613	)		(14,835,580	)
Redemption of bank owned life insurance policies		—			5,581,295
Net change in restricted equity securities		230,300			344,000
Net (increase) decrease in loans		(3,970,823	)		3,594,548
Purchase of premises and equipment		(278,729	)		(163,272	)
Net cash provided by investing activities		6,077,307			24,385,911

Cash flows from financing activities:
Net decrease in deposits		(5,120,899	)		(12,193,435	)
Net increase in federal funds purchased		3,487,000			—
Proceeds from other borrowings		23,000,000			—
Repayment of other borrowings		(8,500,000	)		(14,250,000	)
Net cash provided by (used in) financing activities		12,866,101			(26,443,435	)

Net increase in cash and due from banks		1,147,892			370,571
Cash and due from banks at beginning of period		1,823,132			2,679,003
Cash and due from banks at end of period	$	2,971,024		$	3,049,574

Supplemental disclosures of cash flow information:
Cash paid during the year for interest	$	3,853,837		$	5,881,999
Cash paid during the year for income taxes	$	115,960		$	22,700

Noncash Transactions:
Principal balances of loans transferred to other real estate owned	$	8,844,538		$	5,914,363

See accompanying notes to unaudited consolidated financial statements.

Notes to Consolidated Financial Statements – September 30, 2011 and 2010 (Unaudited) and December 31, 2010

Note 1 - Basis of Presentation

Coastal Banking Company, Inc. (the “Company”) is organized under the laws of the State of South Carolina for the purpose of operating as a bank holding company for CBC National Bank (the “Bank”). The Bank commenced business on May 10, 2000 as Lowcountry National Bank. The Company acquired First National Bank of Nassau County, which began its operations in 1999, through its merger with First Capital Bank Holding Corporation on October 1, 2005. On October 27, 2006, the Company acquired the Meigs, Georgia office of the Bank through merger of Cairo Banking Co. with and into the Bank. On August 10, 2008, Lowcountry National Bank and First National Bank of Nassau County merged into one charter. Immediately after the merger, the name of the surviving bank was changed to CBC National Bank and the main office relocated to 1891 South 14th Street, Fernandina Beach, Nassau County, Florida. The Bank’s branches in South Carolina and Georgia continue to do business under the trade names “Lowcountry National Bank,” and “The Georgia Bank” in their respective markets. The Bank provides full commercial banking services to customers throughout Beaufort County, South Carolina; Nassau County, Florida; and Thomas County, Georgia and is subject to regulation by the Office of the Comptroller of the Currency (the “OCC”) and the Federal Deposit Insurance Corporation (the “FDIC”). The Company is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).

The Bank also has loan production offices in Savannah, Georgia and Jacksonville, Florida, as well as a residential mortgage banking division headquartered in Atlanta, Georgia. The mortgage banking division opened ten additional retail residential loan production offices during the second and third quarters of 2011 in California, Connecticut, Kansas, Maryland, Michigan, New York, and Ohio. The Company also has an investment in Coastal Banking Company Statutory Trust I (“Trust I”) and Coastal Banking Company Statutory Trust II (“Trust II”). Both trusts are special purpose subsidiaries organized for the sole purpose of issuing trust preferred securities.

The consolidated financial statements include the accounts of the Company and the Bank. All intercompany accounts and transactions have been eliminated in consolidation.

The accompanying financial statements have been prepared in accordance with the requirements for interim financial statements and, accordingly, they omit disclosures which would substantially duplicate those contained in the Annual Report on Form 10-K for the year ended December 31, 2010. The financial statements as of September 30, 2011 and for the interim periods ended September 30, 2011 and 2010 are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation. The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. The financial information as of December 31, 2010 has been derived from the audited financial statements as of that date. For further information, refer to the financial statements and the notes included in the Company’s 2010 annual report to shareholders on Form 10-K as filed with the Securities and Exchange Commission.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates that affect the amounts of assets and liabilities and changes therein. Actual results could differ from those estimates.

Accounting Policies Recently Adopted

In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” The provisions of ASU No. 2011-04 clarify the application of the highest and best use, and valuation premise concepts, preclude the application of blockage factors in the valuation of all financial instruments and include criteria for applying the fair value measurement principles to portfolios of financial instruments. The amendments additionally prescribe enhanced financial statement disclosures for Level 3 fair value measurements. The new amendments will be effective on January 1, 2012. The Company is currently assessing the impact of this guidance on its consolidated financial position and results of operations.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” The provisions of ASU 2011-05 provide new guidance that requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. This new accounting guidance will be effective for the Company for the three months ended March 31, 2012. The adoption of this guidance, which involves disclosures only, will not impact the Company’s consolidated financial position or results of operations.

Note 2 -Regulatory Oversight, Capital Adequacy, Operating Losses, Liquidity and Management’s Plans

Regulatory Oversight

The Bank entered into a formal agreement with the OCC on August 26, 2009 (the “Agreement”) that imposes certain operational and financial directives on the Bank. The specific directives of the Agreement address the credit risk in the Bank’s loan portfolio, action required to protect the Bank’s interest in criticized assets, adherence to the Bank’s written profit plan to improve and sustain earnings, limitations on the maximum allowable level of brokered deposits, excluding reciprocal CDARS deposits, and the establishment of a board level Compliance Committee to monitor the Bank’s adherence to the Agreement.

Additionally, in response to a request by the Federal Reserve Bank of Richmond, the Board of Directors of Coastal Banking Company, Inc. adopted a resolution on January 27, 2010. This resolution required that the Company obtain prior approval of the Federal Reserve Board before incurring additional debt, purchasing or redeeming its capital stock, or declaring or paying cash dividends to common shareholders. The resolution also required that the Company provide the Federal Reserve Bank with prior notification before using its cash assets for purposes other than investments in obligations or equity of the Bank, investments in short-term, liquid assets, or payment of normal and customary expenses, including regularly scheduled interest payments on existing debt.

On November 17, 2010 the Company entered into a Memorandum of Understanding (“MOU”), an informal enforcement action, with the Federal Reserve Bank of Richmond in lieu of the board resolution described above. The terms of the MOU are substantially similar to the terms of the Board Resolution. Generally, the MOU requires the Company to obtain prior approval of the Federal Reserve Bank before incurring additional debt, purchasing or redeeming its capital stock, or declaring or paying cash dividends on its securities, including dividends on its common stock and TARP preferred stock, and interest on its trust preferred securities. Additionally, the MOU requires the Company to comply with banking regulations that prohibit certain indemnification and severance payments and that require prior approval of any appointment of any new directors or the hiring or change in position of any senior executive officers of the Company. The MOU also requires the submission of quarterly progress reports.

As a result of the Agreement, and the MOU, the Bank and the Company are now operating under heightened regulatory scrutiny and monitoring. Management has taken aggressive steps to address the components of the Agreement and has frequent contact with the OCC as we work to improve our financial condition and comply with all regulatory directives. Monitoring of our progress by our regulators is much more frequent and includes interim on-site visits as well as ongoing telephone consultations. Management recognizes that failure to adequately address the Agreement and the MOU could result in additional actions by the banking regulators with the potential for more severe operating restrictions and oversight requirements, including, but not limited to, the issuance of a consent order and civil money penalties.

Capital Adequacy

As of September 30, 2011, the Bank exceeded all of the regulatory capital ratio levels to be categorized as “well capitalized.” In light of current market conditions and the Bank’s current risk profile, management has determined that the Bank must achieve and maintain a minimum ratio of total capital to risk-weighted assets of 12% and a minimum leverage ratio of 8% to be considered well capitalized under these market conditions. The Bank exceeded these internal capital ratios as well.

Key to our efforts to maintain existing capital adequacy is the need for the Bank to return to profitability through a focus on increasing core earnings and decreasing the levels of adversely classified and nonperforming assets. Management is pursuing a number of strategic alternatives to improve the core earnings of the Bank and to reduce the level of classified assets. Current market conditions for banking institutions, the overall uncertainty in financial markets and the Bank’s high level of nonperforming assets are potential barriers to the success of these strategies. If current adverse market factors continue for a prolonged period of time, new adverse market factors emerge, and/or the Bank is unable to successfully execute its plans or adequately address regulatory concerns in a sufficient and timely manner, it could have a material adverse effect on the Bank’s business, results of operations and financial position.

Operating Results

The Company recorded net loss of $535,000 for the nine months ended September 30, 2011 compared to net loss of $1,526,000 for the nine months ended September 30, 2010. The prior year loss reflects the favorable non recurring impact of a $939,000 gain on sale of marketable securities, partially offset by the unfavorable non recurring income tax expense of $423,000 from the early redemption of Bank Owned Life Insurance (BOLI) policies. During both years, we experienced excessive levels of nonperforming assets, which caused the Company to record increased carrying costs on foreclosed properties and losses on the sale of foreclosed properties. Carrying costs on foreclosed assets are expected to remain elevated during 2011 as the Company continues to liquidate these nonperforming assets. The current year to date net loss represents an improvement of $991,000 from the net loss of $1,526,000 for the nine months ended September 30, 2010. The current quarter net loss of $369,000 represents an improvement of $127,000 from the net loss of $496,000 for the three months ended September 30, 2010 as a result of lower provision for loan losses in 2011, partially offset by higher provision for income taxes.

Management has implemented a number of actions in an effort to improve earnings, including continued emphasis on non interest income from mortgage banking and small business lending activity, significant reductions to the cost of interest bearing liabilities and strict controls over other operating expenses. These actions have been effective in improving core earnings in 2010 and 2011; however, asset quality charges throughout the year continued to negatively impact earnings. Management will continue to focus on asset quality levels as concerns remain that the existing negative economic conditions may worsen, resulting in continued losses that will hinder our ability to return to profitability and further erode capital levels.

Liquidity

Management monitors liquidity on a daily basis and forecasts liquidity needs over a 90 day horizon in order to anticipate and provide for future needs. We also utilize a comprehensive contingency funding policy that uses several key liquidity ratios or metrics to define different stages of the Company’s overall liquidity position. This policy defines actions or strategies that are employed based on the liquidity position of the Company to reduce the risk of a future liquidity shortfall.

The primary sources of liquidity are cash and cash equivalents, deposits, scheduled repayments of loans, unpledged investment securities, available borrowing facilities and proceeds from loan sales receivable. Within deposits we utilize retail deposits from our branch locations, a modest level of brokered deposits, CDARS reciprocal deposits and deposits from other insured depository institutions. The Agreement requires that our brokered deposits, excluding reciprocal CDARs, not exceed 10% of our total deposits, which is consistent with our existing internal liquidity policy. As a result of our existing internal liquidity policy, we have been and anticipate continuing to be in compliance with the brokered deposit limitation provision of the Agreement. Although the FDIC Call Report defines CDARS reciprocal deposits as brokered deposits, CDARS reciprocal deposits are excluded from the brokered deposit limitation provision in the Agreement. At September 30, 2011 we have the capacity to raise up to an additional $11,210,000 in brokered deposits, if needed, and continue to remain in compliance with the 10% limitation in the Agreement. Our borrowing facilities include collateralized repurchase agreements and unsecured federal funds lines with correspondent banks, as well as borrowing agreements with the Federal Home Loan Bank of Atlanta and the Federal Reserve Bank collateralized by pledged loans and securities.

As of September 30, 2011, the Company had $146.3 million in total borrowing capacity, of which we had utilized $80.0 million or 54.7%, leaving remaining available liquidity of $66.3 million. Additionally, loans available for sale are considered by management as a key source of liquidity as a result of the speed with which these loans are sold and settled for cash. Management expects that, on average, loans originated for sale will be sold and converted to cash within 18 to 20 business days after the loan is originated. The balance of loans available for sale averaged just over $66 million during the first nine months of 2011. Accordingly, in the event of a liquidity crisis, we anticipate having the ability to slow or stop loan origination activity to allow the loans available for sale to convert into cash. Based on current and expected liquidity needs and sources, management expects the Company to be able to meet all obligations as they become due.

Note 3 – Losses Per Share

The following table sets forth the computation of basic and diluted losses per share for the three and nine months ended September 30.

	For the three months ended September 30,						For the nine months ended September 30,
	2011			2010			2011			2010
Net loss	$	(368,903	)	$	(496,489	)	$	(534,987	)	$	(1,526,424	)
Preferred stock dividends		(141,980	)		(140,979	)		(425,178	)		(422,217	)
Net loss available to common shareholders	$	(510,883	)	$	(637,468	)	$	(960,165	)	$	(1,948,641	)

Weighted average common shares		2,577,658			2,566,658			2,574,876			2,565,734
Effect of dilutive securities		3,221			8,334			3,179			8,575
Diluted average common shares		2,580,879			2,574,992			2,578,055			2,574,309

Losses per common share	$	(0.20	)	$	(0.25	)	$	(0.37	)	$	(0.76	)
Diluted losses per common share	$	(0.20	)	$	(0.25	)	$	(0.37	)	$	(0.76	)

Stock option shares in the amount of 213,011 and 230,174 at September 30, 2011 and 2010, respectively, were excluded from the diluted earnings per share calculation due to their anti-dilutive effect.

Note 4 – Investment Securities

Investment securities are as follows:

	September 30, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available for sale
State and municipal securities	$	7,128,996	$	266,111	$	(51,300	)	$	7,343,807
Mortgage-backed securities		21,702,556		809,412		(45,640	)		22,466,328
	$	28,831,552	$	1,075,523	$	(96,940	)	$	29,810,135

	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Available for sale
State and municipal securities	$	7,132,172	$	51,893	$	(206,472	)	$	6,977,593
Mortgage-backed securities		29,861,615		914,063		(32,776	)		30,742,902
	$	36,993,787	$	965,956	$	(239,248	)	$	37,720,495
Held to maturity
Corporate debt securities	$	2,000,000	$	56,807	$	—		$	2,056,807
	$	2,000,000	$	56,807	$	—		$	2,056,807

The following table shows gross unrealized losses and fair value of securities, aggregated by category and length of time that the securities have been in a continuous unrealized loss position, at September 30, 2011.

Investment securities available for sale:

	Less than 12 Months					12 Months or More				Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and municipal securities	$	478,605	$	(3,974	)	$	453,485	$	(47,326)	$	932,090	$	(51,300	)
Mortgage-backed securities		4,913,003		(45,640	)		—		—		4,913,003		(45,640	)
Total	$	5,391,608	$	(49,614	)	$	453,485	$	(47,326)	$	5,845,093	$	(96,940	)

As of September 30, 2011, one individual security available for sale was in a continuous loss position for twelve months or more. The Company has reviewed this investment security in accordance with its accounting policy for other than temporary impairment and believes, based on industry analyst reports of the issuer, that the deterioration in value, as of September 30, 2011, was attributable to general market perceptions of unrated municipal issuers, and not due to the specific credit quality of the issuer. The unrealized loss is considered temporary because the security issuer carries an acceptable credit profile and the repayment sources of principal and interest are government backed. The Company has the ability and intent to hold this security until such time as the value recovers or the security matures.

Investment securities available for sale:

	Less than 12 Months					12 Months or More				Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and municipal securities	$	4,466,571	$	(206,472	)	$	—	$	—	$	4,466,571	$	(206,472	)
Mortgage-backed securities		4,879,208		(32,776	)		—		—		4,879,208		(32,776	)
Total	$	9,345,779	$	(239,248	)	$	—	$	—	$	9,345,779	$	(239,248	)

As of December 31, 2010, no individual securities available for sale were in a continuous loss position for twelve months or more and no securities held to maturity were in a loss position. The Company will review investment securities that are in an unrealized loss position in accordance with its accounting policy for other than temporary impairment by reviewing industry analyst reports and credit ratings on the specific securities. To the extent that any deterioration in value, as of the reporting date, was attributable to changes in market interest rates and not in the credit quality of the issuer, the unrealized losses would be considered temporary because the related security carries an acceptable investment grade and the repayment sources of principal and interest are government backed. The Company has the ability and intent to hold these securities until such time as the value recovers or the securities mature.

The amortized cost and estimated fair value of investment securities at September 30, 2011, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Fair Value
Available for sale
Due in one year or less	$	274,450	$	275,954
Due from one year to five years		1,001,359		1,021,800
Due from five to ten years		2,919,684		3,126,169
Due after ten years		2,933,503		2,919,884
Mortgage-backed securities		21,702,556		22,466,328
	$	28,831,552	$	29,810,135

Securities were pledged to secure public deposits and Federal Home Loan Bank borrowings with an amortized cost and fair value of $9,152,000 and $9,643,000, respectively, as of September 30, 2011 and $10,494,000 and $11,119,000, respectively, as of December 31, 2010. Pledged securities may not be sold without first pledging replacement securities and obtaining consent of the party to whom the securities are pledged.

Gains and losses on sales of securities available for sale consist of the following:

	For the Nine Months Ended September 30,
	2011		2010
Gross gains on sales of securities	$	16,823	$	939,385
Gross losses on sales of securities		—		—
Net realized gains on sales of securities available for sale	$	16,823	$	939,385

Note 5 — Loans and allowance for loan losses

The composition of loans is summarized as follows:

	September 30, 2011		December 31, 2010
Commercial and financial	$	9,178,971	$	10,120,015
Agricultural		151,000		151,000
Real estate – construction, commercial		45,022,956		51,272,575
Real estate – construction, residential		11,791,864		12,094,520
Real estate – mortgage, commercial		89,523,717		87,758,132
Real estate – mortgage, residential		103,344,674		103,852,157
Consumer installment loans		1,616,995		2,145,003
Other		158,999		207,000
Gross loans		260,789,176		267,600,402
Less: Allowance for loan losses		5,785,218		6,007,690
Net loans	$	255,003,958	$	261,592,712

The Bank grants loans and extensions of credit to individuals and a variety of businesses and corporations located in its general trade areas of Beaufort County, South Carolina, Nassau County, Florida and Thomas County, Georgia. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate and is dependent upon the real estate market.

A loan is considered impaired, in accordance with the impairment accounting guidance (FASB ASC 310-10-35-16), when, based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Additionally, recent FASB guidance requires that by definition, all loans classified as troubled debt restructurings must also be classified as impaired. In cases where management believes a restructured loan will return all amounts due under the restructured loan terms, and those terms do not include the loss of any portion of the original principal balance, restructured loans are not internally classified, monitored or managed as impaired loans. Accordingly, GAAP reporting requirements result in a higher level of loans classified as impaired than are considered as impaired by management. Impaired loans as defined by GAAP are summarized as follows:

	September 30, 2011
(In thousands)	Recorded Investment		Unpaid Principal Balance		Recorded Allowance		Average Recorded Investment		Year to Date Interest Income Recognized
With no related allowance recorded:
Commercial, financial & agricultural	$	499	$	737	$	—	$	495	$	10
Real Estate - construction		7,441		9,370		—		7,436		89
Real estate - mortgage		6,731		7,550		—		7,397		235
With an allowance recorded:
Commercial, financial & agricultural		—		—		—		—		—
Real Estate - construction		678		739		270		678		—
Real estate - mortgage		10,353		10,546		1,415		11,068		210
Total impaired loans:
Commercial, financial & agricultural	$	499	$	737	$	—	$	495	$	10
Real Estate - construction	$	8,119	$	10,109	$	270	$	8,114	$	89
Real estate - mortgage	$	17,084	$	18,096	$	1,415	$	18,465	$	445

	December 31, 2010
(In thousands)	Recorded Investment		Unpaid Principal Balance		Recorded Allowance		Average Recorded Investment		Year to Date Interest Income Recognized
With no related allowance recorded:
Commercial, financial & agricultural	$	151	$	378	$	—	$	160	$	11
Real Estate - construction		5,082		7,593		—		5,025		30
Real estate - mortgage		8,401		9,229		—		8,829		163
With an allowance recorded:
Commercial, financial & agricultural		479		479		252		481		12
Real Estate - construction		—		—		—		—		—
Real estate - mortgage		4,841		4,878		542		4,926		121
Total impaired loans:
Commercial, financial & agricultural	$	630	$	857	$	252	$	641	$	23
Real Estate - construction	$	5,082	$	7,593	$	—	$	5,025	$	30
Real estate - mortgage	$	13,242	$	14,107	$	542	$	13,755	$	284

As of September 30, 2011 there are seven restructured loans with a recorded investment of $4,172,000 included in the impaired loans table above, as required by GAAP, that management has not internally classified as impaired because they are performing in accordance with their restructured terms such that we expect to recover all loan principal, however these loans meet the GAAP definition of a TDR. Accordingly, while these loans meet the technical definition of a restructured loan and must therefore be classified as impaired under GAAP, management evaluates these loans as non-impaired.

Loans exhibiting one or more of the following attributes are placed on a nonaccrual status:

a.)

Principal and/or interest is 90 days or more delinquent, unless the obligation is (i) well secured by collateral with a realizable value sufficient to discharge the debt including accrued interest in full, and (ii) in the process of collection, which is reasonably expected to result in repayment of the debt or in its restoration to a current status.

b.)	A borrower’s financial condition has deteriorated to such an extent, or some condition exists, that makes collection of interest and/or principal in full unlikely in management’s opinion.

c.)	Foreclosure or legal action has been initiated as a result of default by the borrower on the terms of the debt.

The following is a summary of current, past due and nonaccrual loans:

	September 30, 2011
(In thousands)	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due & Accruing		Nonaccrual		Total Past Due & Nonaccrual		Current Loans		Total Loans
Commercial and financial	$	––	$	––	$	––	$	33	$	33	$	9,146	$	9,179
Agricultural		––		––		––		151		151		––		151
Real estate – construction, commercial		––		––		––		13,048		13,048		31,975		45,023
Real estate – construction, residential		––		––		––		120		120		11,672		11,792
Real estate – mortgage, commercial		198		––		––		4,525		4,723		84,801		89,524
Real estate – mortgage, residential		646		––		––		4,459		5,105		98,239		103,344
Consumer installment loans		––		––		––		2		2		1,615		1,617
Other		––		––		––		––		––		159		159
	$	844	$	––	$	––	$	22,338	$	23,182	$	237,607	$	260,789

	December 31, 2010
(In thousands)	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due & Accruing		Nonaccrual		Total Past Due & Nonaccrual		Current Loans		Total Loans
Commercial and financial	$	––	$	––	$	––	$	5	$	5	$	10,115	$	10,120
Agricultural		––		––		––		151		151		––		151
Real estate – construction, commercial		373		––		––		9,112		9,485		41,788		51,273
Real estate – construction, residential		––		––		––		75		75		12,019		12,094
Real estate – mortgage, commercial		539		––		––		4,284		4,823		82,935		87,758
Real estate – mortgage, residential		1,220		––		––		8,673		9,893		93,959		103,852
Consumer installment loans		3		––		––		2		5		2,140		2,145
Other		––		––		––		––		––		207		207
	$	2,135	$	––	$	––	$	22,302	$	24,437	$	243,163	$	267,600

Management evaluates all loan relationships periodically in order to assess the financial strength of the borrower and the value of any underlying collateral. Based on the results of these evaluations, management will assign internal loan classifications to designate the relative strength of the credit. The internal grades used are Pass, Special Mention, and Substandard. Within the Pass classification, there are sub grades that range from High to Acceptable, all of which indicate that the loan is expected to continue to perform in accordance with its terms. Loans with potential weaknesses that deserve management’s close attention are classified as Special Mention. If the potential weakness in a Special Mention loan was to go uncorrected, it could result in deteriorating prospects for continued loan performance at some future date; however, the loan is not currently adversely classified. The Substandard classification is assigned to loans that are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. These loans have a well-defined weakness that jeopardizes the payment of the debt or the liquidation of the collateral securing the debt, and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Loans classified as Special Mention or Substandard are subject to increased monitoring by management. This typically includes frequent contact with the borrower to actively manage the borrowing relationship as needed to rehabilitate or mitigate the weakness, or potential weakness, identified.

A summary of loan credit quality is presented below:

(In thousands)	September 30, 2011
	Pass		Special Mention		Substandard		Total
Commercial and financial	$	8,470	$	89	$	620	$	9,179
Agricultural		––		––		151		151
Real estate – construction, commercial		26,471		452		18,100		45,023
Real estate – construction, residential		11,431		96		265		11,792
Real estate – mortgage, commercial		73,742		6,210		9,572		89,524
Real estate – mortgage, residential		94,576		1,871		6,897		103,344
Consumer installment loans		1,574		12		31		1,617
Other		159		––		––		159
	$	216,423	$	8,730	$	35,636	$	260,789

(In thousands)	December 31, 2010
	Pass		Special Mention		Substandard		Total
Commercial and financial	$	9,066	$	––	$	1,054	$	10,120
Agricultural		––		––		151		151
Real estate – construction, commercial		30,053		3,070		18,150		51,273
Real estate – construction, residential		11,818		201		75		12,094
Real estate – mortgage, commercial		73,240		1,698		12,820		87,758
Real estate – mortgage, residential		90,062		2,357		11,433		103,852
Consumer installment loans		2,082		25		38		2,145
Other		207		––		––		207
	$	216,528	$	7,351	$	43,721	$	267,600

Risk Elements in the Loan Portfolio

As addressed in the discussion on the provision and allowance for loan losses in Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations, loans on nonaccrual status were $22,338,000 at September 30, 2011, largely unchanged from the level of $22,302,000 at December 31, 2010. Conversely, over this same time period, the balance of loans internally classified as Special Mention or Substandard declined by $6,706,000 or 13.1%. In effect, loans previously identified as having a weakness migrated from performing to non performing or to OREO, while the level of new loans identified with a potential weakness have declined. In addition to the level of loans on nonaccrual status and the internal loan classifications, there are a number of other portfolio characteristics that management monitors and evaluates to assess the risk profile of the loan portfolio. The following is a summary of risk elements in the loan portfolio:

	Loans with Interest Only Payments
(In thousands)	September 30, 2011				December 31, 2010
Commercial and financial	$	4,827	9	%	$	5,413	9	%
Real estate – construction, commercial		19,046	35	%		22,407	37	%
Real estate – construction, residential		3,251	6	%		2,097	4	%
Real estate – mortgage, commercial		10,175	18	%		11,026	18	%
Real estate – mortgage, residential		17,523	32	%		19,136	31	%
Consumer installment loans		210	––	%		712	1	%
Other		104	––	%		156	––	%
	$	55,136			$	60,947

As shown above, we have a moderate concentration of interest only loans in our portfolio, and such loans are generally regarded as carrying a higher risk profile than fully amortizing loans. It is important to note that none of the interest only loans in our portfolio allow negative amortization, nor do we have any loans with capitalized interest reserves.

	Geographic Concentration of Loan Portfolio
	September 30, 2011
(In thousands)	Florida		Georgia		South Carolina		Other
Commercial and financial	$	5,913	$	140	$	3,007	$	119
Agricultural		––		151		––		––
Real estate – construction, commercial		12,876		6,175		24,044		1,928
Real estate – construction, residential		4,244		1,568		5,140		840
Real estate – mortgage, commercial		33,770		11,654		41,670		2,430
Real estate – mortgage, residential		35,353		31,121		35,342		1,528
Consumer installment loans		552		267		773		25
Other		––		155		4		––
	$	92,708	$	51,231	$	109,980	$	6,870

	Geographic Concentration of Loan Portfolio
	December 31, 2010
(In thousands)	Florida		Georgia		South Carolina		Other
Commercial and financial	$	6,149	$	372	$	3,488	$	111
Agricultural		––		151		––		––
Real estate – construction, commercial		16,206		6,892		26,247		1,928
Real estate – construction, residential		3,835		937		7,322		––
Real estate – mortgage, commercial		33,074		11,025		42,751		908
Real estate – mortgage, residential		34,577		30,189		38,617		469
Consumer installment loans		579		205		1,361		––
Other		32		125		50		––
	$	94,452	$	49,896	$	119,836	$	3,416

We also monitor and evaluate several other loan portfolio characteristics at a total portfolio level rather than by major loan category. These characteristics include:

Junior Liens – Loans secured by liens in subordinate positions tend to have a higher risk profile than loans secured by liens in the first or senior position. At September 30, 2011 the Company held $22,394,000 of loans secured by junior liens, which represented approximately 8.6% of the total net loan portfolio. Net loan charge-offs was $386,000 in the nine months ended September 30, 2011 for all loans secured by junior liens for an annualized loss rate of 2.3%. At December 31, 2010 the Company held $23,418,000 of loans secured by junior liens which represents approximately 8.8% of the total net portfolio of loans. Historical loss experience as measured by net loan charge offs was $414,000 in the year ended December 31, 2010 for all loans secured by junior liens for an annualized loss rate of 1.8%.

High Loan to Value Ratios – Typically the Company will not originate a new loan with a loan to value (LTV) ratio in excess of 100%. However, declines in collateral values can result in the case of an existing loan renewal with an LTV ratio in excess of 100% based on the current appraised value of the collateral. In such cases the borrower may be asked to pledge additional collateral or to renew the loan for a lesser amount. If the borrower lacks the ability to pay down the loan or provide additional collateral, but has the ability to continue to service the debt, the loan will be renewed with an LTV ratio in excess of 100%. At September 30, 2011 the loan portfolio included 36 loans with an aggregate balance of $15,327,000, or 5.9% of the net loan portfolio, with LTV ratios in excess of 100%. At December 31, 2010 the loan portfolio included 29 loans with an aggregate balance of $10,855,000, or 4.1% of the net loan portfolio, with LTV ratios in excess of 100%.

Restructured Loans – Historically, the Company has followed a conservative approach by classifying any loan as restructured whenever the terms of a loan were adjusted to the benefit of any borrower in financial distress, regardless of the status of the loan at the time of restructuring. In some cases we have restructured loans for borrowers who were not delinquent, but for various reasons these borrowers were experiencing financial distress that raised a doubt about their continued ability to make payments under current terms. By adjusting the terms of the loan to better fit the borrower’s current financial condition, expectations are that the loan will avoid a future default. In other cases we have restructured loans for borrowers who were in default at the time the loan terms were restructured. The expectation is that by adjusting the terms of such loans, the borrower may begin to make payments again based on the improved loan terms.

The types of changes that are made for troubled borrowers to restructure their obligations include the following:

·	Deferral of one or more scheduled loan payments to a future date

·	Temporary or permanent reduction of the loan interest rate

·	Conversion from principal and interest payment term to an interest only payment term on a temporary basis, or until maturity

·	Forgiveness of accrued but uncollected interest

·	Extension of loan maturity date

·	Reduction in principal due under the loan agreement

The potential financial effects of restructuring troubled debts includes a reduction in the level of interest income collected, a complete loss of interest income, or a loss of some portion of the original loan principal. All troubled debt restructurings are tested for impairment. If a loan is considered to be collateral dependent, the measurement of impairment is based on the fair value of the collateral, net of estimated liquidation costs. If the loan is not considered to be collateral dependent, the present value of expected cash flows is used to determine any amount of impairment. Any impairment is then charged to the allowance for loan and lease losses or designated as a specific reserve, and as such will be considered as a component of the reserve calculation.

For regulatory purposes, in 2010 and prior years, restructured loans that were accruing interest (not on nonaccrual status) would be reported as performing restructured loans until the end of the fiscal year in which the restructure occurred. At the beginning of the following fiscal year, the “restructured” designation for these performing restructured loans was removed, provided the borrower was paying in accordance with the restructured loan terms and the loan had a market rate of interest.

Recent interpretations of the topic of restructured loans by the Company’s primary regulator will effectively prohibit the practice of removing the “restructured” designation from any restructured loan during the life of the loan, beginning with the third quarter of 2011. For 2011 and later, all restructured loans will continue to be reported as restructured, even if (1) the underlying conditions that resulted in the borrower’s financial distress were cured, (2) the loan terms were modified back to current fair value levels, (3) the loan is current and accruing interest, and (4) the borrower has not missed a payment since the loan was restructured. As a result, expectations are that the level of restructured loans will continue to increase in the future.

The following table provides a summary of all loans that are currently designated as restructured for regulatory purposes.

	September 30, 2011						December 31, 2010
Troubled debt restructurings	Number of loans		Recorded Investment		Unpaid Principal Balance		Number of loans		Recorded Investment		Unpaid Principal Balance
Commercial, financial & agricultural		3	$	323,180	$	328,990		1	$	481,250	$	481,250
Real estate – construction		8		6,067,714		6,348,717		12		6,026,819		6,254,777
Real estate – mortgage		12		5,099,639		5,426,801		14		9,849,187		10,209,623
Total troubled debt restructurings		23	$	11,490,533	$	12,104,508		27	$	16,357,256	$	16,945,650

Of the 27 loans totaling $16,357,000 reported as restructured as of December 31, 2010, there were 6 loans with a total balance of $3,314,000 that are no longer reported as restructured effective January 1, 2011. The loans are no longer reported as restructured because they were accruing interest, they were in compliance with the restructured loan terms and they yielded a market rate of interest at the time of restructure.

The following table provides the payment status as of September 30, 2011 and September 30, 2010 of all loans that were restructured in the twelve month periods ending on those respective dates.

	September 30, 2011				September 30, 2010
	Number of loans		Recorded Investment		Number of loans		Recorded Investment
Restructured loans less than 30 days past due
Commercial, financial & agricultural		2	$	290,254		2	$	542,988
Real estate – construction		2		1,173,839		8		2,289,047
Real estate – mortgage		3		731,679		6		4,736,588
Total restructured loans less than 30 days past due		7	$	2,195,772		16	$	7,568,623
Restructured loans 30 days or more past due
Real estate – construction		––		––		1		313,435
Real estate – mortgage		––		––		1		144,224
Total restructured loans 30 days or more past due		––	$	––		2	$	457,659
Restructured loans on nonaccrual
Real estate – construction		––		––		3		1,673,002
Real estate – mortgage		3		1,266,069		3		502,074
Total restructured loans on nonaccrual		3	$	1,266,069		6	$	2,175,076

Loans classified as Special Mention or Substandard – Management evaluates all loan relationships periodically in order to assess the financial strength of the borrower and the value of any underlying collateral. Loans that are found to have a potential or actual weakness are classified as special mention or substandard and subject to increased monitoring by management. This typically includes frequent contact with the borrower to actively manage the borrowing relationship as needed to rehabilitate or mitigate the weakness identified. At September 30, 2011, the Company had $44,366,000 in loans that were internally classified as Special Mention or Substandard, of which $28,253,000, or 64%, were either current or less than 30 days past due. At December 31, 2010, the Company had $51,072,000 in loans that were internally classified as Special Mention or Substandard, of which $34,437,000, or 67%, were either current or less than 30 days past due. As shown above, the balance of loans internally classified as Special Mention or Substandard declined by $6,706,000, or 13.1%, while the percentage of those loans that were more than 30 days past due increased from 33% to 36%. This pattern reflects the migration of loans previously identified as having a weakness from performing status to non performing status, and ultimately to OREO, while the level of new loans identified with a potential weakness have declined.

We have established an allowance for loan losses through a provision for loan losses charged to expense on our statement of earnings. Additions to the allowance for loan losses are made periodically to maintain the allowance at an appropriate level based on management’s analysis of the potential risk in the loan portfolio. 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. Our judgment as to the adequacy of the allowance for loan losses is based upon a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate. To the extent that the recovery of loan balances has become collateral dependent, we obtain appraisals not less than annually, and then we reduce these appraised values by the amount estimated for selling and holding costs to determine the liquidated value. Any shortfall between the liquidated value and the loan balance is charged against the allowance for loan losses in the month the related appraisal was received. Our losses will undoubtedly vary from our estimates, and there is a possibility that charge-offs can reduce this allowance. Our determination of the allowance for loan losses is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay, commercial and residential real estate market trends, 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 the 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.

An analysis of the activity in the allowance for loan losses is presented below:

	For the Nine Months Ended September 30,
	2011			2010
Balance, beginning of year	$	6,007,690		$	6,386,409
Provision for loan losses		1,715,039			2,445,930
Loans charged off		(2,205,503	)		(2,830,985	)
Recoveries of loans previously charged off		267,992			291,478
Balance, end of period	$	5,785,218		$	6,292,832

The following tables provide additional information concerning changes to the allowance for loan losses within major loan categories:

	For the Nine Months Ended September 30, 2011
(In thousands)	Commercial, Financial & Agricultural			Real Estate - Construction			Real Estate - Mortgage			Consumer		Unallocated			Total
Allowance balance, beginning of year	$	543		$	358		$	4,042		$	326	$	739		$	6,008
Loans charged off		(488	)		(559	)		(1,159	)		––		––			(2,206	)
Recoveries		26			43			194			5		––			268
Provision for loan losses		245			512			1,084			185		(311	)		1,715
Allowance balance, end of period	$	326		$	354		$	4,161		$	516	$	428		$	5,785

	September 30, 2011
(In thousands)	Commercial, Financial & Agricultural			Real Estate - Construction			Real Estate - Mortgage			Consumer		Unallocated			Total
Allowance for loans individually evaluated for impairment		––			270			1,415			––		––			1,685
Allowance for loans collectively evaluated for impairment		326			84			2,746			516		428			4,100
Total allowance for loan losses		326			354			4,161			516		428			5,785
Loans individually evaluated for impairment		499			8,119			17,084			––		––			25,702
Loans collectively evaluated for impairment		8,831			48,696			175,784			1,776		––			235,087
Total loans	$	9,330		$	56,815		$	192,868		$	1,776	$	––		$	260,789

	For the Nine Months Ended September 30, 2010
(In thousands)	Commercial, Financial & Agricultural			Real Estate - Construction			Real Estate - Mortgage			Consumer			Unallocated			Total
Allowance balance, beginning of year	$	346		$	741		$	4,241		$	351		$	707		$	6,386
Loans charged off		(80	)		(1,203	)		(1,476	)		(71	)		––			(2,830	)
Recoveries		1			97			182			11			––			291
Provision for loan losses		155			775			1,481			160			(125	)		2,446
Allowance balance, end of period	$	422		$	410		$	4,428		$	451		$	582		$	6,293

	December 31, 2010
(In thousands)	Commercial, Financial & Agricultural			Real Estate - Construction			Real Estate - Mortgage			Consumer			Unallocated			Total
Allowance for loans individually evaluated for impairment		252			––			542			––			––			794
Allowance for loans collectively evaluated for impairment		291			358			3,500			326			739			5,214
Total allowance for loan losses		543			358			4,042			326			739			6,008
Loans individually evaluated for impairment		630			5,082			13,242			––			––			18,954
Loans collectively evaluated for impairment		9,641			58,285			178,368			2,352			––			248,646
Total loans	$	10,271		$	63,367		$	191,610		$	2,352		$	––		$	267,600

Note 6 — Other Real Estate Owned

A summary of other real estate owned is presented as follows:

	Nine Months Ended September 30,
	2011			2010
Balance, beginning of year	$	14,452,043		$	18,176,169
Additions		8,844,538			5,914,363
Disposals		(6,603,001	)		(6,888,353	)
Valuation write downs and losses on sales		(2,357,168	)		(2,775,872	)
Balance, end of period	$	14,336,412		$	14,426,307

Expenses related to other real estate owned include the following:

	Nine Months Ended September 30,
	2011		2010
Net loss on sales of real estate	$	895,304	$	1,171,910
Valuation write downs		1,461,864		1,603,962
Operating expenses		334,115		455,050
Total expenses related to other real estate owned	$	2,691,283	$	3,230,922

Note 7 — Stock-Based Compensation

The Company adopted a Stock Incentive Plan in 2000 which currently authorizes 389,281 shares of the Company’s common stock for issuance under the Plan. The Plan provides for the total number of shares authorized for issuance under the Plan to be increased upon the issuance of new shares by the Company by an amount equal to the difference between 15% of the total outstanding shares after the issuance of the new shares and the number of shares authorized for issuance prior to the issuance of the new shares. The Plan is administered by the Board of Directors and provides for the granting of options to purchase shares of common stock to officers, directors, employees or consultants of the Company and Bank. The exercise price of each option granted under the Plan will not be less than the fair market value of the shares of common stock subject to the option on the date of grant as determined by the Board of Directors. Options are exercisable in whole or in part upon such terms as may be determined by the Board of Directors, and are exercisable no later than ten years after the date of grant. Options granted under the Plan generally vest over a five-year vesting period. Pursuant to the Plan, no Incentive Stock Option may be granted more than ten years after February 15, 2000, the effective date of the Plan. As of September 30, 2011, there were 97,040 shares available for grant under this Plan as non-qualified stock options.

Additionally, the Company assumed the outstanding options under the 1999 First Capital Bank Holding Corporation Stock Option Plan (the “First Capital Plan”) in connection with the merger of First Capital Bank Holding Company with and into the Company on October 1, 2005. As a result of the merger, each outstanding option under the First Capital Plan was converted into an option to purchase Coastal Banking Company, Inc. common stock. Coastal assumed and maintains the First Capital Plan solely to administer the options that were outstanding as of the effective time of the merger. As of the effective time of the merger, the Company elected to discontinue the issuance of options under the First Capital Plan.

On August 24, 2011, the Company granted a restricted stock award to Michael G. Sanchez, Chief Executive Officer, for 6,500 shares of the Company’s common stock. The restricted stock vests and becomes transferable on the later of the date when the Company has fully repaid all obligations under the TARP Capital Purchase Program or the two year anniversary date of the grant date of the restricted stock. The restricted stock was granted to Mr. Sanchez as compensation for his service to the Company. The ultimate cost to the Company from this grant will be $14,200, and will be expensed between August 24, 2011 and August 24, 2013.

On May 26, 2010, the Company granted a restricted stock award to Michael G. Sanchez, Chief Executive Officer, for 20,000 shares of the Company’s common stock. The restricted stock vests and becomes transferable on the later of the date when the Company has fully repaid all obligations under the TARP Capital Purchase Program or the two year anniversary date of the grant date of the restricted stock. The restricted stock was granted to Mr. Sanchez as compensation for his service to the Company. The ultimate cost to the Company from this grant will be $68,000, and will be expensed between May 26, 2010 and May 26, 2012.

On May 26, 2010, the Company granted non-qualified stock options to all full time employees for a total of 126,000 options. The options vest over a five year period beginning on May 26, 2010. The ultimate cost to the Company from this grant will be impacted by future option forfeitures, but in any case will not exceed $175,492, and will be expensed between May 26, 2010 and the last vesting date of May 26, 2015.

On August 15, 2008, the Board of Directors of Coastal Banking Company approved a reduction in the exercise price of 42,603 incentive stock options that were previously issued and outstanding. The options had been issued to 14 officers and employees of the Company with an average exercise price of $19.26 per share. The new exercise price was $7.50 per share, the market value of the Company's common stock on the day the lower exercise price was set by the Board action. The ultimate full cost to the Company will be impacted by future option forfeitures, but in any case will not exceed $63,075 over the period beginning on August 15, 2008 and ending on December 31, 2012.

On March 21, 2008, the Company granted a restricted stock award to Gary Horn, Regional President of Lowcountry National Bank, for 5,000 shares of the Company’s common stock. The restricted stock vests in five equal annual increments on the anniversary date of the grant date of the restricted stock. The restricted stock was granted to Mr. Horn as compensation for his service to the Bank. The ultimate cost to the Company from this grant will be $68,750, and will be expensed between March 21, 2008 and March 21, 2013.

Note 8 — Fair Value

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic (FASB ASC 820), the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between willing market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1 - Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2 - Valuation is based on inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on 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 asset or liability.

Level 3 - Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires significant management judgment or estimation.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.

The table below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2011, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Investment securities available for sale	$	29,810,135	$	1,294,230	$	28,515,905	$	––
Loans held for sale		66,523,424		––		65,308,815		1,214,609
Derivative asset positions		1,195,054		––		1,195,054		––
Total fair value of assets measured on a recurring basis	$	97,528,613	$	1,294,230	$	95,019,774	$	1,214,609
Liabilities:
Derivative liability positions	$	1,479,342	$	––	$	1,479,342	$	––
Total fair value of liabilities measured on a recurring basis	$	1,479,342	$	––	$	1,479,342	$	––

The table below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2010, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Investment securities available for sale	$	37,720,495	$	408,363	$	37,312,132	$	––
Loans held for sale		55,336,007		––		54,286,053		1,049,954
Derivative asset positions		763,457		––		763,457		––
Total fair value of assets measured on a recurring basis	$	93,819,959	$	408,363	$	92,361,642	$	1,049,954
Liabilities:
Derivative liability positions	$	1,403,004	$	––	$	1,403,004	$	––
Total fair value of liabilities measured on a recurring basis	$	1,403,004	$	––	$	1,403,004	$	––

The table below presents a reconciliation of level 3 assets as of September 30, 2011 and 2010.

	Loans held for sale
	2011			2010
Balance, beginning of year	$	1,049,954		$	542,791
Total gains included in net income		88,110			84,100
Issuances		9,915,142			20,281,920
Sales		(9,838,597	)		(18,974,895	)
Transfers in or out of Level 3		––			––
Balance, end of period	$	1,214,609		$	1,933,916

Assets Measured at Fair Value on a Nonrecurring Basis

The following is a description of the valuation methodologies used for instruments measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Loan impairment is reported when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan's existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require an increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectability of a loan is confirmed. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan impairment as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan impairment as nonrecurring Level 3.

Other real estate owned (“OREO”) is adjusted to fair value upon transfer of the loan collateral to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the OREO or management’s estimation of the value of the OREO. When the fair value of the OREO is based on an observable market price or a current appraised value, the Company records the OREO as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the OREO is further impaired below the appraised value and there is no observable market price, the Company records the OREO as nonrecurring Level 3.

The table below presents the Company’s assets for which a nonrecurring change in fair value has been recorded during the nine months ended September 30, 2011, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total losses for the nine months ended September 30, 2011
Assets:
Impaired loans	$	21,530,184	$	––	$	––	$	21,530,184	$	––
Other real estate owned		14,336,412		––		––		14,336,412		(2,357,168	)
Total fair value of assets measured on a nonrecurring basis	$	35,866,596	$	––	$	––	$	35,866,596	$	(2,357,168	)

The table below presents the Company’s assets for which a nonrecurring change in fair value has been recorded during the year ended December 31, 2010, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total losses for the year ended December 31, 2010
Assets:
Impaired loans	$	18,953,740	$	––	$	––	$	18,953,740	$	––
Other real estate owned		14,452,043		––		––		14,452,043		(3,927,693	)
Total fair value of assets measured on a nonrecurring basis	$	33,405,783	$	––	$	––	$	33,405,783	$	(3,927,693	)

Fair Value of Financial Instruments

The fair value of a financial instrument is the current amount that would be exchanged between willing parties in an orderly transaction. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered as representative of the liquidation value of the Bank, but rather represent a good-faith estimate of the increase or decrease in value of financial instruments held by the Bank since purchase, origination, or issuance.

The following methods and assumptions were used in this analysis in estimating the fair value of financial instruments:

Cash, due from banks, interest-bearing deposits in banks, federal funds sold, and federal funds purchased: The carrying amount of cash, due from banks, interest-bearing deposits in banks, federal funds sold, and federal funds purchased approximates fair value.

Securities: The fair values of securities available for sale are determined by an independent securities accounting service provider using quoted prices on nationally recognized securities exchanges or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. The carrying amount of equity securities with no readily determinable fair value approximates fair value.

Loans: The carrying amount of variable-rate loans that reprice frequently and have no significant change in credit risk approximates fair value. The fair value of fixed-rate loans is estimated based on discounted contractual cash flows, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. The fair value of impaired loans is estimated based on discounted contractual cash flows or underlying collateral values, where applicable.

Loans Held for Sale (LHFS): Residential mortgage loans are originated for sale as whole loans in the secondary market. These loans are carried at fair value, with changes in the fair value of these loans recognized in mortgage banking noninterest income. Direct loan origination costs and fees are deferred at origination, and then recognized in the gain or loss on loan sales when the loans are sold. Gains and losses on loan sales (sales proceeds minus the carrying value of the loan sold) are recorded as noninterest income.

Derivative asset and liability positions: The fair value of derivative asset and liability positions is based on available quoted market prices.

Deposits: The carrying amount of demand deposits, savings deposits and variable-rate certificates of deposits approximates fair value. The fair value of fixed-rate certificates of deposit is estimated based on discounted contractual cash flows using interest rates currently being offered for certificates of similar maturities.

Other Borrowings: The carrying amount of variable rate borrowings and federal funds purchased approximates fair value. The fair value of fixed rate other borrowings is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

Junior Subordinated Debentures: The fair value of the Company’s trust preferred securities is based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

Accrued Interest: The carrying amount of accrued interest approximates fair value.

Off-Balance-Sheet Instruments: The carrying amount of commitments to extend credit and standby letters of credit approximates fair value. The carrying amount of the off-balance-sheet financial instruments is based on fees charged to enter into such agreements.

The carrying amount and estimated fair value of the Company’s financial instruments are as follows:

	September 30, 2011				December 31, 2010
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash, due from banks, and interest-bearing deposits in banks	$	3,372,927		3,372,927	$	2,229,832		2,229,832
Federal funds sold		125,317		125,317		185,258		185,258
Securities available for sale		29,810,135		29,810,135		37,720,495		37,720,495
Securities held to maturity		––		––		2,000,000		2,056,807
Restricted equity securities		4,242,200		4,242,200		4,472,500		4,472,500
Loans held for sale		66,523,424		66,523,424		55,336,007		55,336,007
Loans, net		255,003,958		252,839,186		261,592,712		258,660,152
Derivative asset positions		1,195,054		1,195,054		763,457		763,457
Accrued interest receivable		916,405		916,405		1,130,560		1,130,560

Financial liabilities:
Deposits		340,929,380		342,138,070		346,050,279		348,358,038
Federal funds purchased		3,487,000		3,487,000		––		––
Other borrowings		51,500,000		53,798,637		37,000,000		40,303,524
Junior subordinated debentures		7,217,000		7,217,000		7,217,000		7,223,552
Derivative liability positions		1,479,342		1,479,342		1,403,004		1,403,004
Accrued interest payable		592,022		592,022		424,654		424,654

Note 9 – Derivative Financial Instruments

Mortgage banking derivatives used in the ordinary course of business consist of best efforts and mandatory forward sales contracts and interest rate lock commitments on residential mortgage loan applications. Forward sales contracts represent future commitments to deliver loans at a specified price and by a specified date and are used to manage interest rate risk on loan commitments and mortgage loans held for sale. Rate lock commitments represent commitments to fund loans at a specific rate and by a specified expiration date. These derivatives involve underlying items, such as interest rates, and are designed to mitigate risk. Substantially all of these instruments expire within 60 days from the date of issuance. Notional amounts are amounts on which calculations and payments are based, but which do not represent credit exposure, as credit exposure is limited to the amounts required to be received or paid.

The following tables include the notional amounts and realized gain (loss) for mortgage banking derivatives recognized in Mortgage Banking income for the periods ending September 30, 2011 and December 31, 2010:

Derivatives not designated as hedging instruments (in thousands)	September 30, 2011			December 31, 2010
Mandatory forward sales contracts
Notional amount	$	202,001		$	105,001
Loss on change in market value of mandatory forward sales contracts	$	(748	)	$	(361	)
Derivative asset balance included in other assets	$	568		$	651
Derivative liability balance included in other liabilities	$	1,315		$	1,012

Best efforts forward sales contracts
Notional amount	$	6,667		$	4,454
Gain on change in market value of best efforts forward sales contracts	$	29		$	78
Derivative asset balance included in other assets	$	34		$	78
Derivative liability balance included in other liabilities	$	6		$	––

Rate lock loan commitments
Notional amount	$	199,701		$	64,691
Gain (loss) on change in market value of rate lock commitments	$	435		$	(357	)
Derivative asset balance included in other assets	$	593		$	34
Derivative liability balance included in other liabilities	$	158		$	391

Forward sales contracts also contain an element of risk in that the counterparties may be unable to meet the terms of such agreements. In the event the parties to deliver commitments are unable to fulfill their obligations, the Company could potentially incur significant additional costs by replacing the positions at then current market rates. The Company manages its risk of exposure by limiting counterparties to those banks and institutions deemed appropriate by management and the Board of Directors. The Company does not expect any counterparty to default on their obligations and therefore, the Company does not expect to incur any cost related to counterparty default.

The Company is exposed to interest rate risk on loans held for sale and rate lock loan commitments. As market interest rates increase or decrease, the fair value of mortgage loans held for sale and rate lock commitments will decline or increase accordingly. To offset this interest rate risk, the Company enters into derivatives such as forward contracts to sell loans. The fair value of these forward sales contracts will change as market interest rates change, and the change in the value of these instruments is expected to largely, though not entirely, offset the change in fair value of loans held for sale and rate lock commitments. The objective of this activity is to minimize the exposure to losses on rate lock commitments and loans held for sale due to market interest rate fluctuations. The net effect of derivatives on earnings will depend on risk management activities and a variety of other factors, including market interest rate volatility, the amount of rate lock commitments that close, the ability to fill the forward contracts before expiration, and the time period required to close and sell loans.

Note 10 - Supplemental Segment Information

The Bank has three reportable segments: community banking, SBA lending, and mortgage banking operations. The community banking segment provides traditional banking services offered through the Bank’s branch locations, including limited retail residential mortgage banking origination activity at selected branch locations.

Prior to January 2011, SBA lending revenues and expenses were included within the totals for the community banking segment. At the beginning of 2011 the SBA lending division results were isolated to monitor and evaluate the impact of this division on total bank results. After evaluating the impact of the SBA lending division on the Bank’s results during the first six months of 2011, it became apparent that this division should be a separate reportable segment, and so it is included as such for the first time as of September 30, 2011.

The Small Business Administration lending division originates SBA loans throughout the southeastern United States by the Bank’s SBA business development officers. These officers serve markets in Jacksonville and Vero Beach, Florida; Atlanta, Georgia; Charlotte, North Carolina; and Beaufort, South Carolina. The majority of loans originated by the division are processed through the SBA 7(a) loan program. Participations in these loans are typically sold to secondary market investors within 30 days of the loan being funded. All loan funding, sales and servicing activity is centralized at the Bank’s operations center in Fernandina Beach, Florida.

The mortgage banking operations segment originates residential mortgage loans submitted through a network of independent mortgage brokers, a modest level of retail loan originations from an internet leads based business channel, and beginning in April 2011 from a national network of ten traditional retail mortgage lending branches. Most of these loans are sold to various investors on the secondary market while a limited number of loans are retained in the Bank’s loan portfolio. All wholesale and internet retail mortgage banking activity is conducted in the Bank’s mortgage banking offices in Atlanta, Georgia, as is the national retail mortgage lending administration function. The ten retail lending branches are located in California, Connecticut, Kansas, Maryland, Michigan, New York, and Ohio, and are staffed by 144 new employees hired during the second and third quarters of 2011.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit and loss from operations before income taxes not including nonrecurring gains and losses.

All direct costs and revenues generated by each segment are allocated to the segment; however, there is no allocation of indirect corporate overhead costs to the SBA lending or mortgage banking segments. The Company accounts for intersegment revenues and expenses as if the revenue/expense transactions were to third parties at current market prices.

The Company’s reportable segments are strategic business units that offer different products and services to a different customer base. They are managed separately because each segment has different types and levels of credit and interest rate risk.

(In thousands)	Community Banking						SBA Lending Operations				Mortgage Banking Operations
Three months ended September 30,	2011			2010			2011		2010		2011		2010
Interest income	$	3,140		$	4,000		$	270	$	*	$	1,010	$	893
Interest expense		855			1,320			9		*		393		416
Net interest income		2,285			2,680			261		*		617		477
Provision for loan losses		555			1,355			82		*		66		6
Net interest income after provision		1,730			1,325			179		*		551		471
Non interest income		257			306			910		*		4,552		2,914
Non interest expense		3,867			3,908			368		*		4,022		1,942
Net income (loss) before tax expense (benefit)		(1,880	)		(2,277	)		721		*		1,081		1,443
Income tax expense (benefit)		(243	)		(771	)		217		*		317		433
Net income (loss) after taxes	$	(1,637	)	$	(1,506	)	$	504	$	*	$	764	$	1,010

(In thousands)	Community Banking						SBA Lending Operations				Mortgage Banking Operations
Nine months ended September 30,	2011			2010			2011		2010		2011		2010
Interest income	$	9,814		$	12,541		$	786	$	*	$	2,436	$	2,366
Interest expense		3,009			4,644			26		*		986		1,156
Net interest income		6,805			7,897			760		*		1,450		1,210
Provision for loan losses		1,474			2,403			129		*		112		43
Net interest income after provision		5,331			5,494			631		*		1,338		1,167
Non interest income		799			1,851			2,732		*		7,614		4,613
Non interest expense		10,628			11,200			964		*		7,130		3,403
Net income (loss) before tax expense (benefit)		(4,498	)		(3,855	)		2,399		*		1,822		2,377
Income tax expense (benefit)		(1,004	)		(665	)		720		*		542		713
Net income (loss) after taxes	$	(3,494	)	$	(3,190	)	$	1,679	$	*	$	1,280	$	1,664

*SBA Lending Operations revenues and expenses were included in Community Banking totals during 2010.

Note 11 – Reclassifications

Certain amounts reported as of December 31, 2010, or the periods ended September 30, 2010, have been reclassified to conform with the presentation of September 30, 2011. These reclassifications had no effect on previously reported net loss or shareholders’ equity.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is our discussion and analysis of certain significant factors that have affected our financial position and operating results and those of our subsidiary, CBC National Bank, during the periods included in the accompanying financial statements. This commentary should be read in conjunction with the financial statements and the related notes and the other statistical information included in this report.

This report contains “forward-looking statements” relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management. The words “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” and “intend,” as well as other similar words and expressions of the future, are intended to identify forward-looking statements. Our actual results may differ materially from the results discussed in the forward-looking statements, and our operating performance each quarter is subject to various risks and uncertainties that are discussed in detail in our filings with the Securities and Exchange Commission, including, without limitation:

·	significant increases in competitive pressure in the banking and financial services industries;

·	changes in the interest rate environment which could reduce anticipated or actual margins;

·	changes in political conditions or the legislative or regulatory environment;

general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a continued or increased deterioration in credit quality or a reduced demand for credit, including the resultant effect on our loan portfolio and allowance for loan losses;

·	the ability to increase market share;

·	changes occurring in business and monetary conditions and inflation;

·	changes in technology;

·	the potential that loan charge-offs may exceed the allowance for loan losses or that such allowance will be increased as a result of factors beyond our control;

·	fluctuations in consumer spending and saving habits;

·	adverse changes in the market value of real estate serving as the collateral underlying our loans;

·	the rate of delinquencies and amounts of charge-offs;

·	the rates of loan growth;

·	unanticipated regulatory or judicial proceedings;

·	adverse changes in asset quality and resulting credit risk-related losses and expenses;

·	changes in monetary, accounting or tax policies;

·	loss of consumer confidence and economic disruptions resulting from terrorist activities;

·	adverse conditions in the securities markets, including the stock market, the public debt market and other capital markets; and

·	other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

Overview

The following discussion describes our results of operations for the quarter and nine months ended September 30, 2011 as compared to the quarter and nine months ended September 30, 2010 and also analyzes our financial condition as of September 30, 2011 as compared to December 31, 2010. Like most community banks, we derive most 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. 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.

Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb possible 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, as well as several tables describing our allowance for loan losses. See comments in the section entitled “Provision and Allowance for Loan Losses.”

In addition to earning interest on our loans and investments, we earn income through fees, gain on sales of loans and marketable securities, cash surrender value of life insurance and other service charges to our customers. We describe the various components of this non-interest income, as well as our non-interest expense, in the following discussion.

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

Critical Accounting Policies

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

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

Results of Operations

Net Interest Income

The Bank’s net interest income is determined by the level of our earning assets, primarily loans outstanding, and the management of our net interest margin. For the quarter ended September 30, 2011, net interest income totaled $3,164,000 as compared to $3,157,000 for the quarter ended September 30, 2010 for an increase of $7,000. On a consecutive quarter basis, net interest income was up by $237,000, or 8%, from the $2,927,000 earned during the quarter ended June 30, 2011.

Total interest income decreased by $471,000, or 10%, to $4,421,000 for the three months ended September 30, 2011 compared to $4,892,000 for the three months ended September 30, 2010. On a consecutive quarter basis, total interest income increased by $169,000, or 4%, from the $4,252,000 earned during the quarter ended June 30, 2011.

The impact of the interest rate environment is seen in the Prime interest rate, which has been set at a historical low rate of 3.25% since December 16, 2008. This historic low Prime interest rate has had an extremely negative impact on the yield earned by the Bank on that portion of the loan portfolio that carries rates based on the Prime interest rate index. At September 30, 2011 and September 30, 2010 the Bank held $109,736,000 and $119,347,000, respectively, in loans carrying rates based on the Prime interest rate index.

In addition to the negative impact of decreased interest rates, interest income was also negatively impacted by elevated nonperforming loans and a decrease in average interest earning assets. Average interest earning assets decreased to an average balance of $379,208,000 during the quarter ended September 30, 2011, down by $25,770,000, or 6%, from the average balance during the quarter ended September 30, 2010. This decline was largely the result of decreases in the Bank’s investment portfolio as well as portfolio loans. The overall impact of these factors was a decrease in interest income from investment securities of $140,000, or 30%, to $327,000 in the three months ended September 30, 2011 compared to $467,000 earned in the three months ended September 30, 2010. Interest and fees earned on loans decreased by $332,000, or 8%, to $4,091,000 in the three months ended September 30, 2011 from $4,423,000 in the three months ended September 30, 2010. On a consecutive quarter basis, interest income from investments decreased by $31,000, or 9%, from $358,000 earned during the quarter ended June 30, 2011. Interest and fees earned on loans increased by $202,000, or 5%, from $3,889,000 during the quarter ended June 30, 2011.

Interest income not recognized on non-accruing loans during the quarter ended September 30, 2011 was $280,000, an increase of $10,000 from the $270,000 of interest income not recognized during the same quarter in 2010. On a consecutive quarter basis, interest income not recognized on non-accruing loans decreased $48,000 from $328,000 during the quarter ended June 30, 2011.

Total interest expense decreased by $479,000, or 28%, to $1,257,000 for the three months ended September 30, 2011 compared to $1,736,000 for the same period in 2010. On a consecutive quarter basis, total interest expense decreased by $68,000, or 5%, from $1,325,000 expensed during the quarter ended June 30, 2011. The decrease in interest expense reflects the Company’s continued efforts to reduce deposit and other borrowing costs.

The net interest margin is a performance metric that reports how successful the Bank’s investment decisions have been relative to its funding choices. It is calculated by dividing the annualized net interest income by the balance of the average interest earning assets for the period. The net interest margin realized on earning assets increased by 22 basis points to 3.31% for the three months ended September 30, 2011 when compared to the 3.09% net interest margin earned during the same three months in 2010. On a consecutive quarter basis, the net interest margin improved by 7 basis points from 3.24% during the quarter ended June 30, 2011.

The net interest rate spread is the difference between the average yield earned on loans, investment securities and other earning assets, and the rate paid on interest bearing deposits and other borrowings. The net interest rate spread improved by 24 basis points to 3.20% for the three months ended September 30, 2011 compared to the 2.96% net interest rate spread earned during the same three month period in 2010. On a consecutive quarter basis, the net interest rate spread improved by 8 basis points from 3.12% during the quarter ended June 30, 2011.

For the nine months ended September 30, 2011, net interest income totaled $9,015,000 as compared to $9,107,000 for the same period in 2010, for a decrease of $92,000, or 1%. Total interest income decreased by $1,870,000, or 13%, to $13,037,000 for the nine months ended September 30, 2011 compared to $14,907,000 for the nine months ended September 30, 2010. Interest and fees on loans decreased by $1,231,000, or 9%, to $11,944,000 in the nine months ended September 30, 2011 from $13,175,000 in the nine months ended September 30, 2010. Interest income on investment securities decreased by $641,000, or 37%, to $1,080,000 in the nine months ended September 30, 2011 compared to $1,721,000 in the nine months ended September 30, 2010. Total interest expense decreased by $1,779,000, or 31%, to $4,021,000 for the nine months ended September 30, 2011 compared to $5,800,000 for the same period in 2010. The net interest margin and the interest rate spread were 3.23% and 3.11%, respectively, for the nine months ended September 30, 2011. The net interest margin realized on earning assets and the interest rate spread were 2.99% and 2.86%, respectively, for the nine months ended September 30, 2010.

Interest Rate Sensitivity and Asset Liability Management

Interest rate sensitivity measures the timing and magnitude of the repricing of assets compared with the repricing of liabilities and is an important part of asset/liability management of a financial institution. The objective of interest rate sensitivity management is to generate stable growth in net interest income, and to manage the risks associated with interest rate movements. Management constantly reviews interest rate risk exposure under various interest rate scenarios so that adjustments in interest rate sensitivity can be made on a timely basis. Since the assets and liabilities of the Company are primarily monetary in nature (receivable or payable in fixed, determinable amounts), the performance of the Company is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

Net interest income is the primary component of net income for financial institutions. Net interest income is affected by the timing and magnitude of repricing of as well as the mix of interest sensitive and noninterest sensitive assets and liabilities. “Gap” is a static measurement of the difference between the contractual maturities or repricing dates of interest sensitive assets and interest sensitive liabilities for a given time period. This projected Gap exposure is expressed as a ratio of interest sensitive assets to interest sensitive liabilities in an attempt to predict the behavior of the Company’s net interest income in general terms during periods of movement in interest rates. In general, if the Company is asset sensitive the projected Gap exposure will be 1.0 or higher, indicating that more of its interest sensitive assets are expected to reprice than its interest sensitive liabilities over the same period. By example, a projected Gap ratio of 1.20 indicates that $1.20 of interest sensitive assets are expected to reprice for every $1.00 of interest sensitive liabilities expected to reprice over a given time period. In a rising interest rate environment, assets repricing more quickly are expected to enhance net interest income. Alternatively, decreasing interest rates would be expected to have the opposite effect on net interest income since assets would theoretically be repricing at lower interest rates more quickly than interest sensitive liabilities. Although it can be used as a general predictor, gap as a predictor of movements in net interest income has limitations due to the static nature of its definition and due to its inherent assumption that all assets and liabilities will reprice immediately and fully at the contractually designated time. At September 30, 2011, the Company, as measured by gap, and adjusted for its expectations of changes in interest bearing categories that might not move completely in tandem with changing interest rates, is asset sensitive with a cumulative projected Gap ratio of 1.61 over a three month period, and a cumulative projected Gap ratio of 1.04 over a one year period. Management has several tools available to it to evaluate and affect interest rate risk, including deposit pricing policies and changes in the mix of various types of assets and liabilities. The Company also forecasts its sensitivity to interest rate changes not less than quarterly using modeling software. For more information on asset-liability management, see the Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission.

Provision and Allowance for Loan Losses

There are risks inherent in making all loans, including risks with respect to the period of time over which loans may be repaid, risks resulting from changes in economic and industry conditions, risks inherent in dealing with individual borrowers, and, in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral. We establish and maintain an allowance for loan losses based on a number of qualitative factors including, among other things, historical experience, evaluation of economic conditions, regular reviews of delinquencies and loan portfolio quality and a number of assumptions about future events, which we believe to be reasonable, but which may not prove to be accurate. We believe that changes in economic and industry conditions capture the impact of general declines in the value of collateral property, and in this way our qualitative factors reflect general declines in collateral values.

To the extent that the recovery of loan balances has become collateral dependent, we obtain appraisals not less than annually, and then we reduce these appraised values for selling and holding costs to determine the liquidated value. Any shortfall between the liquidated value and the loan balance is charged against the allowance for loan losses in the month the related appraisal was received. In the ordinary course of managing and monitoring nonperforming loans, information may come to our attention that indicates the collateral value has declined further from the value established in the most recent appraisal. Such other information may include prices on recent comparable property sales or internet based property valuation estimates. In cases where this other information is deemed reliable, and the impact of a further reduction in collateral value would result in a further loss to the Company, we will record an increase to the allowance to reflect the additional estimated collateral shortfall.

The provision for loan losses is the periodic charge to operating earnings that management believes is necessary to maintain the allowance for possible loan losses at an adequate level. The amount of these periodic charges is based on management’s analysis of the potential risk in the loan portfolio. This analysis includes, among other things, evaluation of the trends in key loan portfolio metrics as follows:

(In thousands)	September 30, 2011		June 30, 2011		March 31, 2011		December 31, 2010		September 30, 2010		June 30, 2010		March 31, 2010		December 31, 2009
Portfolio loans, gross	$	260,789	$	259,561	$	263,596	$	267,600	$	277,611	$	284,604	$	285,972	$	289,659

Loans past due > 30 days and still accruing interest	$	844	$	1,950	$	2,063	$	2,135	$	6,063	$	4,884	$	5,844	$	2,032

Loans on nonaccrual	$	22,338	$	25,399	$	20,678	$	22,302	$	19,998	$	16,666	$	12,992	$	13,754
(as a % of loans, gross)		8.57%		9.79%		7.84%		8.33%		7.20%		5.83%		4.54%		4.75%

Net loan charge offs (recoveries)	$	846	$	685	$	407	$	535	$	1,553	$	863	$	123	$	2,072
(as a % of loans, gross)		0.32%		0.26%		0.15%		0.20%		0.56%		0.30%		0.04%		0.72%

Portfolio loans, gross addresses the impact on the provision for loan losses from changes in the size and composition of our loan portfolio. In the past we applied various reserve factors to our portfolio based on the risk-rated categories of loans because we had relatively little charge off activity prior to the quarter ended December 31, 2008. As a result of increasing charge off activity over the past three years, we have begun to rely more on historical levels and trends to establish various reserve percentages based on the relative inherent risk for a particular loan type and grade. The inherent risk is established based on peer group data, information from regulatory agencies, the experience of the Bank’s lending officers, and recent trends in portfolio losses. These reserve factors are continuously evaluated and subject to change depending on trends in national and local economic conditions, the depth of experience of the Bank’s lenders, delinquency trends and other factors. As our portfolio size has decreased over the last two years, there has been a shift in composition from higher risk rated real estate construction loans to comparably lower risk rated owner occupied residential real estate loans.

Loans past due greater than 30 days and still accruing interest has proven to be a useful leading indicator of directional trends in future loan losses. As the level of this metric rises, expectations are for a comparable increase in loans moving into a nonaccrual status and ultimately foreclosure resulting in increased losses. This pattern has been observed in the past where increases in loans past due greater than 30 days and still accruing are followed in future quarters with the same directional changes in the level of loans on nonaccrual. The level of loans past due greater than 30 days and still accruing interest has declined for four consecutive quarters to $844,000 at September 30, 2011, the lowest level reported in over four years. While this is an encouraging metric, management will continue to carefully monitor past due loans and work aggressively to manage loan delinquency levels. It is likely that the weakening loan quality that began in late 2008 will continue to be an area of concern in future periods.

Loans on nonaccrual has been another leading indicator of potential future losses from loans. We typically place loans on nonaccrual status when they become 90 days past due. In addition to the interest lost when a loan is placed on nonaccrual status, there is an increased probability of a loan on nonaccrual moving into foreclosure with a potential loss outcome. Although it is not shown in the table above, the level of loans on nonaccrual peaked at $25,925,000 at June 30, 2009. Over the following three quarters, this measure declined by 50% to $12,992,000 at the end of the first quarter of 2010. However, since March 31, 2010, we experienced three consecutive quarters of deterioration with the level of loans on nonaccrual increasing to $22,302,000 at December 31, 2010. The level of nonaccrual loans in 2011 declined in the first quarter, rose in the second quarter, and declined again in the third quarter, with the result that loans on nonaccrual at September 30, 2011 of $22,338,000 were nearly unchanged from the level of loans on nonaccrual at the end of 2010. Recent changes in this asset quality indicator do not appear to indicate broad portfolio deterioration, but reflects of two large relationships going into default during the second quarter of 2011. Regardless, management remains vigilant in its loan monitoring and loss mitigation efforts.

Net loan charge offs or recoveries reflect our practice of charging recognized losses to the allowance and adding subsequent recoveries back to the allowance. During the three months ended September 30, 2011, we recorded charge offs net of recoveries of $846,000. This amount represented an increase of $161,000, or 24%, from the $685,000 in net charge offs recorded during the prior quarter ended June 30, 2011, and a decrease of $707,000, or 46% from the $1,553,000 net charge offs during the same quarter in the prior year.

Prior to the fourth fiscal quarter of 2008, we had very little charge off activity and therefore, had limited historical information upon which to base past estimates. Accordingly, we continue to assess the implications of trends in recent charge off activity on potential future losses. The recent volatility in the level of quarterly net loan charge offs or recoveries makes it difficult to identify a specific trend or establish reliable future expectations. As a result, there can be no assurance that charge offs of loans in future periods will not increase or 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. Thus, there is a risk that substantial additional increases in the allowance for loan losses could be required, which would result in a decrease in our net income and possibly our capital.

In addition to considering the metrics described above, we evaluate the collectability of individual loans, the balance of impaired loans, economic conditions that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans and a review of specific problem loans. Based on this process and as shown below, the provision charged to expense was $703,000 for the three months ended September 30, 2011, as compared to $1,361,000 for the three months ended September 30, 2010. On a consecutive quarter basis, this provision level was $206,000, or 41%, higher than the $497,000 provision charged to expense during the quarter ended June 30, 2011.

(In thousands)	September 30, 2011		June 30, 2011		March 31, 2011		December 31, 2010			September 30, 2010			June 30, 2010			March 31, 2010		December 31, 2009
Provision during quarter ended	$	703	$	497	$	515	$	250		$	1,361		$	685		$	400	$	2,125

Provision added in excess of net charge offs	$	(143)	$	(188)	$	108	$	(285	)	$	(192	)	$	(178	)	$	277	$	53

Allowance for loan losses	$	5,785	$	5,928	$	6,116	$	6,008		$	6,293		$	6,485		$	6,663	$	6,386
(as a % of loans, gross)		2.22%		2.28%		2.32%		2.25%			2.27%			2.28%			2.33%		2.20%

The difference between the amount of the provision for loan losses and net loan charge offs will result in expansion or shrinkage of the level of the allowance for loan losses. As shown above, during the three months ended September 30, 2011 the current provision for loan losses of $703,000 was less than net charge offs against the allowance of $846,000 by $143,000. The result was a decrease to the allowance for loan losses by $143,000 to $5,785,000, or 2.22%, of gross loans outstanding at September 30, 2011, as compared to $5,928,000, or 2.28%, of gross loans outstanding at June 30, 2011.

From a historical perspective, prior to 2008, while the level of loans on nonaccrual was relatively stable, the allowance for loan losses was maintained in the range of 1.2% to 1.3% of the balance of gross loans. As we moved into 2008 and experienced an increase in loans on nonaccrual, it was determined that an increase to the allowance level was appropriate given the projected increased risk of loss, and so the allowance was increased to a range of 1.4% to 1.6% during 2008. The weakening of the loan portfolio performance continued into 2009 with actual loss levels that exceeded projections from earlier in 2008, resulting in the decision to increase the allowance level further, to the range of 1.6% to 1.8% in early 2009. With nonaccrual loans reaching a peak in mid-2009, further analysis and projections of potential loan losses in the Bank’s existing portfolio supported a further increase in the allowance level to a range of 2.0% to 2.3% of gross loans outstanding, which has been sustained over the last two years.

Management continues to carefully monitor past due and nonaccrual loans. Management acknowledges that future asset quality results may vary from our estimates and expectations, resulting in negative asset quality metrics, which could have a material adverse effect on our results of operations and financial condition.

Noninterest Income

Noninterest income for the three months ended September 30, 2011 totaled $5,718,000, as compared to $3,219,000 for the three months ended September 30, 2010. The largest increase was in mortgage banking income, which increased $1,602,000 to $4,581,000 for the quarter ended September 30, 2011 compared to $2,979,000 for the same period of 2010. SBA loan income increased $866,000 to $907,000 for the quarter ended September 30, 2011 compared to $41,000 for the same period of 2010.

Noninterest income for the nine months ended September 30, 2011 totaled $11,145,000, as compared to $6,464,000 for the nine months ended September 30, 2010. The largest increase was in mortgage banking income, which increased $2,986,000 to $7,705,000 for the first three quarters of 2011, compared to $4,719,000 for the same period of 2010. SBA loan income increased $2,548,000 to $2,731,000 for the nine months ended September 30, 2011, compared to $183,000 for the same period of 2010. This increased income was partially offset by the reduction in nonrecurring gain on sale of securities available for sale of $17,000 during the first three quarters of 2011 compared to net gain of $939,000 recorded during the first three quarters of 2010.

Noninterest Expense

Total noninterest expense for the three months ended September 30, 2011 was $8,257,000, as compared to $5,850,000 for the same period in 2010. The largest contributor to this increase was salaries and benefits, which increased by $1,351,000 to $3,963,000 for the three months ended September 30, 2011 compared to $2,612,000 for the same period in 2010. The increase in compensation expense resulted from a combination of staffing additions at the national retail mortgage banking branches as well as increased commission and incentive costs from residential mortgage banking and SBA lending activity. Also contributing to this increase was an increase in advertising expense, which increased $626,000 to $641,000 during the third quarter of 2011 compared to $15,000 during the third quarter of 2010. The significant increase in advertising is related to marketing costs for new loan leads purchased for the ten new retail mortgage offices opened during the second and third quarters of 2011. Other real estate expenses increased $142,000 to $1,254,000 during the third quarter of 2011, compared to $1,112,000 during the third quarter of 2010. Occupancy expense increased $95,000 to $488,000 during the third quarter of 2011, compared to $393,000 during the same period in 2010, and also related to the new retail mortgage offices. These increases were partially offset by a decrease in FDIC insurance expense of $56,000 during the third quarter 2011 compared to the same period in 2010.

Total noninterest expense for the nine months ended September 30, 2011 was $18,722,000, as compared to $14,604,000 for the same period in 2010. The largest contributor to this increase was salaries and benefits, which increased by $3,112,000 to $9,090,000 for the nine months ended September 30, 2011 compared to $5,978,000 for the same period in 2010. The increase in compensation expense resulted from a combination of staffing additions at the national retail mortgage banking branches as well as increased commission and incentive costs from mortgage banking and SBA lending activity. Also contributing to this increase was an increase in advertising expense related to marketing costs for loan leads purchased for the new retail mortgage offices, which increased $619,000 to $716,000 during the first nine months of 2011, compared to $97,000 during the same period in 2010. Legal and professional fees increased $200,000 to $685,000 during the first three quarters of 2011, compared to $485,000 during the first three quarters of 2010. Occupancy expense increased $163,000 to $1,216,000 for the nine months ended September 30, 2011, compared to $1,053,000 during the same period of 2010. These increases were partially offset by a decrease in other real estate expenses of $540,000, and a decrease in FDIC insurance expense of $140,000 during the first three quarters of 2011 compared to the first three quarters of 2010.

Mortgage Banking Operations

The primary source of direct income generated by this division is the gain on sale of mortgage loans which was $4,581,000 for the quarter ended September 30, 2011 compared to $2,979,000 for the quarter ended September 30, 2010. For the first nine months of 2011, the gain was $7,705,000 compared to $4,719,000 for the same period in 2010. The increase in gain on sale is a result of increased volume caused by both the new national retail mortgage offices and, also the attractive mortgage rate environment during the third quarter of 2011. The direct noninterest expenses incurred by the division were $4,022,000 for the third quarter of 2011, an increase of $2,080,000 over the third quarter 2010 expenses of $1,942,000. The largest contributor to this increase was in salaries and benefits, which were $2,399,000 for third quarter 2011, compared to $1,281,000 for third quarter 2010, and largely reflect a combination of staffing additions at the national retail mortgage banking branches as well as the higher commissions paid in the third quarter of 2011 as compared to the third quarter of 2010. For the nine months ended September 30, 2011, noninterest expenses incurred by the mortgage banking division were $7,130,000, an increase of $3,727,000 compared to $3,403,000 of noninterest expense for the first nine months of 2010. The largest contributor to this increase was in salaries and benefits, which were $4,418,000 for the first nine months of 2011, compared to $2,191,000 for the same period in 2010.

Beyond the impact of the noninterest income and expense from this division, the Bank earns interest income at the respective note rates on the balance of loans originated by the division from the time the loan is funded until it is sold to a secondary market investor. The average outstanding daily balance of residential mortgage loans available for sale was $82,505,000 for the three months ended September 30, 2011 and $70,138,000 for the three months ended September 30, 2010. The interest income earned on these loans available for sale was $889,000 and $812,000 during the three months ended September 30, 2011 and 2010, respectively. For the nine months ended September 30, the average outstanding daily balance of residential loans available for sale was $66,717,000 in 2011 and $60,795,000 in 2010. The interest income earned on these loans available for sale was $2,246,000 and $2,194,000 during the nine months ended September 30, 2011 and 2010, respectively.

The combination of the above factors resulted in net income at the mortgage banking division of $764,000 for the three months ended September 30, 2011, compared to net income for the three months ended September 30, 2010 of $1,010,000. For the nine months ended September 30, net income was $1,280,000 at the mortgage banking division in 2011, compared to net income of $1,664,000 in the same period in 2010. The 2011 net income for the mortgage banking division reflects startup costs related to the national retail branch additions of $250,000 for the nine months ended September 30, 2011.

Income Taxes

For the three months ended September 30, 2011, we recognized income tax expense of $291,000, compared to income tax (benefit) of ($338,000) for the third quarter of 2010. Our effective tax rate was (372%) for the third quarter of 2011 and 41% for the third quarter of 2010. For the first nine months of 2011, we recognized income tax expense of $258,000, compared to income tax expense of $48,000 for the first nine months of 2010. Our effective tax rate for the nine month period was (93%) in 2011 and (3%) in 2010. The fluctuation in effective tax rates reflects the impact of permanent book-to-tax differences in both years, including the impact of the early redemption of several bank owned life insurance (“BOLI”) policies during 2010. The BOLI policy redemptions generated taxable income, but did not result in GAAP income upon redemption with the result being the recognition of a substantial tax expense on the taxable gain, but no corresponding GAAP income.

The Company accounts for income taxes in accordance with income tax accounting guidance (FASB ASC 740, Income Taxes). On January 1, 2009, the Company adopted the recent accounting guidance related to accounting for uncertainty in income taxes, which sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions.

The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.

Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50%, and the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold includes an assessment of the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.

Management has considered both negative and positive indicators in assessing the likelihood that the Company will realize the deferred tax asset through future taxable operating income.

The cumulative loss incurred by the Company in 2008, 2009, and 2010 was the primary negative factor considered by management. Additionally, general economic conditions in the Company’s primary markets and the potential for ongoing weakening asset quality were also evaluated as a potential negative factor.

Offsetting these negative factors were numerous positive factors considered by management including:

·	Prior to the losses in 2008, 2009 and 2010 from asset quality costs, the Company had a history of consistent earnings with cumulative pretax net income of $13,879,000 for the five year period ending December 31, 2007.

·	After nine consecutive quarterly losses through December 31, 2010, the Company’s banking subsidiary, CBC National Bank, has been profitable for each of the three consecutive fiscal quarters ending September 30, 2011.

·	Over the last year, core earnings have increased to levels last attained in 2006, and so management is cautiously optimistic that more likely than not over the next two to five years taxable income will return to levels approaching those prior to 2008.

Management recommended and the Board of Directors authorized early redemptions of the majority of our BOLI policies during 2010. Liquidating these policies generated taxable income which was utilized to offset a portion of our net operating loss carry forward and decrease the related deferred tax asset in the process. The proceeds from liquidating these policies were available to fund other earning assets, shifting approximately $210,000 of annual tax exempt earnings to a like amount of taxable earnings.

The existing portfolio of marketable securities had an unrealized mark to market gain as of September 30, 2011 of $1,076,000, which could consume up to $366,000 of the deferred tax asset if the decision was made to sell securities from this portfolio and replace them with current market rate securities.

·	During 2010 we sold approximately $4.8 million of tax exempt municipal bonds, generating a taxable gain of $167,000, which allowed us to reinvest the proceeds of sale into securities that generate taxable income.

·	During 2010 we sold approximately $16.4 million of mortgage backed securities, generating a taxable gain of $772,000 and reducing the deferred tax asset by $262,000.

Based on the above analysis, management continues to believe that there is a low probability that the Company would realize the full deferred tax asset over the next three tax years through future taxable operating income and implementation of tax strategies as described above. Therefore, there has been no reduction to the deferred tax valuation allowance of $1,826,000 that was recorded in the year ended December 31, 2010. Further, despite the fact that taxable losses during 2011 have generated net operating loss carryforward credits, no additional deferred tax asset has been recorded in the nine months ended September 30, 2011. Management will continue to monitor the deferred tax asset and adjust the valuation allowance as needed to properly reflect any changes in the probability of future realization of the deferred tax asset.

Net Loss

The combination of the above factors resulted in net loss of $369,000 for the three months ended September 30, 2011, compared to net loss for the three months ended September 30, 2010 of $496,000. For the nine months ended September 30, net loss was $535,000 in 2011, compared to net loss of $1,526,000 in the same period in 2010. Basic and diluted loss per share available to common shareholders were ($.20) for the quarter ended September 30, 2011, compared to basic and diluted loss per share of ($.25) for the three month period ended September 30, 2010. Basic and diluted loss per share available to common shareholders were ($.37) for the nine months ended September 30, 2011, compared to basic and diluted loss per share of ($.76) for the nine months ended September 30, 2010.

Financial Condition

During the first nine months of 2011, total assets increased $14,071,000, or 3.29%, when compared to December 31, 2010. The largest increase was in loan sales receivable, which increased $18,904,000, or 60%, when compared to December 31, 2010. Also, loans held for sale increased $11,187,000, or 20.22%, when compared to December 31, 2010. These increases were partially offset by decreases in investment securities available for sale and portfolio loans. Investment securities available for sale decreased $7,910,000, or 20.97%, as a result of mortgage backed securities and collateralized mortgage obligations principal prepayments, several security calls and maturities. During the first nine months of 2011, portfolio loans decreased $6,811,000, or 2.55%, when compared to December 31, 2010. During the first nine months of 2011, total liabilities increased $14,701,000, or 3.73%, when compared to December 31, 2010. Other borrowings increased $14,500,000, or 39.19%, and federal fund purchased increased $3,487,000, when compared to December 31, 2010. These increases were partially offset by a decrease in deposits of $5,121,000, or 1.48%.

Investment Securities

Investment securities available for sale decreased to $29,810,000 at September 30, 2011 from $37,720,000 at December 31, 2010. The decrease in investment securities was due to principal repayments, calls, and maturities of securities during the first half of 2011. The one investment security held to maturity that we held at December 31, 2010 matured in September 2011.

Loans

Gross loans totaled $260,789,000 at September 30, 2011, a decrease of $6,811,000, or 2.55%, since December 31, 2010. We continue to work to reduce our exposure to higher risk loans by avoiding growth in the balance of real estate - construction, commercial loans; and instead focusing our lending efforts on real estate - mortgage, residential loans and real estate - mortgage, commercial loans. All loans are domestic, we have no foreign loans.

Premises and Equipment

Premises and equipment, net of depreciation, totaled $7,298,000 at September 30, 2011. The decrease of $82,000 from the December 31, 2010 amount of $7,380,000 was due to regular depreciation of assets totaling $305,000, loss on disposal totaling $49,000, and sales proceeds totaling $7,000, offset by purchases of new premises and equipment totaling $279,000.

Other Real Estate Owned

Other real estate owned represents collateral property taken back from borrowers in partial or full satisfaction of their defaulted debt obligation to the Company. We track our historical experience of loans that ultimately convert to other real estate owned by collateral type and by geographic exposure as shown on the following tables:

	Book Value of Other Real Estate at September 30, 2011
(In thousands)	Florida		Georgia		South Carolina		Total
Residential	$	1,494	$	1,297	$	2,990	$	5,781
Commercial		970		473		1,683		3,126
Finished lots		1,126		––		1,053		2,179
Raw land		2,458		592		200		3,250
	$	6,048	$	2,362	$	5,926	$	14,336

	Number of Parcels at September 30, 2011
	Florida		Georgia		South Carolina		Total
Residential		13		6		37		56
Commercial		5		1		6		12
Finished lots		18		––		14		32
Raw land		6		2		1		9
		42		9		58		109

	Book Value of Other Real Estate at December 31, 2010
(In thousands)	Florida		Georgia		South Carolina		Total
Residential	$	1,893	$	1,897	$	898	$	4,688
Commercial		1,646		984		1,608		4,238
Finished lots		1,360		315		1,300		2,975
Raw land		1,166		1,185		200		2,551
	$	6,065	$	4,381	$	4,006	$	14,452

	Number of Parcels at December 31, 2010
	Florida		Georgia		South Carolina		Total
Residential		14		8		4		26
Commercial		5		1		5		11
Finished lots		19		18		13		50
Raw land		4		3		1		8
		42		30		23		95

During the nine months ended September 30, 2011 we sold a total of 43 other real estate owned properties with a total book value of $7,495,000. The net proceeds from these sales were $6,603,000, which resulted in a net recovery of approximately 64.5% of the original loan amounts and 88.1% of the book value of the other real estate sold. During the nine months ended September 30, 2010 we sold a total of 30 other real estate owned properties with a total book value of $8,060,000. The net proceeds from these sales were $6,888,000, which resulted in a net recovery of approximately 61.3% of the original loan amounts and 85.5% of the book value of the other real estate sold.

The Bank’s special asset group is charged with the administration and liquidation of other real estate owned. Our approach has been to manage each property individually in such a way as to maximize our net proceeds upon sale. Management continues to evaluate other methods to liquidate these properties more quickly, but such methods typically result in a much lower recovery relative to the original loan amount. Management attempts to balance the desire to aggressively drive down the level of nonperforming assets with the objective to maximize recovery levels from liquidation of these assets.

Deposits

Total deposits decreased by $5,121,000, or 1%, to a total of $340,929,000 at September 30, 2011 from $346,050,000 at December 31, 2010. Noninterest-bearing demand deposits increased $4,279,000, or 23%, while interest-bearing deposits decreased $9,400,000, or 3%. The Company has continued its use of a modest level of brokered deposits, which carry substantially lower interest rates than comparable term core retail deposits. Brokered deposits are issued in individual’s names and in the names of trustees with balances participated out to others. Core retail deposits are deposits which are gathered in the normal course of business, without the use of a broker. Core reciprocal deposits are gathered in the same manner as core retail deposits, but the funds are participated out to other banks through use of the CDARS reciprocal transactions program. The CDARS program allows depositors to obtain FDIC insurance for deposits up to $50 million by exchanging the portions of their deposits in excess of FDIC insurance limitations with other financial institutions participating in the CDARS program. In return, we receive an equal amount of deposits back from other CDARS participating financial institutions, such that there is no net change in the level of total deposits on our balance sheet. Pursuant to the formal agreement entered into with the OCC, the Bank is required to limit its level of brokered deposits to no more than ten percent of total deposits, such requirement does not include reciprocal CDARS.

Balances and percentages within the major deposit categories are as follows:

	September 30, 2011
(In thousands)	Core Retail Deposits		Core Reciprocal Deposits		Brokered Deposits		Total Deposits
Noninterest-bearing demand deposits	$	23,227	$	––	$	––	$	23,227
Interest-bearing demand deposits		114,574		––		––		114,574
Savings deposits		4,545		––		––		4,545
Certificates of deposit $100,000 and over		90,422		28,235		––		118,657
Other time deposits		55,678		1,208		23,040		79,926
	$	288,446	$	29,443	$	23,040	$	340,929

	December 31, 2010
(In thousands)	Core Retail Deposits		Core Reciprocal Deposits		Brokered Deposits		Total Deposits
Noninterest-bearing demand deposits	$	18,948	$	––	$	––	$	18,948
Interest-bearing demand deposits		118,812		––		––		118,812
Savings deposits		3,764		––		––		3,764
Certificates of deposit $100,000 and over		90,272		27,633		––		117,905
Other time deposits		66,978		1,426		18,217		86,621
	$	298,774	$	29,059	$	18,217	$	346,050

Other Borrowings

Other Borrowings of $51,500,000 at September 30, 2011 are composed of advances from the Federal Home Loan Bank of Atlanta (FHLB), and represent an increase from $37,000,000 at December 31, 2010. This increase in the level of borrowings was exclusively for short terms of 60 days or less and was utilized to fund the growth in the balance of residential mortgage loans available for sale and loan sales receivables, which are also short term assets. As short term borrowings tend to carry lower interest rates than longer term borrowings, this increase in the balance of short term borrowings pushed down the weighted average cost of borrowings by 159 basis points from 3.31% at December 31, 2010 to 1.72% at September 30, 2011.

At September 30, 2011 the Bank pledged $88,891,000 of its portfolio loans to FHLB and could borrow up to an aggregate of $59,735,000 on such collateral. The Bank had also pledged $36,901,000 of its portfolio loans to Federal Reserve Bank of Atlanta at September 30, 2011, and could borrow up to an aggregate of $24,658,000 on such collateral at the Discount Window. At December 31, 2010 the Bank pledged $98,499,000 of its portfolio loans to FHLB and could borrow up to an aggregate of $53,666,000 on such collateral. The Bank also pledged $48,390,000 of its portfolio loans to Federal Reserve Bank of Atlanta at December 31, 2010, and could borrow up to an aggregate of $28,267,000 on such collateral at the Discount Window.

During the third quarter of 2011, the Bank requested and obtained a $2 million letter of credit from the FHLB to be issued in favor of Wells Fargo Bank, a major purchaser of the Bank’s mortgage loans available for sale. Consistent with the growth in residential mortgage banking origination levels, there was an increase in the level of mandatory forward loan sale commitments between the Bank and Wells Fargo Bank. As a result, Wells Fargo was exposed to an increasing level of credit risk in the event that the Bank failed to deliver loans for sale under these commitments, and so a letter of credit was required to mitigate that credit risk. While this letter of credit had no impact on the level of borrowings outstanding, it is collateralized by loans and securities pledged to the FHLB, and as such it has reduced the Bank’s borrowing capacity with the FHLB by $2 million.

FHLB advances outstanding and related terms at September 30, 2011 and December 31, 2010 are shown in the following tables:

			FHLB Advances Outstanding September 30, 2011
Type advance	Balance		Interest rate			Maturity date	Convertible date
Fixed rate	$	5,000,000		0.14	%	October 12, 2011
Fixed rate		5,000,000		0.13	%	October 24, 2011
Fixed rate		2,000,000		0.13	%	October 25, 2011
Fixed rate		2,000,000		0.13	%	October 26, 2011
Fixed rate		5,000,000		0.13	%	October 31, 2011
Fixed rate		4,000,000		0.14	%	November 28, 2011
Fixed rate		2,500,000		3.30	%	April 9, 2012
Convertible fixed rate advance		1,500,000		4.05	%	September 7, 2012	December 7, 2011
Fixed rate		10,000,000		4.25	%	May 21, 2014
Fixed rate		5,000,000		3.71	%	June 24, 2015
Convertible fixed rate advance		2,000,000		3.69	%	September 7, 2017	December 7, 2011
Variable rate overnight advance		7,500,000		0.36	%
Total	$	51,500,000		1.72	%

			FHLB Advances Outstanding December 31, 2010
Type advance	Balance		Interest rate			Maturity date	Convertible date
Fixed rate	$	2,500,000		3.00	%	April 8, 2011
Fixed rate		5,000,000		5.65	%	June 1, 2011
Fixed rate		2,500,000		3.30	%	April 9, 2012
Convertible fixed rate advance		1,500,000		4.05	%	September 7, 2012	March 7, 2011
Fixed rate		10,000,000		4.25	%	May 21, 2014
Fixed rate		5,000,000		3.71	%	June 24, 2015
Convertible fixed rate advance		2,000,000		3.69	%	September 7, 2017	March 7, 2011
Variable rate overnight advance		8,500,000		0.47	%
Total	$	37,000,000		3.31	%

Junior Subordinated Debentures

In May 2004, Coastal Banking Company Statutory Trust I issued $3 million of trust preferred securities with a maturity of July 23, 2034. The proceeds from the issuance of the trust preferred securities were used by the Trust to purchase $3,093,000 of the Company’s junior subordinated debentures, which accrue interest at a floating rate equal to 3 month LIBOR plus 275 basis points. The Company used the proceeds from the sale of the junior subordinated debentures for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of the Trust.

In June 2006, Coastal Banking Company Statutory Trust II issued $4 million of trust preferred securities with a maturity of September 30, 2036. The proceeds from the issuance of the trust preferred securities were used by the Trust to purchase $4,124,000 of the Company’s junior subordinated debentures, which accrue interest at a fixed rate of 7.18% until September 30, 2011 and a variable rate thereafter equal to 3 month LIBOR plus 160 basis points. The Company used the proceeds from the sale of the junior subordinated debentures for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of the Trust.

Pursuant to the terms of the junior subordinated debentures held by Coastal Banking Company Statutory Trust I and Coastal Banking Company Statutory Trust II, the Company has the option to defer distributions on such securities at any time, and from time to time, for a period not to exceed twenty consecutive quarters. During the fourth quarter of 2010, the Company elected to defer the interest payments on its trust preferred securities. Furthermore, pursuant to the terms of the MOU, the Company is prohibited from paying interest on its trust preferred securities absent prior written approval from the Federal Reserve Bank of Richmond. At September 30, 2011, we had unpaid accrued interest on junior subordinated debentures of $389,000.

For more information, see our Annual Report on Form 10-K for the year ended December 31, 2010.

Liquidity and Capital Resources

Liquidity

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

We meet our liquidity needs through scheduled maturities of loans and investments on the asset side and through pricing policies on the liability side for interest-bearing deposit accounts and with advances from approved borrowing facilities with correspondent banks, the Federal Home Loan Bank of Atlanta, and the Federal Reserve Bank discount window. At September 30, 2011, the Bank had $66,259,000 borrowing capacity available under its existing borrowing facilities compared to $105,283,000 available at December 31, 2010, which is currently well in excess of our projected liquidity needs. This decline in borrowing capacity reflects the increased level of short term borrowings to fund the growth in residential mortgage loans available for sale. In addition to borrowing facilities, the Bank considers the balance of mortgage loans sold for which payment by the purchasing investor is pending as an additional source of liquidity. At September 30, 2011 the loan sales receivable was $50,410,000 and 83% of that receivable was received as cash within 31 calendar days. Another key metric of our liquidity position is the loan-to-total deposit ratio, which was 76% at September 30, 2011 and 77% at December 31, 2010.

Off-Balance Sheet Commitments

We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments consist of commitments to extend credit, standby letters of credit and loans sold with representations and warranties. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are written conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Our exposure to credit loss in the event of non-performance by the other party to the instrument is represented by the contractual notional amount of the instrument.

Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We use the same credit policies in making commitments to extend credit as we do for on-balance sheet instruments. Collateral held for commitments to extend credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties.

Loans on one-to-four family residential mortgages originated by us are sold to various other financial institutions with representations and warranties that are usual and customary for the industry. In addition to these representations and warranties, our loan sale contracts define a condition in which the borrower fails to make any one of the first four loan payments within 30 days of the due date as an Early Payment Default (“EPD”). In the event of an EPD occurrence, we are required to return the premium paid by the investor for the loan as well as pay certain administrative fees. In the event of a breach of any of the representations and warranties related to a loan sold, we could be liable for damages to the investor up to and including a “make whole” demand that involves, at the investor’s option, either reimbursing the investor for actual losses incurred on the loan or repurchasing the loan in full. Our maximum exposure to credit loss in the event of a loan repurchase related to a make whole claim would be the unpaid principal balance of the loan to be repurchased along with any premium paid by the investor when the loan was purchased and other minor collection cost reimbursements.

From the September 2007 inception of the mortgage banking division through September 30, 2011, we have sold nearly 14,200 residential mortgage loans into the secondary market with a principal balance of just over $3 billion. From this population of sold loans, the Bank has received notification from purchasers of a total of fourteen EPD claims, three in 2008, seven in 2009, three in 2010, and one in 2011. Beyond the initial payment to the purchasers of $73,700 upon receipt of the EPD claims, the maximum remaining exposure under investor claims of a representation and warranty breach would be the difference between the total loan amount and the liquidated value of the underlying collateral. In the case of our 14 EPD claims received since the inception of mortgage banking operations, the aggregate loan balance was $2,360,000 and consisted of 14 single family residences. Original loan to value ratios ranged from 65% to 98% and loans with a loan to value ratio over 80% have a mortgage insurance policy in place. If repurchase was required in the future, management believes that the potential amount of loss would not be material and that sufficient reserves exist to fully absorb any loss. Management does not anticipate any material credit risk related to potential EPD claims on loans that have been previously sold and are no longer on the Bank’s balance sheet. Because the risk of an EPD claim only exists during the first four payments after a loan is originated, we report the total of the most recent four months mortgage banking lending volume as our off balance sheet credit risk from EPD claims.

As discussed above, the representations and warranties in our loan sale agreements provide that we repurchase loans or indemnify the investors for losses or costs on loans we sell under certain limited conditions. Some of these conditions include underwriting errors or omissions, fraud or material misstatements by the borrower in the loan application or invalid market value on the collateral property due to deficiencies in the appraisal. From the total population of sold loans, in four years of operations we have been required to settle four make whole claims at a cost of $324,000, and we have repurchased two loans totaling $638,000. The two repurchased loans are both current and performing in accordance with their loan terms.

Management has recognized the potential risk from costs related to EPD claims and breaches of representations and warranties made in connection with residential loan sales. Nationally the industry has seen a significant increase in the level of loan “put backs” to lenders on the basis of representation and warranty breaches. It is noteworthy that our loan sale activity began in late 2007 at a time when underwriting requirements had changed and limited documentation loans were no longer eligible for purchase in the secondary market. Accordingly, the population of loans we have sold was underwritten based on fully documented information. While this will not eliminate all risk of repurchase or indemnification costs, we believe it significantly mitigates that risk as evidenced by the relatively insignificant level of repurchase and indemnification costs incurred to date.

In recognition of risk from potential EPD claims and breaches of representations and warranties, an indemnification reserve has been established and maintained since mortgage banking loan sales began in late 2007 to cover potential costs. We have limited history of costs incurred, so additions to the reserve are made monthly based on a percentage of loan balances sold that month. This approach recognizes that the risk of indemnification costs will rise in relation to the level of loans sold. The balance in this indemnification reserve was $961,000 at September 30, 2011 and based on the Company’s modest historical loss experience and the current level of indemnification claims under review, management believes this level of reserve is adequate for potential exposure in connection with loan sale indemnification or EPD claims. However, we can provide no assurance that our methodology will not change and that the balance of this indemnification reserve will prove sufficient to cover actual costs in the future.

The Bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and loans sold with representations and warranties is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. In most cases, the Bank requires collateral to support financial instruments with credit risk.

The following table summarizes our off-balance-sheet financial instruments whose contract amounts represent credit risk as of September 30, 2011:

Commitments to extend credit	$	16,628,000
Standby letters of credit	$	57,000
Loans sold with representations and warranties	$	310,983,000

Management is not aware of any significant concentrations of loans to classes of borrowers or industries that would be affected similarly by economic conditions. Although the Bank’s loan portfolio is diversified, a substantial portion of our borrowers’ ability to honor the terms of their loans is dependent on the economic conditions in Beaufort County, South Carolina; Nassau County, Florida; and Fulton and Thomas Counties, Georgia as well as the surrounding areas. In addition, a substantial portion of our loan portfolio is collateralized by improved and unimproved real estate and is therefore dependent on the local real estate markets.

Contractual Obligations

Summarized below are our contractual obligations as of September 30, 2011.

(In thousands)	Total		Less than 1 year		1 to 3 years		3 to 5 years		More than 5 years
Other borrowings	$	51,500	$	34,500	$	10,000	$	5,000	$	2,000
Operating lease obligations		834		451		352		31		––
Junior subordinated debentures		7,217		––		––		––		7,217
	$	59,551	$	34,951	$	10,352	$	5,031	$	9,217

Capital Resources

The Federal Reserve Board and bank regulatory agencies require bank holding companies and financial institutions to maintain capital at adequate levels based on a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital includes common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, plus senior perpetual preferred stock issued to the United States Department of Treasury under TARP and a limited amount of trust preferred securities less certain intangible assets and the disallowed portion of our deferred tax asset. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital includes the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio. At both the holding company and bank level, we are subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “well-capitalized,” we must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a Tier 1 leverage ratio of at least 5%. Additionally, in light of current market conditions and the Bank’s current risk profile, management has determined that the Bank must achieve and maintain a minimum ratio of total capital to risk-weighted assets of 12% and a minimum leverage ratio of 8% to be considered well capitalized under these market conditions.

At September 30, 2011, total shareholders’ equity was $32.4 million at the holding company and $39.1 million at CBC National Bank. The Bank was considered “well capitalized” and the holding company met or exceeded its applicable regulatory capital requirements. The following table summarizes the Company’s and Bank’s capital ratios at September 30, 2011:

	Coastal Banking Company	CBC National Bank
Total capital (to risk-weighted assets)	16.08%	15.86%
Tier 1 capital (to risk-weighted assets)	14.81%	14.59%
Tier 1 capital (to total average assets)	9.35%	9.21%

On December 5, 2008, Coastal issued and sold 9,950 preferred shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “TARP preferred stock”), along with a Warrant to purchase common stock to the United States Department of the Treasury (the “Treasury”) as part of the Capital Purchase Program (“CPP”). The Treasury’s investment in Coastal is part of the government’s program to provide capital to the healthy financial institutions that are the core of the nation’s economy in order to increase the flow of credit to consumers and businesses and provide additional assistance to distressed homeowners facing foreclosure. The TARP preferred stock has an annual 5% cumulative preferred dividend rate, payable quarterly. The dividend rate increases to 9% after December 31, 2013. Dividends compound if they accrue in arrears. The Board has approved and Coastal paid all dividends on the CPP preferred through November 15, 2010. However, pursuant to the MOU entered into with the Federal Reserve Board, the Company is prohibited from paying dividends on its TARP preferred stock without prior regulatory approval.

The MOU also prohibits the Company from paying interest on its trust preferred securities without prior regulatory approval. The Company has not been successful in obtaining the required regulatory approval to pay interest on its trust preferred securities since December 2010. As a result, pursuant to the terms of the trust preferred securities, the Company has elected to defer all interest payments that have become due and payable on its trust preferred securities since the fourth quarter of 2010. Pursuant to the terms of the trust preferred securities, absent authorization of a majority of the holders of the outstanding trust preferred securities, the Company is prohibited from paying dividends on its TARP preferred stock until the Company pays all interest payments due and payable on the trust preferred securities. As a result, the Company cannot pay dividends on its TARP preferred stock without breaching the terms of its trust preferred securities, and so the Company has not paid the last three TARP dividend payments that were due in February 2011, May, 2011, and August 2011.

On February 17, 2011, the Federal Reserve Bank denied our request to pay dividends on our TARP preferred stock and interest on our trust preferred securities, until such time as the Company has shown sustained profitability, improvement in asset quality indicators, and compliance with existing regulatory guidance related to such payments. Cash dividends on the TARP preferred stock are cumulative and accrue and compound on each subsequent payment date. At September 30, 2011, we had unpaid TARP preferred stock dividends in arrears of $373,125. If we miss six quarterly dividend payments on the TARP preferred stock, whether or not consecutive, the Treasury will have the right to appoint two directors to Coastal’s board of directors until all accrued but unpaid dividends have been paid.

The TARP preferred stock has a liquidation preference of $1,000 per share plus accrued dividends. The TARP preferred stock has no redemption date and is not subject to any sinking fund. The TARP preferred stock carries certain restrictions. The TARP preferred stock ranks senior to our common stock and also provides certain limitations on compensation arrangements of executive officers. During the first three years, Coastal may not reinstate a cash dividend on its common shares nor purchase equity shares without the approval of the U.S. Treasury, subject to certain limited exceptions. Coastal may not reinstate a cash dividend on its common shares to the extent preferred dividends remain unpaid. Generally, the TARP preferred stock is non-voting. However, should Coastal fail to pay six quarterly dividends, the holder may elect two directors to the Company’s Board of Directors until such dividends are paid. In connection with the issuance of the TARP preferred stock, a Warrant to purchase 205,579 common shares was issued with an exercise price of $7.26 per share, which was calculated based upon the average closing prices of our common stock on the 20 trading days ending on the last trading day prior to the date that our application was approved to participate in the TARP Capital Purchase Program. The Warrant is immediately exercisable and expires in ten years. The Warrant is subject to a proportionate anti-dilution adjustment in the event of stock dividends or splits, among other events.

Regulatory Matters

From time to time, various bills are introduced in the United States Congress with respect to the regulation of financial institutions. Certain of these proposals, if adopted, could significantly change the regulation of banks and the financial services industry. We cannot predict whether any of these proposals will be adopted or, if adopted, how these proposals would affect us.

On August 26, 2009, the Bank entered into a formal agreement with the OCC (the “Agreement”). The Agreement contains certain operational and financial restrictions, which address the concerns identified in the Bank’s report of examination. Under the terms of the Agreement, the Bank has prepared and provided written plans and/or reports on the following items: reducing the high level of credit risk in the Bank; taking immediate and continuing action to protect the Bank’s interest in criticized assets; ensuring the Bank’s adherence to its written profit plan to improve and sustain earnings; limiting brokered deposits, excluding reciprocal CDARS, that would cause the Bank’s level of brokered deposits to be in excess of ten percent of total deposits; and establishing a Compliance Committee to monitor the Bank’s adherence to the Agreement.

On January 27, 2010, pursuant to a request by the Federal Reserve Bank of Richmond, the board of directors of Coastal Banking Company, Inc. adopted a resolution, which provided that the Company must obtain prior approval of the Federal Reserve Board before incurring additional debt, purchasing or redeeming its capital stock, or declaring or paying dividends, excluding dividends on preferred stock related to our participation in the TARP CPP.

On November 17, 2010, the Company entered into a Memorandum of Understanding, an informal enforcement action, with the Federal Reserve Bank of Richmond in lieu of the board resolution adopted on January 27, 2010. The terms of the MOU are substantially similar to those of the board resolution and require the Company to obtain prior approval of the Federal Reserve Board before incurring additional debt, purchasing or redeeming its capital stock, or declaring or paying cash dividends, including dividends on its TARP preferred stock, and paying interest on its trust preferred securities. Additionally, the MOU requires the Company to comply with banking regulations that prohibit certain indemnification and severance payments and require prior approval of any appointment of new directors or the hiring or change in position of any senior executive officers of the Company. The MOU also requires the submission of quarterly progress reports.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.

Pursuant to Item 305(e) of Regulation S-K, no disclosure under this item is required.

ITEM 4. CONTROLS AND PROCEDURES.

As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (Disclosure Controls). Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO (hereinafter in Item 4 “management, including the CEO and CFO,” are referred to collectively as “management”), as appropriate to allow timely decisions regarding required disclosure.

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

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

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

None.

ITEM 1A. RISK FACTORS

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

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None.

ITEM 4. REMOVED AND RESERVED.

ITEM 5. OTHER INFORMATION.

None.

ITEM 6. EXHIBITS.

31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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

	COASTAL BANKING COMPANY, INC.

Date: November 14, 2011	By:	/s/ MICHAEL G. SANCHEZ
		Michael G. Sanchez
		Chief Executive Officer


Date: November 14, 2011	By:	/s/ PAUL R. GARRIGUES
		Paul R. Garrigues
		Chief Financial Officer

INDEX TO EXHIBITS

Exhibit

Number Description

31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Attached files

COASTAL BANKING CO INC Reports

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