Monarch Financial Holdings, Inc. - FORM 10-Q

Attached files

file	filename
EX-32.1 - EXHIBIT - Monarch Financial Holdings, Inc.	mnrk-06302014xex321.htm
EX-31.2 - EXHIBIT - Monarch Financial Holdings, Inc.	mnrk-06302014xex312.htm
EXCEL - IDEA: XBRL DOCUMENT - Monarch Financial Holdings, Inc.	Financial_Report.xls
EX-31.1 - EXHIBIT - Monarch Financial Holdings, Inc.	mnrk-06302014xex311.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

_______________________________________________________

FORM 10-Q

_______________________________________________________



ý	QUARTERLY REPORT UNDER SECTION 13 0R 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarterly Period Ended: June 30, 2014



¨	TRANSITION REPORT UNDER SECTIONS 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-34565

_______________________________________________________

MONARCH FINANCIAL HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

_______________________________________________________



VIRGINIA	20-4985388
(State of other jurisdiction of Incorporation or organization)	(I.R.S. Employer Identification No.)

1435 Crossways Blvd.

Chesapeake, Virginia 23320

(Address of Principal Executive Offices, Zip Code)

(757) 389-5111

(Registrant's telephone number, including area code, of agent for service)

Not Applicable

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

_______________________________________________________

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

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

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



Large accelerated filer	¨	Accelerated filer	ý
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 ¨ No ý

The number of shares of common stock outstanding as of August 1, 2014 was 10,628,588.

Table of Contents

MONARCH FINANCIAL HOLDINGS, INC.

FORM 10-Q

June 30, 2014

INDEX



PART I.	FINANCIAL INFORMATION
	ITEM 1.	Consolidated Statements of Condition as of June 30, 2014 and December 31, 2013	4
		Consolidated Statements of Income for the three and six months ended June 30, 2014 and June 30, 2013	5
		Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2014 and June 30, 2013	6
		Consolidated Statements of Stockholders' Equity for the six months ended June 30, 2014 and June 30, 2013	7
		Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and June 30, 2013	8
		Notes to Consolidated Financial Statements	9
	ITEM 2.	Managements' Discussion and Analysis of Financial Condition and Results of Operations	32
	ITEM 3.	Quantitative and Qualitative Disclosures about Market Risk	59
	ITEM 4.	Controls and Procedures	61
PART II.	OTHER INFORMATION
	Item 1.	Legal Proceedings	62
	Item 1A.	Risk Factors	62
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	62
	Item 3.	Defaults Upon Senior Securities	62
	Item 4.	Mine Safety Disclosures	62
	Item 5.	Other Information	62
	Item 6.	Exhibits	63

Table of Contents

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MONARCH FINANCIAL HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF CONDITION



	Unaudited
	June 30, 2014			December 31, 2013
ASSETS:
Cash and due from banks	$	19,660,698		$	18,971,268
Interest bearing bank balances	37,166,315			31,955,092
Federal funds sold	29,760,855			53,984,962
Total cash and cash equivalents	86,587,868			104,911,322
Investment securities available-for-sale, at fair value	23,772,526			48,821,760
Loans held for sale, net at fair value for June 30, 2014	156,584,246			99,717,785
Loans held for investment, net of unearned income	700,158,722			712,671,467
Less: allowance for loan losses	(9,069,877		)	(9,061,369		)
Loans, net	691,088,845			703,610,098
Property and equipment, net	31,407,114			28,881,536
Restricted equity securities	3,168,700			3,683,250
Bank owned life insurance	7,526,115			7,409,436
Goodwill	775,000			775,000
Intangible assets, net	14,881			104,167
Other real estate owned, net of valuation allowance	144,000			301,963
Other assets	22,829,297			18,484,343
Total assets	$	1,023,898,592		$	1,016,700,660
LIABILITIES:
Deposits:
Demand deposits—non-interest bearing	$	240,348,078		$	206,891,499
Demand deposits—interest bearing	51,562,887			55,527,954
Savings deposits	24,538,724			22,137,321
Money market savings	377,096,023			374,461,494
Time deposits	197,747,402			234,100,222
Total deposits	891,293,114			893,118,490
Borrowings:
Trust preferred subordinated debt	10,000,000			10,000,000
Federal Home Loan Bank advances	1,125,492			1,175,485
Total borrowings	11,125,492			11,175,485
Other liabilities	18,649,624			14,661,087
Total liabilities	921,068,230			918,955,062
STOCKHOLDERS’ EQUITY:
Preferred stock, $5 par value, 2,000,000 shares authorized; none issued	—			—
Common stock, $5 par value; 20,000,000 shares authorized; issued and outstanding, 10,624,668 shares (includes non-vested shares of 299,910) at June 30, 2014 and 10,502,323 shares (includes non-vested shares of 215,960); at December 31, 2013	51,623,790			51,431,815
Additional paid-in capital	7,675,072			7,068,715
Retained earnings	43,565,948			39,437,119
Accumulated other comprehensive loss	(159,186		)	(419,496		)
Total Monarch Financial Holdings, Inc. stockholders’ equity	102,705,624			97,518,153
Non-controlling interests	124,738			227,445
Total equity	102,830,362			97,745,598
Total liabilities and stockholders’ equity	$	1,023,898,592		$	1,016,700,660

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

Table of Contents

ITEM 1. FINANCIAL STATEMENTS (CONTINUED)

MONARCH FINANCIAL HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)



	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2014			2013			2014			2013
Interest income:
Interest and fees on loans held for investment	$	9,089,071		$	9,040,004		$	18,567,963		$	18,014,998
Interest on loans held for sale	1,274,498			1,773,692			2,047,230			4,507,264
Interest on investment securities	91,929			57,302			167,978			114,871
Interest on federal funds sold	24,179			25,312			64,557			30,470
Dividends on equity securities	22,410			69,225			52,410			143,660
Interest on other bank accounts	54,905			9,952			90,937			18,094
Total interest income	10,556,992			10,975,487			20,991,075			22,829,357
Interest expense:
Interest on deposits	839,303			1,020,913			1,673,716			2,050,375
Interest on trust preferred subordinated debt	123,359			124,200			245,696			243,242
Interest on borrowings	14,224			38,810			28,586			327,988
Total interest expense	976,886			1,183,923			1,947,998			2,621,605
Net interest income	9,580,106			9,791,564			19,043,077			20,207,752
Provision for loan losses	—			—			—			—
Net interest income after provision for loan losses	9,580,106			9,791,564			19,043,077			20,207,752
Non-interest income:
Mortgage banking income	17,369,228			20,572,388			29,571,390			36,738,324
Service charges and fees	538,579			477,660			1,008,791			928,814
Title income	167,454			232,423			272,488			486,774
Investment and insurance income	335,887			245,524			781,359			452,460
Other	87,725			146,276			173,496			248,917
Total non-interest income	18,498,873			21,674,271			31,807,524			38,855,289
Non-interest expenses:
Salaries and employee benefits	8,492,446			8,502,755			16,764,007			16,707,830
Commissions and incentives	6,770,022			9,703,820			10,780,986			16,769,296
Loan origination expense	2,060,570			2,630,295			3,423,711			4,460,732
Occupancy expense	2,395,088			2,130,445			4,671,791			3,996,963
Marketing expense	797,908			744,646			1,319,749			1,257,604
Data processing expense	476,806			435,771			956,084			836,729
Telephone	293,451			308,138			604,588			563,062
Professional fees	333,735			222,768			583,574			509,857
Foreclosed property expense	35,860			1,494			42,999			2,598
Other expenses	1,351,098			1,492,752			2,606,128			2,928,834
Total non-interest expenses	23,006,984			26,172,884			41,753,617			48,033,505
Income before income taxes	5,071,995			5,292,951			9,096,984			11,029,536
Income tax provision	(1,767,500		)	(1,797,773		)	(3,238,740		)	(3,791,326		)
Net income	3,304,495			3,495,178			5,858,244			7,238,210
Less: Net income attributable to non-controlling interests	(120,921		)	(428,540		)	(137,405		)	(713,443		)
Net income attributable to Monarch Financial Holdings, Inc.	$	3,183,574		$	3,066,638		$	5,720,839		$	6,524,767
Basic net income per share	$	0.30		$	0.29		$	0.54		$	0.66
Diluted net income per share	$	0.30		$	0.29		$	0.54		$	0.62

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

Table of Contents

ITEM 1. FINANCIAL STATEMENTS (CONTINUED)

MONARCH FINANCIAL HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2014			2013			2014			2013
Net Income	$	3,304,495		$	3,495,178		$	5,858,244		$	7,238,210
Other comprehensive income:
Change in unrealized gain (loss) on interest rate swap, net of income taxes	49,422			47,424			96,300			100,033
Change in unrealized gain (loss) on securities available for sale, net of income taxes	103,882			(211,637		)	161,436			(238,298		)
Change in unrealized loss on supplemental executive's retirement plan, net of income taxes	1,287			(141,889		)	2,574			(141,889		)
Other comprehensive income	154,591			(306,102		)	260,310			(280,154		)
Total comprehensive income (loss)	3,459,086			3,189,076			$	6,118,554		$	6,958,056
Less: Comprehensive income attributable to non-controlling interests	(120,921		)	(428,540		)	(137,405		)	(713,443		)
Comprehensive income attributable to Monarch Financial Holdings, Inc.	$	3,338,165		$	2,760,536		$	5,981,149		$	6,244,613

Unrealized gain on interest rate swap	$	76,035		$	72,961		$	148,155		$	146,022
Income tax expense	(26,613		)	(25,537		)	(51,855		)	(45,989		)
Net unrealized gain on interest rate swap	$	49,422		$	47,424		$	96,300		$	100,033

Unrealized holding gain (loss) on securities available for sale	$	159,818		$	(323,003	)	$	248,363		$	(363,399	)
Income (expense) benefit	(55,936		)	111,366			(86,927		)	125,101
Net unrealized gain (loss) on securities available for sale	$	103,882		$	(211,637	)	$	161,436		$	(238,298	)

Unrealized (gain) loss on supplemental executive's retirement plan	$	1,980		$	(218,291	)	$	3,960		$	(218,291	)
Income tax benefit	(693		)	76,402			(1,386		)	76,402
Net unrealized loss on supplemental executive's retirement plan	$	1,287		$	(141,889	)	$	2,574		$	(141,889	)

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

Table of Contents

ITEM 1. FINANCIAL STATEMENTS (CONTINUED)

MONARCH FINANCIAL HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(unaudited)



	Common Stock					Additional Paid-In Capital			Preferred Stock			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Non-controlling Interest			Total
	Shares		Amount			Additional Paid-In Capital			Preferred Stock			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Non-controlling Interest			Total
Balance—December 31, 2012	8,326,479		$	41,632,395		$	12,717,727		$	2,405,615		$	30,786,208		$	(200,022	)	$	1,604,918		$	88,946,841
Net income for the six months ended June 30, 2013												6,524,767						713,443			7,238,210
Other comprehensive loss															(280,154		)				(280,154		)
Stock-based compensation expense, net of forfeitures and income taxes	—		—			300,465															300,465
Stock options exercised	32,473		162,365			54,519															216,884
Series B noncumulative perpetual preferred shares converted to common stock, less fractional shares	1,804,184		9,020,920			(6,615,558		)	(2,405,615		)										(253		)
Cash dividend declared on common stock ($0.11 per share)												(1,078,324		)							(1,078,324		)
Common stock issued through dividend reinvestment	11,448		57,240			63,402															120,642
Distributions to non-controlling interests																		(710,124		)	(710,124		)
Balance - June 30, 2013	10,174,584		$	50,872,920		$	6,520,555		$	—		$	36,232,651		$	(480,176	)	$	1,608,237		$	94,754,187

Balance—December 31, 2013	10,286,363		$	51,431,815		$	7,068,715		$	—		$	39,437,119		$	(419,496	)	$	227,445		$	97,745,598
Net income for the six months ended June 30, 2014												5,720,839						137,405			5,858,244
Other comprehensive income															260,310						260,310
Stock-based compensation expense, net of forfeitures and income taxes	(1,200	)	(6,000		)	425,049															419,049
Stock options exercised, net of income taxes	25,456		127,280			88,452															215,732
Cash dividend declared on common stock ($0.15 per share)												(1,592,010		)							(1,592,010		)
Common stock issued through dividend reinvestment	14,139		70,695			92,844															163,539
Cash in lieu of fractional shares						12															12
Contributions from non-controlling interests																		99			99
Distributions to non-controlling interests																		(240,211		)	(240,211		)
Balance - June 30, 2014	10,324,758		$	51,623,790		$	7,675,072		$	—		$	43,565,948		$	(159,186	)	$	124,738		$	102,830,362

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

Table of Contents

ITEM 1. FINANCIAL STATEMENTS (CONTINUED)

MONARCH FINANCIAL HOLDINGS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)



	Six months ended June 30,
	2014			2013
Operating activities:
Net income	$	5,858,244		$	7,238,210
Adjustments to reconcile to net cash (used in) provided by operating activities:
Provision for loan losses	—			—
Depreciation	1,415,329			1,126,252
Accretion of discounts and amortization of premiums, net	3,048			12,755
Deferral of loan costs, net of deferred fees	(82,379		)	(240,987		)
Amortization of intangible assets	89,286			89,286
Stock-based compensation	419,049			300,465
Appreciation of bank-owned life insurance	(116,679		)	(117,312		)
Net gain on disposition of property and equipment	—			(16,296		)
Net loss on sale of other real estate	33,263			—
Deferred income tax expense	1,409,203			—
Changes in:
Loans held for sale	(56,866,461		)	252,488,883
Interest receivable	170,105			(128,139		)
Other assets	(5,823,518		)	7,424,844
Other liabilities	3,969,510			1,109,976
Net cash (used in) provided by operating activities	(49,522,000		)	269,287,937
Investing activities:
Purchases of available-for-sale securities	(8,347,950		)	(5,025,740		)
Proceeds from sales and maturities of available-for-sale securities	33,642,499			2,710,088
Proceeds from sale of other real estate	268,700			—
Proceeds from sale of assets	—			25,000
Purchases of premises and equipment	(3,970,751		)	(3,779,553		)
Redemption of restricted equity securities	514,550			8,570,850
Loan originations, net of principal repayments	12,459,632			(35,726,371		)
Net cash provided by (used in) investing activities	34,566,680			(33,225,726		)
Financing activities:
Net increase in non-interest-bearing deposits	33,456,579			28,759,218
Net (decrease) increase in interest-bearing deposits	(35,281,955		)	(31,855,115		)
Cash dividends paid on common stock	(1,592,010		)	(1,078,324		)
Net decrease in FHLB advances and federal funds purchased	(49,993		)	(193,073,048		)
Net decrease in short term borrowings	—			(5,000,000		)
Contributions from non-controlling interests	99			—
Distributions to non-controlling interests	(240,211		)	(710,124		)
Proceeds from issuance of common stock, net of issuance costs	163,539			120,642
Proceeds from exercise of stock options	175,806			216,884
Cash in lieu of fractional shares	12			(253		)
Net cash used in financing activities	(3,368,134		)	(202,620,120		)
CHANGE IN CASH AND CASH EQUIVALENTS	(18,323,454		)	33,442,091
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR	104,911,322			57,774,578
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	86,587,868		$	91,216,669
SUPPLEMENTAL SCHEDULES AND CASH FLOW INFORMATION
Cash paid for:
Interest on deposits and other borrowings	$	1,950,828		$	2,726,281
Income taxes	$	1,923,000		$	4,622,400
Loans transferred to foreclosed real estate during the year	$	144,000		$	95,074
Loans to facilitate sale of real estate	$	—		$	—
Unrealized (loss) gain on securities available for sale	$	248,363		$	(363,399	)
Unrealized gain on interest rate swap	$	148,155		$	146,022
Unrealized loss on supplemental executive's retirement plan	$	3,960		$	(218,291	)

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

Table of Contents

MONARCH FINANCIAL HOLDINGS, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. BASIS OF PRESENTATION

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments consisting of normal recurring accruals necessary to present fairly Monarch Financial Holdings, Inc.’s financial position as of June 30, 2014; the consolidated statements of income for the three and six months ended June 30, 2014 and 2013; the consolidated statements of comprehensive income for the three and six months ended June 30, 2014 and 2013; the consolidated statement of changes in stockholders’ equity for the six months ended June 30, 2014 and 2013; and the consolidated statements of cash flows for the six months ended June 30, 2014 and 2013. These financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore, do not include all of the disclosures required by generally accepted accounting principles. The financial statements include the accounts of Monarch Financial Holdings, Inc. and its subsidiaries, and all significant inter-company accounts and transactions have been eliminated. Operating results for the three and six month period ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ended December 31, 2014. Certain immaterial prior year amounts have been reclassified to conform to current year presentations.

Recent Accounting Pronouncements

In January 2014, the FASB issued ASU 2014-01, “Investments-Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in this ASU should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this ASU are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company is currently assessing the impact that ASU 2014-01 will have on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, “Receivables-Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently assessing the impact that ASU 2014-04 will have on its consolidated financial statements.

In April 2014, the FASB issued ASU 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.” The amendments in this ASU change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization’s operations and financial results and include disposals of a major geographic area, a major line of business, or a major equity method investment. The new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. Additionally, the new guidance requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The amendments in the ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-08 to have a material impact on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers: Topic 606”. This ASU applies to any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards. The guidance supersedes the revenue recognition requirements in Topic 605, “Revenue Recognition”, most industry-specific guidance, and some cost guidance

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included in Subtopic 605-35, “Revenue Recognition-Construction-Type and Production-Type Contracts”. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To be in alignment with the core principle, an entity must apply a five step process including: identification of the contract(s) with a customer, identification of performance obligations in the contract(s), determination of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue when (or as) the entity satisfies a performance obligation. Additionally, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer have also been amended to be consistent with the guidance on recognition and measurement. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2014-09 will have on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures”. This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014; however, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2014-11 will have on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, “Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period”. The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation - Stock Compensation (Topic 718)”, should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Company is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.

NOTE 2. GENERAL

Monarch Financial Holdings, Inc. (the "Company" "Monarch") is a Virginia-chartered, single bank holding company engaged in business and consumer banking, investment and insurance sales, and mortgage origination and brokerage. The Company was created on June 1, 2006 through a reorganization plan, under the laws of the Commonwealth of Virginia, in which Monarch Bank (the "Bank") became a wholly-owned subsidiary. Monarch Bank was incorporated on May 1, 1998, and opened for business on April 14, 1999. The Company's corporate office and main office are both located in the Greenbrier area of Chesapeake. In addition there are ten other Virginia banking offices – in the Great Bridge area in Chesapeake, the Lynnhaven area, the Town Center area, the Oceanfront area, the Kempsville area, and the Hilltop area in Virginia Beach, the Ghent area and in the downtown area in Norfolk, the southwest area in Suffolk, and the New Town area in Williamsburg. In North Carolina our banking division operates as OBX Bank through two offices in Kitty Hawk and Nags Head.

In August 2001, we formed Monarch Investment, LLC, to enable us to offer additional services to our clients. The Bank owns 100% of Monarch Investment, LLC. In August 2012, the Company formed an affiliation with Raymond James Financial Services, Inc., a broker-dealer headquartered in St. Petersburg, Florida, and launched Monarch Bank Private Wealth ("MBPW"). MBPW is a division of Monarch Bank that offers private banking to high net worth individuals. In addition, through its affiliation with Raymond James Financial Services, Inc., MBPW is able to offer these same individuals financial planning, trust and investment services. Monarch Investment, LLC, continues to provide non-deposit investment services under the name of Monarch Investments.

In January 2003, Monarch Investment, LLC, purchased a non-controlling interest in Bankers Insurance, LLC, in a joint venture with the Virginia Bankers Association and many other community banks. Bankers Insurance, LLC, is a full service property/

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casualty and life/health agency that ranks as one of the largest agencies in Virginia. Bankers Insurance, LLC, provides insurance to our customers and to the general public.

In February 2004, we formed Monarch Capital, LLC, for the purpose of engaging in the commercial real estate brokerage business. The Bank owns 100% of Monarch Capital, LLC.

In May 2007, Monarch expanded banking operations into northeastern North Carolina with the opening of a banking office in the town of Kitty Hawk, under the name of OBX Bank (OBX). We opened a second office in the town of Nags Head in December 2009. OBX Bank, which operates as a division of Monarch, is led by a local management team and a local advisory board of directors.

In June 2007, we announced the expansion of mortgage operations through the acquisition of a team of experienced mortgage bankers, and the formation of a division operating as Monarch Mortgage ("MM"). MM originates and sells conventional, FHA, VA and VHDA residential loans and offers additional mortgage products such as construction-permanent loans for the Bank’s loan portfolio. Monarch Mortgage's primary office is in Virginia Beach with additional offices in Alexandria, Chesapeake, Fairfax, Fredericksburg, Manassas, Midlothian, Norfolk, Newport News, Oakton, Reston, Richmond, Suffolk, and Woodbridge, Virginia, Annapolis, Bowie, Crofton, Dunkirk, Frederick, Greenbelt, Rockville,Towson and Waldorf, Maryland and Charlotte, Kitty Hawk, Mooresville, Nags Head, Southport and Wilmington, North Carolina, and Greenwood, South Carolina.

In July 2007, Monarch Investment, LLC, purchased a 50.01% ownership in Coastal Home Mortgage, LLC, from another bank. This joint venture provides residential loan services through Monarch Mortgage. The 49.99% ownership is shared by four individuals involved in commercial and residential construction in the Hampton Roads area.

In October 2007, Monarch Investment, LLC, formed a title insurance company, Real Estate Security Agency, LLC (RESA), along with TitleVentures, LLC. Monarch Investment, LLC, owns 75% of RESA and TitleVentures, LLC, owns 25%. RESA offers residential and commercial title insurance to the clients of Monarch Mortgage and Monarch Bank.

In March 2010, Monarch Investment, LLC, formed Regional Home Mortgage, LLC, in Chesapeake, Virginia. Monarch Investment, LLC, owns 51% and TREG Funding, LLC owns 49% of the company, which was formed for the primary purpose of providing residential mortgages to clients of TREG Funding, LLC. TREG Funding, LLC is associated with The Real Estate Group, a leading realty firm in Chesapeake and Virginia Beach, Virginia.

In September 2010, Monarch Investment, LLC, formed Monarch Home Funding, LLC, in Norfolk, Virginia. The primary purpose of the company, of which Monarch Investment, LLC, owned 51% and Danaus, LLC, owned 49%, was to provide residential mortgages to clients of Danaus, LLC. Danaus, LLC was associated with Nancy Chandler Associates, a leading realty firm with offices in Norfolk and Chesapeake, Virginia. This company was liquidated as of March 31, 2014.

In March 2011, Monarch Investment, LLC, formed Crossways Holdings, LLC, in Chesapeake, Virginia. Crossways Holdings, LLC is a single member limited liability company, formed for the purpose of acquiring, maintaining, utilizing and disposing of assets for Monarch Bank.

NOTE 3. EARNINGS PER SHARE (“EPS”)

Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised, converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations.



	For the Three Months Ended June 30,
	2014		2013
Net income available to common shareholders (numerator, basic)	$	3,183,574	$	3,066,638
Weighted average shares outstanding - basic (denominator)	10,620,869		10,401,992
Income per common share—basic	$	0.30	$	0.29
Net income (numerator, diluted)	$	3,183,574	3,066,638
Weighted average shares—diluted (denominator)	10,660,217		10,483,420
Income per common share—diluted	$	0.30	$	0.29
Dilutive effect-average number of common shares	39,348		81,428
Dilutive effect-average number of convertible non-cumulative perpetual preferred, if converted	—		—
Dilutive effect-average number of shares	39,348		81,428

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	For the Six Months Ended June 30,
	2014		2013
Net income available to common shareholders (numerator, basic)	$	5,720,839	$	6,524,767
Weighted average shares outstanding - basic (denominator)	10,596,786		9,854,418
Income per common share—basic	$	0.54	$	0.66
Net income (numerator, diluted)	$	5,720,839	6,524,767
Weighted average shares—diluted (denominator)	10,636,968		10,467,707
Income per common share—diluted	$	0.54	$	0.62
Dilutive effect-average number of common shares	40,182		73,986
Dilutive effect-average number of convertible non-cumulative perpetual preferred, if converted	—		539,303
Dilutive effect-average number of shares	40,182		613,289

There were no options to purchase common stock excluded from the computation of earnings per common share for the three and six months ended June 30, 2014 or June 30, 2013.

On November 30, 2009, we issued and sold 800,000 shares of Series B noncumulative convertible perpetual preferred stock ("Series B" or "Series B preferred") at $25.00 per share in a public offering. Each share of Series B preferred was convertible at the option of the shareholder to 3.75 shares of common stock (reflecting a split adjusted original conversion price of $6.67 per share of common stock), subject to some adjustments. The Series B preferred stock also carried a forced conversion option for the Company which could be exercised if for 20 trading days within any period of 30 consecutive trading days, the closing price of common stock exceeded 130% of the then applicable conversion price (split adjusted price $8.67). The Series B preferred stock was also redeemable by the Company, in whole or in part, on or after the third anniversary of the issue date (November 30, 2012) for the liquidation amount of $25.00 per share plus any declared and unpaid dividends. Holders of our Series B preferred stock began exercising their option to convert to common stock in June 2012. On March 8, 2013, the Company force converted all remaining outstanding shares of Series B preferred stock. There were no remaining shares outstanding at March 31, 2014 or 2013. The dilutive impact of these shares is included in the year to date earnings per share calculation at June 30, 2013.

The table below summarizes the conversion activity.



	(a)	(b)	(c)	(d)
Period	Total Number of Shares of Preferred Stock Converted to Common Stock	Total Number of Shares of Common Stock After Conversion	Total Number of Preferred Shares Remaining to Convert	Maximum Number of Post Conversion Whole Shares Remaining That May Yet Be Converted
March 1, 2013 - March 8, 2013	271,020	1,016,312	—	—
February 1, 2013 - February 28, 2013	172,074	645,264	271,020	1,016,325
January 1, 2013 - January 31, 2013	38,029	142,608	443,094	1,661,602
December 1, 2012 - December 31, 2012	6,966	26,121	481,123	1,804,211
November 1, 2012 - November 30, 2012	147,456	552,950	488,089	1,830,333
October 1, 2012 - October 31, 2012	153,355	575,071	635,545	2,383,293
June 1, 2012 - June 30, 2012	30	41,623	788,900	2,958,375

NOTE 4. OTHER COMPREHENSIVE INCOME

The following table presents the changes in accumulated other comprehensive income, by category, net of tax:

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	Unrealized Loss on Supplemental Executive's Retirement Plan			Unrealized Gains on Securities			Unrealized Loss on Interest Rate Swap			Accumulated Other Comprehensive Income (Loss)
Balance at April 1, 2014	$	(138,028	)	$	(76,090	)	$	(99,659	)	$	(313,777	)
Net change for the quarter ended June 30, 2014	1,287			103,882			49,422			154,591
Balance at June 30, 2014	$	(136,741	)	$	27,792		$	(50,237	)	$	(159,186	)

Balance at December 31, 2013	(139,315		)	(133,644		)	(146,537		)	(419,496		)
Net change for the six months ended June 30, 2014	2,574			161,436			96,300			260,310
Balance at June 30, 2014	(136,741		)	27,792			(50,237		)	(159,186		)

Balance at April 1, 2013	$	—		$	111,186		$	(285,260	)	$	(174,074	)
Net change for the quarter ended June 30, 2013	(141,889		)	(211,637		)	47,424			(306,102		)
Balance at June 30, 2013	$	(141,889	)	$	(100,451	)	$	(237,836	)	$	(480,176	)

Balance at December 31, 2012	$	—		$	137,847		$	(337,869	)	$	(200,022	)
Net change for the six months ended June 30, 2013	(141,889		)	(238,298		)	100,033			(280,154		)
Balance at June 30, 2013	$	(141,889	)	$	(100,451	)	$	(237,836	)	$	(480,176	)

In the second quarter of 2013 an unrealized loss of $143,176, net of tax, associated with a change in the discount rate on the Company's Supplemental Executive's Retirement Plan ("SERP") from 5.85% to 4.50%, was moved into other comprehensive income. Expenses of $1,287 and $2,574 related to SERP were re-classed out of other comprehensive income into other expense in earnings during the second quarter and first six months ended June 30, 2014. Expense of $1,287 was re-classed out of accumulated other comprehensive income into earnings during the second quarter and first six months ended June 30, 2013.

NOTE 5. INVESTMENT SECURITIES

Securities available-for-sale consist of the following:



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
June 30, 2014
U.S. government agency obligations	$	20,394,373	$	37,513	$	(69,690	)	$	20,362,196
Mortgage-backed securities	1,425,966		14,798		(2,623		)	1,438,141
Municipal securities	1,909,430		73,441		(10,682		)	1,972,189
Corporate debt securities	—		—		—			—
	$	23,729,769	$	125,752	$	(82,995	)	$	23,772,526

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
December 31, 2013
U.S. government agency obligations	$	45,542,209	$	1,653	$	(197,951	)	$	45,345,911
Mortgage-backed securities	1,572,910		10,980		(16,729		)	1,567,161
Municipal securities	1,912,248		42,080		(45,640		)	1,908,688
Corporate debt securities	—		—		—			—
	$	49,027,367	$	54,713	$	(260,320	)	$	48,821,760

Monarch did not own any held-to-maturity securities at June 30, 2014 or December 31, 2013.

The amortized cost and fair value of securities by contractual maturity date at June 30, 2014 were as follows:

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Securities available-for-sale:	Amortized Cost		Fair Value
Due in one year or less	$	499,990	$	500,175
Due from one to five years	16,573,261		16,532,561
Due from five to ten years	4,479,519		4,488,174
Due after ten years	2,176,999		2,251,616
Total	$	23,729,769	$	23,772,526

There were twenty-three investments in our securities portfolio with unrealized losses as of June 30, 2014.



As of June 30, 2014	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
U.S. government agency obligations	$	4,393,506	$	(6,298	)	$	7,437,395	$	(63,392	)	$	11,830,901	$	(69,690	)
Mortgage-backed securities	—		—			362,378		(2,623		)	362,378		(2,623		)
Municipal securities	—		—			509,575		(10,682		)	509,575		(10,682		)
Total	$	4,393,506	$	(6,298	)	$	8,309,348	$	(76,697	)	$	12,702,854	$	(82,995	)

Seventeen investments have been in a continuous unrealized loss position for more than 12 months. They are as follows:



	Count	Amortized Cost		Fair Value
U.S. government agency obligations	15	$	7,500,787	$	7,437,395
Mortgage-backed securities	1	365,001		362,378
Municipal securities	1	520,257		509,575
Total	17	$	8,386,045	$	8,309,348

We have the ability to carry these investments to their final maturity. Other-than-temporarily impaired (“OTTI”) guidance for investments states that an impairment is OTTI if any of the following conditions exist: the entity intends to sell the security; it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis; or, the entity does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell). An impaired security identified as OTTI should be separated and losses should be recognized in earnings. These losses are related to changes in the interest rates available for similar securities rather than credit issues with the underlying instruments. We do not intend to sell these securities prior to maturity, at which time the full principal will be recovered. Based on this guidance, there were no securities considered OTTI at June 30, 2014 or December 31, 2013 and there were no losses related to OTTI recognized in accumulated other comprehensive income at June 30, 2014 or December 31, 2013.

NOTE 6. LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSS

The following table provides a breakdown, by class of our loans held for investment at June 30, 2014 and December 31, 2013.

Loans held for Investment

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	June 30, 2014			December 31, 2013
Commercial	$	109,595,604		$	119,367,962
Real estate
Construction	155,350,359			155,551,690
Residential (1-4 family)	98,572,353			89,846,277
Home equity lines	68,784,781			67,177,011
Multifamily	23,930,936			27,392,561
Commercial	239,078,183			250,178,584
Real estate subtotal	585,716,612			590,146,123
Consumers
Consumer and installment loans	4,500,621			2,911,397
Overdraft protection loans	88,530			71,009
Loans to individuals subtotal	4,589,151			2,982,406
Total gross loans	699,901,367			712,496,491
Unamortized loan costs, net of deferred fees	257,355			174,976
Loans held for investment, net of unearned income	700,158,722			712,671,467
Allowance for loan losses	(9,069,877		)	(9,061,369		)
Total net loans	$	691,088,845		$	703,610,098

We have certain lending policies and procedures in place designed to balance loan growth and income with an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, credit concentrations, policy exceptions, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Our loan portfolio is divided into three loan types; commercial, real estate and consumer. Some of these loan types are further broken down into segments. The commercial loan portfolio, which is not broken down further, includes commercial and industrial loans which are usually secured by the assets being financed or other business assets. The real estate portfolio is broken down into construction, residential 1-4 family, home equity lines, multifamily, and commercial real estate loan segments. The consumer loan portfolio is segmented into consumer and installment loans, and overdraft protection loans.

Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand their business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined the borrower’s management possesses sound ethics and solid business acumen, we examine current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and normally incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation or sale of the income producing property securing the loan, or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing our commercial real estate portfolio are diverse in terms of type. This diversity helps reduce our exposure to adverse economic events that could affect any single market or industry. Management monitors and evaluates commercial real estate loans based on purpose, collateral, geography, cash flow, loan to value, and risk grade criteria. As a general rule, we avoid financing special purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At June 30, 2014 approximately 47% and at December 31, 2013, approximately 40% of the outstanding principal balance of our commercial real estate loans portfolio was secured by owner-occupied properties.

With respect to loans to developers and builders, secured by non-owner occupied properties we may originate from time to time, we generally require the borrower to have an existing relationship with the Company and a record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates

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and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of considerable funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, supply and demand, government regulation of real property, general economic conditions and the availability of long-term financing.

We generally require multifamily real estate loan borrowers to have an existing relationship with the Company, a record of success and guarantor financial strength, commensurate with the project size. The underlying feasibility of a multifamily project is stress tested for sensitivity to both capitalization and interest rate changes. Each project is underwritten separately and additional underwriting standards are required for the guarantors, which include, but are not limited to, a maximum loan-to-value percentage, global cash flow analysis and contingent liability analysis. Sources of repayment for these types of loans may be rent rolls or sales of the developed property, either by unit or as a whole.

Consumer and residential loan originations utilize analytics to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. This monitoring, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend, sensitivity analysis, shock analysis and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

We perform periodic reviews on various segments of our loan portfolio in addition to presenting our larger loan relationships for loan committee review. We utilize an independent company to perform a periodic review to evaluate and validate our credit risk program. Results of these reviews are presented to management and our board. Additionally, we are subject to annual examination by our regulators. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as our policies and procedures.

We have an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. This methodology begins with a look at the three loan types; commercial, real estate, and consumer. Loans within the commercial and real estate categories are evaluated on an individual or relationship basis and assigned a risk grade based on the characteristics of the loan or relationship. Loans within the consumer type are assigned risk grades and evaluated as a pool, unless specifically identified through delinquency or other signs of credit deterioration, at which time the identified loan would be individually evaluated.

We designate loans within our loans held for investment portfolio as either “pass” or “watch list” based on nine numerical risk grades which are assigned to the loans. These numeric designations represent, from best to worst: minimal, modest, average, acceptable, acceptable with care, special mention, substandard, doubtful and loss. Special mention, substandard, doubtful and loss risk grades are watch list. A loan risk graded as loss is generally charged-off when identified. A loan risk graded as doubtful is considered watch list and classified as nonaccrual. There were no loans in our portfolio classified as doubtful or loss at June 30, 2014 or December 31, 2013. Special mention loans and substandard loans are considered watch list risk grades and may or may not be classified as nonaccrual, based on current performance. Watch list graded loans or relationships are evaluated individually to determine if all, or a portion, of our investment in the borrower is at risk. If a risk is quantified, a specific loss allowance is assigned to the identified loan or relationship. We evaluate our investment in the borrower using either the present value of expected future cash flows, discounted at the historical effective interest rate of the loan, or for a collateral-dependent loan, the fair value of the underlying collateral.

We evaluate additional risk inherent in our satisfactory risk grade groups through a methodology that looks at these loans on a pool basis by loan segment which is further delineated by purpose. Each segment is assigned an expected loss factor based on a four-year moving average “look-back” at our historical losses for that particular segment. We believe this four year moving average "look back" is a reasonable period of reference to assist us in capturing the loss currently remaining in our loan portfolio and this methodology provides a supportable means of evaluating the potential risk in our portfolio because the delineation by purpose establishes a stronger focus on areas of weakness and strength within the portfolio.

Additional metrics, in the form of environmental risk factors, may be applied to a specific class or risk grade of loans within the portfolio based on local or national trends, identifiable events or other economic factors. For the periods presented, five internal and four external environmental factors were applied to the general risk grade groups. The five internal factors are specific to Monarch with regard to lending policies and practices, nature, volume and term of various portfolios, experience level and depth of management, changes in loan quality and concentrations of credits. The four external environmental factors focus on legal and

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regulatory impacts, changes in economic conditions, competitive pressures and uncertainties surrounding pending governmental actions and their impact on areas within our footprint. The assumptions used to determine the allowance are reviewed to ensure their theoretical foundation, data integrity, computational processes, and reporting practices are appropriate and properly documented.

We utilize various sources in assessing the economic conditions in our target markets and areas of concentration. We track unemployment trends in both Hampton Roads and Virginia compared to the national average. We monitor trends in our industry and among our peers through reports such as the Uniform Bank Performance Report which are made available to us through the Federal Financial Institutions Examination Council. Additionally, we utilize various industry sources that include information published by CB Richard Ellis, an international firm specializing in commercial real estate reporting and REIS, a provider of commercial real estate information and analytics to monitor local, state and national trends.

We evaluate the adequacy of our allowance for loan losses monthly. A degree of imprecision or uncertainty is inherent in our allowance estimates because it requires that we incorporate a range of probable outcomes which may change from period to period. It requires that we exercise judgment as to the risks inherent in our portfolios, economic uncertainties, historical loss and other subjective factors, including industry trends. No single statistic or measurement determines the adequacy of the allowance for loan loss. Changes in the allowance for loan loss and the related provision expense can materially affect net income.

The following table segregates our portfolio between pass and watch list loans, delineated by segments, within loan type for June 30, 2014 and December 31, 2013.



	June 30, 2014
			Watch List						Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total		Weighted Average Risk Grade
Commercial	$	107,356,843	$	—	$	2,238,761	$	109,595,604	3.37
Real estate
Construction	148,703,118		519,603		6,127,638		155,350,359		3.56
Residential (1-4 family)	89,967,818		1,458,384		7,146,151		98,572,353		4.12
Home equity lines	66,972,818		49,314		1,762,649		68,784,781		4.13
Multifamily	21,689,103		1,954,614		287,219		23,930,936		3.48
Commercial	228,854,775		1,686,652		8,536,756		239,078,183		3.76
Real estate subtotal	556,187,632		5,668,567		23,860,413		585,716,612		3.80
Consumers
Consumer and installment loans	4,418,394		—		82,227		4,500,621		4.06
Overdraft protection loans	88,530		—		—		88,530		4.69
Loans to individuals subtotal	4,506,924		—		82,227		4,589,151		4.07
Total gross loans	$	668,051,399	$	5,668,567	$	26,181,401	$	699,901,367	3.73

	December 31, 2013
			Watch List						Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total		Weighted Average Risk Grade
Commercial	$	112,512,939	$	12,891	$	6,842,132	$	119,367,962	3.45
Real estate
Construction	147,478,248		978,247		7,095,195		155,551,690		3.77
Residential (1-4 family)	80,560,400		3,329,470		5,956,407		89,846,277		4.22
Home equity lines	65,790,766		—		1,386,245		67,177,011		4.13
Multifamily	26,078,523		1,005,985		308,053		27,392,561		3.70
Commercial	242,167,855		2,295,326		5,715,403		250,178,584		3.73
Real estate subtotal	562,075,792		7,609,028		20,461,303		590,146,123		3.85
Consumers
Consumer and installment loans	2,823,254		—		88,143		2,911,397		4.10
Overdraft protection loans	71,009		—		—		71,009		4.43
Loans to individuals subtotal	2,894,263		—		88,143		2,982,406		4.11
Total gross loans	$	677,482,994	$	7,621,919	$	27,391,578	$	712,496,491	3.79

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An aging of our loan portfolio by class as of June 30, 2014 and December 31, 2013 is as follows:



Age Analysis of Past Due Loans
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Recorded Investment > 90 days and Accruing		Recorded Investment Nonaccrual Loans
June 30, 2014
Commercial	$	16,486	$	—	$	—	$	16,486	$	109,579,118	$	—	$	—
Real estate
Construction	—		426,200		—		426,200		154,924,159		—		116,800
Residential (1-4 family)	242,911		—		1,360,761		1,603,672		96,968,681		472,052		1,024,359
Home equity lines	—		208,490		27,355		235,845		68,548,936		27,355		533,690
Multifamily	—		—		—		—		23,930,936		—		—
Commercial	—		—		1,352,732		1,352,732		237,725,451		—		1,352,732
Real estate subtotal	242,911		634,690		2,740,848		3,618,449		582,098,163		499,407		3,027,581
Consumers
Consumer and installment loans	133,723		8,397		3,001		145,121		4,355,500		—		3,001
Overdraft protection loans	—		—		—		—		88,530		—		—
Loans to individuals subtotal	133,723		8,397		3,001		145,121		4,444,030		—		3,001
Total gross loans	$	393,120	$	643,087	$	2,743,849	$	3,780,056	$	696,121,311	$	499,407	$	3,030,582

December 31, 2013
Commercial	$	15,000	$	362,103	$	—	$	377,103	$	118,990,859	$	—	$	—
Real estate
Construction	126,164		—		231,398		357,562		155,194,128		—		357,561
Residential (1-4 family)	2,056,872		12,554		1,151,809		3,221,235		86,625,042		472,052		825,964
Home equity lines	49,338		61,526		—		110,864		67,066,147		—		552,193
Multifamily	—		—		—		—		27,392,561		—		—
Commercial	—		—		—		—		250,178,584		—		—
Real estate subtotal	2,232,374		74,080		1,383,207		3,689,661		586,456,462		472,052		1,735,718
Consumers
Consumer and installment loans	213,666		12,087		—		225,753		2,685,644		—		4,352
Overdraft protection loans	—		—		—		—		71,009		—		—
Loans to individuals subtotal	213,666		12,087		—		225,753		2,756,653		—		4,352
Total gross loans	$	2,461,040	$	448,270	$	1,383,207	$	4,292,517	$	708,203,974	$	472,052	$	1,740,070

The column “recorded investment nonaccrual loans”, in the Age Analysis table above, includes nonaccrual loans totaling $3,030,582 and $1,740,070 at June 30, 2014 and December 31, 2013, respectively.

We currently have seven performing loans classified as restructured loans: two commercial real estate loans totaling $4,022,575, four residential 1-4 family loan totaling $875,739, and one consumer loan for $79,226. At June 30, 2014, all restructured loans are current. We restructured two loans in the second quarter of 2014. We did not restructure any loans during the second quarter of 2013. We have not had any defaults on restructured loans within twelve months of restructuring, during the quarter ended June 30, 2014 or 2013.

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Additional information on restructured loans in our portfolio as of June 30, 2014 is as follows:

Troubled Debt Restructurings



	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment
Quarter Ended June 30, 2014	2	691,966	628,966
Quarter Ended June 30, 2013	None	—	—

Troubled Debt Restructurings That Subsequently Defaulted



	Number of Contracts	Recorded Investment
Quarter Ended June 30, 2014	None	—
Quarter Ended June 30, 2013	None	—

A summary of the activity in the allowance for loan losses account is as follows:



Allocation of the Allowance for Loan Losses
				Real Estate
June 30, 2014	Commercial			Construction			Residential			Home Equity			Multifamily		Commercial
Allowance for credit losses:
Beginning balance	$	1,219,255		$	1,978,320		$	1,685,502		$	2,132,916		$	59,586	$	1,305,131
Charge-offs	(14,789		)	(106,812		)	(75,554		)	—			—		—
Recoveries	91,600			15,931			20,639			77,493			—		—
Provision	(445,568		)	(95,900		)	481,437			(226,152		)	8,981		478,787
Ending balance	$	850,498		$	1,791,539		$	2,112,024		$	1,984,257		$	68,567	$	1,783,918

Individually evaluated for impairment	$	343,154		$	630,436		$	854,403		$	571,046		$	—	$	1,037,015
Collectively evaluated for impairment	507,344			1,161,103			1,257,621			1,413,211			68,567		746,903
Financing receivables:
Ending balance	$	109,595,604		$	155,350,359		$	98,572,353		$	68,784,781		$	23,930,936	$	239,078,183
Ending balance: individually evaluated for impairment	2,238,761			6,127,638			6,986,121			1,762,649			287,219		8,536,756
Ending balance: collectively evaluated for impairment	$	107,356,843		$	149,222,721		$	91,586,232		$	67,022,132		$	23,643,717	$	230,541,427



	Consumers
	Consumer and Installment loans		Overdraft Protection			Unallocated			Total
Allowance for credit losses:
Beginning balance	$	99,271	$	688		$	580,700		$	9,061,369
Charge-offs	—		—			—			(197,155		)
Recoveries	—		—			—			205,663
Provision	1,502		(449		)	(202,638		)	—
Ending balance	$	100,773	$	239		$	378,062		$	9,069,877

Individually evaluated for impairment	$	79,226	$	—		$	—		$	3,515,280
Collectively evaluated for impairment	21,547		239			378,062			5,554,597
Financing receivables:
Ending balance	$	4,500,621	$	88,530		$	—		$	699,901,367
Ending balance: individually evaluated for impairment	82,227		—			—			26,021,371
Ending balance: collectively evaluated for impairment	$	4,418,394	$	88,530		$	—		$	673,879,996

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				Real Estate
December 31, 2013	Commercial			Construction			Residential			Home Equity			Multifamily			Commercial
Allowance for credit losses:
Beginning balance	$	1,749,641		$	2,360,707		$	1,545,315		$	1,402,448		$	290,532		$	2,882,398
Charge-offs	(2,468,074		)	—			(148,766		)	(582,480		)	—			—
Recoveries	175,991			1,039,591			39,607			98,067			—			20,000
Provision	1,761,697			(1,421,978		)	249,346			1,214,881			(230,946		)	(1,597,267		)
Ending balance	$	1,219,255		$	1,978,320		$	1,685,502		$	2,132,916		$	59,586		$	1,305,131

Individually evaluated for impairment	$	712,699		$	736,248		$	274,259		$	510,118		$	—		$	616,393
Collectively evaluated for impairment	506,556			1,242,072			1,411,243			1,622,798			59,586			688,738
Financing receivables:
Ending balance	$	119,367,962		$	155,551,690		$	89,846,277		$	67,177,011		$	27,392,561		$	250,178,584
Ending balance: individually evaluated for impairment	6,842,132			7,095,195			5,956,407			1,386,245			308,053			5,715,403
Ending balance: collectively evaluated for impairment	$	112,525,830		148,456,495			$	83,889,870		$	65,790,766		$	27,084,508		$	244,463,181



	Consumers
	Consumer and Installment loans			Overdraft Protection			Unallocated			Total
Allowance for credit losses:
Beginning balance	$	55,192		$	501		$	623,266		$	10,910,000
Charge-offs	(22,759		)	(416		)	—			(3,222,495		)
Recoveries	587			21			—			1,373,864
Provision	66,251			582			(42,566		)	—
Ending balance	$	99,271		$	688		$	580,700		$	9,061,369

Individually evaluated for impairment	$	83,792		$	—		—			$	2,933,509
Collectively evaluated for impairment	15,479			688			580,700			6,127,860
Financing receivables:
Ending balance	$	2,911,397		$	71,009		$	—		$	712,496,491
Ending balance: individually evaluated for impairment	88,143			—			—			27,391,578
Ending balance: collectively evaluated for impairment	$	2,823,254		$	71,009		$	—		$	685,104,913

A loan is considered impaired when, based on current information and events; it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. In addition to loans 90 days past due and still accruing, nonaccrual loans and restructured loans, all loans risk graded doubtful or substandard qualify, by definition, as impaired.

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The following table sets forth our impaired loans at June 30, 2014 and December 31, 2013.



Impaired Loans
	With No Related Allowance
	Recorded Investment		Unpaid Principal Balance		Average Recorded Investment		Interest Income Recognized
June 30, 2014
Commercial	$	768,783	$	768,783	$	773,647	$	29,312
Real estate
Construction	4,063,532		4,063,532		4,076,185		112,257
Residential (1-4 family)	3,342,118		3,607,006		3,398,284		83,369
Home equity lines	899,227		962,201		900,626		8,785
Multifamily	287,219		287,219		296,773		9,849
Commercial	2,687,112		2,687,113		2,878,656		74,778
Consumers
Consumer and installment loans	3,001		4,448		3,834		—
Overdraft protection loans	—		—		—		—
Total	$	12,050,992	$	12,380,302	$	12,328,005	$	318,350
December 31, 2013
Commercial	$	776,894	$	776,894	$	773,156	$	62,141
Real estate
Construction	4,790,328		4,790,328		5,211,772		287,107
Residential (1-4 family)	4,800,479		5,057,318		4,968,002		230,432
Home equity lines	666,794		714,083		714,644		4,062
Multifamily	308,053		308,053		325,385		21,972
Commercial	2,725,290		2,725,290		3,066,767		216,296
Consumers
Consumer and installment loans	4,351		5,543		10,700		—
Overdraft protection loans	—		—		—		—
Total	$	14,072,189	$	14,377,509	$	15,070,426	$	822,010

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	With Related Allowance
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
June 30, 2014
Commercial	$	1,469,978	$	1,469,978	$	343,154	$	1,504,750	$	46,942
Real estate
Construction	2,064,106		2,080,404		630,436		2,068,885		54,146
Residential (1-4 family)	3,644,003		3,654,396		854,403		4,197,844		116,076
Home equity lines	863,422		863,422		571,046		865,143		17,978
Multifamily	—		—		—		—		—
Commercial	5,849,644		6,220,335		1,037,015		6,366,543		302,216
Consumers
Consumer and installment loans	79,226		79,226		79,226		82,085		1,434
Overdraft protection loans	—		—		—		—		—
Total	$	13,970,379	$	14,367,761	$	3,515,280	$	15,085,250	$	538,792
December 31, 2013
Commercial	$	6,065,238	$	6,065,238	$	712,699	$	7,909,717	$	516,400
Real estate
Construction	2,304,867		2,336,216		736,248		2,336,327		108,594
Residential (1-4 family)	1,155,928		1,161,148		274,259		1,036,338		47,930
Home equity lines	719,451		719,451		510,118		720,206		41,035
Multifamily	—		—		—		—		—
Commercial	2,990,113		2,990,113		616,393		3,097,242		443,415
Consumers
Consumer and installment loans	83,792		83,792		83,792		11,124		472
Overdraft protection loans	—		—		—		—		—
Total	$	13,319,389	$	13,355,958	$	2,933,509	$	15,110,954	$	1,157,846

NOTE 7. FAIR VALUE ACCOUNTING

Fair Value Hierarchy and Fair Value Measurement

We group our assets and liabilities that are recorded 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. These levels are:


•	Level 1 – Valuations based on quoted prices in active markets for identical assets or liabilities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.


•	Level 2 – Valuations based on quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-based valuations for which all significant assumptions are observable or can be corroborated by observable market data.


•	Level 3 – Valuations 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. Valuations are determined using pricing models and discounted cash flow models and includes management judgment and estimation which may be significant.

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The following table presents our assets and liabilities related to continuing operations, which are measured at fair value on a recurring basis for each of the fair value hierarchy levels, as of June 30, 2014 and December 31, 2013:



	Fair Value Measurements at Reporting Date Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Description
Assets at June 30, 2014
Investment securities—available for sale
U.S. government agency obligations	$	20,362,196	$	—	$	20,362,196	$	—
Mortgage-backed securities	1,438,141		—		1,438,141		—
Municipal securities	1,972,189		—		1,972,189		—
Loans held for sale	156,584,246		—		156,584,246		—
Interest rate lock commitments	1,347,870		—		1,347,870		—
Derivative financial asset	1,873,253		—		1,873,253		—
Liabilities at June 30, 2014
Derivative financial liability	2,769,024		—		2,769,024		—
Assets at December 31, 2013
Investment securities—available for sale
U.S. government agency obligations	$	45,345,911	$	—	$	45,345,911	$	—
Mortgage-backed securities	1,567,161		—		1,567,161		—
Municipal securities	1,908,688		—		1,908,688		—
Corporate debt securities	—		—		—		—
Loans held for sale	99,717,785		—		99,717,785		—
Liabilities at December 31, 2013
Derivative financial liability	225,442		—		225,442		—

The following table provides quantitative disclosures about the fair value measurements of our assets related to continuing operations which are measured at fair value on a nonrecurring basis as of June 30, 2014 and December 31, 2013.



	Fair Value Measurements at Reporting Date Using
Description	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
At June 30, 2014
Real estate owned	$	144,000	$	—	$	—	$	144,000
Restructured and impaired loans, net	10,455,099		—		—		10,455,099
At December 31, 2013
Real estate owned	$	301,963	$	—	$	—	$	301,963
Restructured and impaired loans, net	10,385,880		—		—		10,385,880

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The following table displays quantitative information about Level 3 Fair Value Measurements for June 30, 2014 and December 31, 2013.



	Fair Value Measurement at June 30, 2014
	Fair Value		Valuation Technique	Unobservable Inputs	Weighted Average
Commercial	$	1,126,824	Market comparables	Discount applied to market comparables (1)	27	%
Real Estate
Construction	1,433,670		Market comparables	Discount applied to market comparables (1)	43	%
Residential (1-4 family)	2,789,600		Market comparables	Discount applied to market comparables (1)	18	%
Home equity lines	292,376		Market comparables	Discount applied to market comparables (1)	25	%
Multifamily	—		Market comparables	Discount applied to market comparables (1)	—	%
Commercial	4,812,629		Market comparables	Discount applied to market comparables (1)	24	%
Consumer
Consumer and installment loans	—		Market comparables	Discount applied to market comparables (1)	100	%
Total restructures and impaired loans	$	10,455,099
Real estate owned	$	144,000	Market comparables	Discount applied to market comparables (1)	36	%



	Fair Value Measurement at December 31, 2013
	Fair Value		Valuation Technique	Unobservable Inputs	Weighted Average
Commercial	$	5,352,539	Market comparables	Discount applied to market comparables (1)	18	%
Real Estate
Construction	1,568,619		Market comparables	Discount applied to market comparables (1)	44	%
Residential (1-4 family)	881,669		Market comparables	Discount applied to market comparables (1)	40	%
Home equity lines	209,333		Market comparables	Discount applied to market comparables (1)	26	%
Multifamily	—		Market comparables	Discount applied to market comparables (1)	—	%
Commercial	2,373,720		Market comparables	Discount applied to market comparables (1)	19	%
Consumer
Consumer and installment loans	—		Market comparables	Discount applied to market comparables (1)	100	%
Total restructures and impaired loans	$	10,385,880
Real estate owned	$	301,963	Market comparables	Discount applied to market comparables (1)	11	%

(1) A discount percentage is applied based on age of independent appraisals, current market conditions, and experience within the local markets.

For the three and six months ended June 30, 2014 a loss of $33,263 was reported on the sale of other real estate owned. No gains were reported. For the three and six months ended June 30, 2013 there were no gains or losses to report on the sale of other real estate owned. Gains or losses on sale of other real estate owned are included in foreclosed property expense.

At the time a loan secured by real estate becomes real estate owned, we record the property at fair value net of estimated selling costs. Upon foreclosure and through liquidation, we evaluate the property’s fair value as compared to its carrying amount and record a valuation adjustment when the carrying amount exceeds fair value. Any valuation adjustments at the time a loan becomes real estate owned is charged to the allowance for loan losses. Any subsequent valuation adjustments are applied to earnings in our consolidated statements of income. No valuation adjustments related to other real estate owned were recorded in the three and six months ended June 30, 2014 or 2013. Adjustments, when necessary, are included in foreclosed property expense.

Valuation Methods

The following notes summarize the significant assumptions used in estimating the fair value of financial instruments:

Short-term financial instruments are valued at their carrying amounts and included in the Company’s balance sheet, which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments. This approach applies to cash and cash equivalents, loans held for sale and overnight borrowings.

Investment securities – available-for-sale are valued at quoted market prices, if available. For securities for which no quoted market price is available, we estimate the fair value on the basis of quotes for similar instruments or other available information. Investment securities classified as available-for-sale are reported at their estimated fair value with unrealized gains and losses

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reported in accumulated other comprehensive income. To the extent that the cost basis of investment securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. The specific identification method is used in computing realized gains or losses.

Loans held for sale are recorded at their fair value when originated and reevaluated quarterly, based on our expected return from the secondary market.

Loans held for investment are valued on the basis of estimated future receipts of principal and interest, which are discounted at various rates. Loan prepayments are assumed to occur at the same rate as in previous periods when interest rates were at levels similar to current levels. Future cash flows for homogeneous categories of consumer loans, such as motor vehicle loans, are estimated on a portfolio basis and discounted at current rates offered for similar loan terms to new borrowers with similar credit profiles.

The carrying amounts of accrued interest approximate fair value.

Interest rate lock commitments ("IRLC") are recorded at fair value, which is based on estimated future receipts net of estimate future expenses when the underlying loan is sold on the secondary market, using observable Level 2 market inputs, reflecting current market inputs as of the measurement date.

Restricted equity securities are recorded at cost, which approximates fair value.

Bank owned life insurance represents insurance policies on officers of the Bank. The cash values of the policies are estimated using information provided by insurance carriers. These policies are carried at their cash surrender value, which approximates the fair value.

The fair value of demand deposits and deposits with no defined maturity is taken to be the amount payable on demand at the reporting date. The fair value of fixed-maturity deposits is estimated using rates currently offered for deposits of similar remaining maturities. The intangible value of long-term relationships with depositors is not taken into account in estimating the fair values disclosed.

The fair value of all borrowings is based on discounting expected cash flows at the interest rate of debt with the same or similar remaining maturities and collateral requirements.

Derivative financial instruments are recorded at fair value using observable Level 2 market inputs related to:

•Loans held for sale forward sales commitments are recorded at their fair value based on the estimated number of days remaining in the IRLC at the measurement date and expected return from the secondary market. Forward mortgage loan sales commitments are recorded at their fair value based on the gain or loss that would occur if the loan were paired off with an investor at measurement date. A derivative asset of $1,873,253 and a derivative liability of $2,691,737 related to loans held for sale were recorded at June 30, 2014. No derivative assets or liabilities related to loans held for sale were recorded at December 31, 2013.

•A rate swap on Trust Preferred stock has been recorded at fair value based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date. Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction. Valuation adjustments may be made to reflect both our credit risk and the counterparties’ credit quality in determining the fair value of the derivative. Level 2 inputs for the valuations are limited to observable market prices for London Interbank Offered Rate (LIBOR) observable market prices for LIBOR swap rates, and three month LIBOR basis spreads at commonly quoted intervals. Our derivative financial liability consists of an interest rate swap that qualifies as a cash flow hedge which had an unrealized loss of $77,287 at June 30, 2014 and $225,442 at December 31, 2013.

Real Estate Owned is carried at the fair value less estimated selling costs. Upon foreclosure and through liquidation, we evaluate the property's fair value as compared to its carrying amount and record a valuation adjustment when the carrying amount exceeds fair value less selling costs. Any valuation adjustments at the time a loan becomes real estate owned is charged to the allowance for loan losses. Fair value is determined through an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). When evaluating fair value, management may discount the appraisal further if, based on their understanding of the market conditions, it is determined the collateral is further impaired below the appraisal value (Level 3). Any subsequent valuation adjustments are applied to earnings in our consolidated statements of income. We did not record any losses due to valuation adjustments for the three and six months ended June 30, 2014. We recorded $0 losses due to valuation adjustments on real estate owned within foreclosed property expense in the year ended December 31, 2013.

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Restructured and Impaired Loans measurement is generally based on the present value of expected future cash flows discounted at the loan's effective interest rate, unless in the case of collateral-dependent loans, the observable market price, or the fair value of the collateral can be readily determined. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). When evaluating fair value, management may discount the appraisal further if, based on their understanding of the market conditions, it is determined the collateral is further impaired below the appraised value (Level 3). The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Restructured and impaired loans are periodically reevaluated to determine if additional adjustments to the carrying value are necessary.

It is not practicable to separately estimate the fair values for off-balance-sheet credit commitments, including standby letters of credit and guarantees written, due to the lack of cost-effective reliable measurement methods for these instruments.

Fair Value of Financial Instruments

The following table presents the carrying amounts and fair value of our financial instruments at June 30, 2014 and December 31, 2013. GAAP defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than through a forced or liquidation sale for purposes of this disclosure. The carrying amounts in the table are included in the balance sheet under the indicated captions.

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			Fair Value Measurements at June 30, 2014 using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Carrying Value		Level 1		Level 2		Level 3		Balance
Assets
Cash and cash equivalents	$	86,587,868	$	86,587,868	$	—	$	—	$	86,587,868
Investment securities available for sale	23,772,526		—		23,772,526		—		23,772,526
Loans held for sale	156,584,246		—		156,584,246		—		156,584,246
Loans held for investment (net)	691,088,845		—		—		703,232,410		703,232,410
Accrued interest receivable	1,982,027		—		1,982,027		—		1,982,027
Restricted equity securities	3,168,700		—		3,168,700		—		3,168,700
Bank owned life insurance	7,526,115		—		7,526,115		—		7,526,115
Interest rate lock commitments	1,347,870		—		1,347,870		—		1,347,870
Derivative financial assets	1,873,253		—		1,873,253		—		1,873,253
Liabilities
Deposits	$	891,293,114	$	—	$	887,920,019	$	—	$	887,920,019
Borrowings	11,125,492		—		11,184,959		—		11,184,959
Accrued interest payable	55,574		—		55,574		—		55,574
Derivative financial liabilities	2,769,024		—		2,769,024		—		2,769,024

			Fair Value Measurements at December 31, 2013 using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Carrying Value		Level 1		Level 2		Level 3		Balance
Assets
Cash and cash equivalents	$	104,911,322	$	104,911,322	$	—	$	—	$	104,911,322
Investment securities available for sale	48,821,760		—		48,821,760		—		48,821,760
Loans held for sale	99,717,785		—		99,717,785		—		99,717,785
Loans held for investment (net)	703,610,098		—		—		716,133,189		716,133,189
Accrued interest receivable	2,152,132		—		2,152,132		—		2,152,132
Restricted equity securities	3,683,250		—		3,683,250		—		3,683,250
Bank owned life insurance	7,409,436		—		7,409,436		—		7,409,436
Liabilities
Deposits	$	893,118,490	$	—	$	889,702,779	$	—	$	889,702,779
Borrowings	11,175,485		—		11,259,958		—		11,259,958
Accrued interest payable	58,404		—		58,404		—		58,404
Derivative financial liability	225,442		—		225,442		—		225,442

NOTE 8. STOCK-BASED COMPENSATION

In May 2014, Monarch stockholders ratified the adoption of the Monarch Bank 2014 Equity Incentive Plan ("2014EIP"), a stock-based compensation plan which succeeds the Monarch Bank 2006 Equity Incentive Plan (“2006EIP”). The 2006EIP had succeeded the Monarch Bank 1999 Incentive Stock Option Plan ("1999ISO") and was the only plan under which equity-based compensation could be awarded. Like the 2006EIP, the 2014EIP authorizes the compensation committee to grant options, stock appreciation rights, stock awards, performance stock awards, and stock units to designated directors, officers, key employees, consultants and advisers to the Company and its subsidiaries.

The 2014EIP authorized the Company to issue up to 1,000,000 shares of Monarch Common Stock plus the number of shares of our Common Stock outstanding under the predecessor plans. The Plan also provides that no award may be granted more than 10 years after the May 2014 ratification date.

As of June 30, 2014, 206,957 shares were available for grants under the predecessor plans. A total of 526,582 shares are subject to outstanding awards under the 2006EIP and 1999ISO, including 121,072 stock options and 405,510 shares of non-vested

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restricted stock. The stock options outstanding as of June 30, 2014 have a weighted average exercise price of $7.80 and a weighted average remaining term of 11 months and are fully vested. Restricted stock typically vests over a 60 month period. Total compensation costs are recognized over the service period to vesting.

No additional options were granted in the periods covered. There were 1,586 and 25,456 in options exercised in the second quarter and first half of 2014. No options on shares were forfeited in the second quarter and first half of 2014.

Compensation expense related to our restricted stock totaled $195,803 and $419,049 in the second quarter and first half of 2014. Remaining vesting periods are between 6 and 54 months with unrecognized remaining compensation expense of $1,921,896. We issued 0 and 87,750 shares of restricted stock in the second quarter and first half of 2014. No shares vested and 2,700 and 3,700 shares were forfeited in the second quarter and first half of 2014.

NOTE 9. SEGMENT REPORTING

Reportable segments include community banking and retail mortgage banking services. Community banking involves making loans to and generating deposits from individuals and businesses in the markets where we have offices. Retail mortgage banking originates residential loans and subsequently sells them to investors. Our mortgage banking segment is a strategic business unit that offers different products and services. It is managed separately because the segment appeals to different markets and, accordingly, requires different technology and marketing strategies.

Funding for retail mortgage banking services' loans held for sale (LHFS) portfolio is provided by community banking services. The outstanding LHFS balance and related interest earned for the bank's interim holding period of these loans is recorded in the community banking segment. This interim interest income was $1,274,498 and $2,047,230 in the second quarter and first half of 2014, respectively. In the second quarter and first half of 2013 interim interest income was $1,773,692 and $4,507,264, respectively. In the event of early payment default, Monarch has recorded a reserve for loan repurchases which totaled $2,675,126 at June 30, 2014 and $3,171,891 at December 31, 2013. Our reserve for loan repurchases is not a part of our loan loss reserve and is carried in other liabilities. This reserve, which is an estimate of the potential for losses based on investor contracts, is not an indication that losses will occur and is periodically analyzed and adjusted through income.

The retail mortgage banking segment’s most significant revenue and expense is non-interest income and non-interest expense, respectively. We do not have other reportable operating segments. (The accounting policies of the segments are the same as those described in the summary of significant accounting policies in Note 1 of our annual 10-K.) All inter-segment sales prices are market based. The assets and liabilities and operating results of our other wholly owned subsidiary, Monarch Capital, LLC, are included in the mortgage banking segment. Monarch Capital, LLC, provides commercial mortgage brokerage services.

Segment information for the three and six months ended June 30, 2014 and 2013 is shown in the following tables.

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Selected Financial Information



	Commercial and Other Banking			Mortgage Banking Operations			Inter-segment Eliminations			Total
Quarter Ended June 30, 2014
Income:
Interest income	$	10,397,287		$	159,705		$	—		$	10,556,992
Non-interest income	1,304,304			17,369,228			(174,659		)	18,498,873
Total operating income	11,701,591			17,528,933			(174,659		)	29,055,865
Expenses:
Interest expense	(976,886		)	—			—			(976,886		)
Provision for loan losses	—			—			—			—
Personnel expense	(3,930,738		)	(11,327,260		)	(4,470		)	(15,262,468		)
Other non-interest expenses	(3,970,887		)	(3,952,758		)	179,129			(7,744,516		)
Total operating expenses	(8,878,511		)	(15,280,018		)	174,659			(23,983,870		)
Income before income taxes	2,823,080			2,248,915			—			5,071,995
Provision for income taxes	(983,793		)	(783,707		)	—			(1,767,500		)
Less: Net income attributable to non-controlling interests	(6,857		)	(114,064		)	—			(120,921		)
Net income attributable to Monarch Financial Holdings, Inc.	$	1,832,430		$	1,351,144		$	—		$	3,183,574

Quarter Ended June 30, 2013
Income:
Interest income	$	10,768,727		$	206,760		$	—		$	10,975,487
Non-interest income	1,483,453			20,572,388			(381,570		)	21,674,271
Total operating income	12,252,180			20,779,148			(381,570		)	32,649,758
Expenses:
Interest expense	(1,183,923		)	—			—			(1,183,923		)
Provision for loan losses	—			—			—			—
Personnel expense	(3,565,057		)	(14,626,970		)	(14,548		)	(18,206,575		)
Other non-interest expenses	(2,807,784		)	(5,554,643		)	396,118			(7,966,309		)
Total operating expenses	(7,556,764		)	(20,181,613		)	381,570			(27,356,807		)
Income before income taxes	4,695,416			597,535			—			5,292,951
Provision for income taxes	(1,592,594		)	(205,179		)	—			(1,797,773		)
Less: Net income attributable to non-controlling interests	(19,397		)	(409,143		)	—			(428,540		)
Net income attributable to Monarch Financial Holdings, Inc.	$	3,083,425		$	(16,787	)	$	—		$	3,066,638

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	Commercial and Other Banking			Mortgage Banking Operations			Inter-segment Eliminations			Total
Six Months Ended June 30, 2014
Income:
Interest income	$	20,723,919		$	267,156		$	—		$	20,991,075
Non-interest income	2,526,025			29,571,390			(289,891		)	31,807,524
Total operating income	23,249,944			29,838,546			(289,891		)	52,798,599
Expenses:
Interest expense	(1,947,998		)	—			—			(1,947,998		)
Provision for loan losses	—			—			—			—
Personnel expense	(7,602,757		)	(19,937,330		)	(4,906		)	(27,544,993		)
Other non-interest expenses	(7,315,501		)	(7,187,920		)	294,797			(14,208,624		)
Total operating expenses	(16,866,256		)	(27,125,250		)	289,891			(43,701,615		)
Income before income taxes	6,383,688			2,713,296			—			9,096,984
Provision for income taxes	(2,272,743		)	(965,997		)	—			(3,238,740		)
Less: Net income attributable to non-controlling interests	(6,541		)	(130,864		)	—			(137,405		)
Net income attributable to Monarch Financial Holdings, Inc.	$	4,104,404		$	1,616,435		$	—		$	5,720,839

Six Months Ended June 30, 2013
Income:
Interest income	$	22,337,552		$	491,805		$	—		$	22,829,357
Non-interest income	3,022,890			36,738,324			(905,925		)	38,855,289
Total operating income	25,360,442			37,230,129			(905,925		)	61,684,646
Expenses:
Interest expense	(2,621,605		)	—			—			(2,621,605		)
Provision for loan losses	—			—			—			—
Personnel expense	(6,988,193		)	(26,458,319		)	(30,614		)	(33,477,126		)
Other non-interest expenses	(5,493,899		)	(9,999,019		)	936,539			(14,556,379		)
Total operating expenses	(15,103,697		)	(36,457,338		)	905,925			(50,655,110		)
Income before income taxes	10,256,745			772,791			—			11,029,536
Provision for income taxes	(3,525,243		)	(266,083		)	—			(3,791,326		)
Less: Net income attributable to non-controlling interests	(40,818		)	(672,625		)	—			(713,443		)
Net income attributable to Monarch Financial Holdings, Inc.	$	6,690,684		$	(165,917	)	$	—		$	6,524,767



Segment Assets
June 30, 2014	$	1,017,309,316	$	17,041,995	$	(10,452,719	)	$	1,023,898,592
December 31, 2013	$	1,015,770,066	$	11,991,775	$	(11,061,181	)	$	1,016,700,660

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NOTE 10. GOODWILL AND INTANGIBLE ASSETS

Goodwill and intangible assets with indefinite lives are recorded at cost and are reviewed at least annually for impairment based on evidence of certain impairment indicators. Intangible assets with identifiable lives are amortized over their estimated useful lives. The intangible assets have a weighted-average useful life of 1 month.

Information concerning goodwill and intangible assets is presented in the following table:



	June 30, 2014			December 31, 2013
Amortizable intangible assets	$	1,250,000		$	1,250,000
Accumulated amortization—intangible assets	(1,235,119		)	(1,145,833		)
Amortizable intangible assets, net	$	14,881		$	104,167
Goodwill	$	775,000		$	775,000

Amortization expense for intangible assets totaled $44,643 and $89,286 for both three and six month periods, ending June 30, 2014 and 2013.



Estimated Amortization Expense:
For the remaining months of the year ended 12/31/2014	14,881
	$	14,881

NOTE 11. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

We entered into an interest rate swap agreement with PNC Bank (PNC) of Pittsburgh, PA on July 29, 2009, for our $10 million Trust preferred borrowing, which carries a floating interest rate of 90 day London Interbank Offered Rate (LIBOR) plus 160 basis points. The terms of this hedge allows us to mitigate our exposure to interest-rate fluctuations by swapping our floating rate obligation for a fixed rate obligation. The notional amount of the swap agreement is $10 million, and has an expiration date of September 30, 2014. Under the terms of our agreement, at the end of each quarter we will swap our floating rate for a fixed rate of 3.26%. Including the additional 160 basis points, the effective fixed rate of interest cost will be 4.86% on our $10 million Trust Preferred borrowing for five years.

The fixed-rate payment feature of this swap is structured to mirror the provisions of the hedged borrowing agreement. This swap qualifies as a cash flow hedge and the underlying liability is carried at fair value in other liabilities, with the changes in fair value of the instrument included in Stockholders’ Equity in accumulated other comprehensive income.

Our credit exposure, if any, on the interest rate swap is limited to the net favorable value (net of any collateral pledged) and interest payments of the swap by the counter-party. Conversely, when an interest rate swap is in a liability position we are required to post collateral to PNC which is evaluated monthly and adjusted based on the fair value of the hedge on the last day of the month. The fair value of this swap instrument was a liability of $77 thousand at June 30, 2014 for which our collateral requirement was $100 thousand.

NOTE 12. SUBSEQUENT EVENT

On July 24, 2014 we announced that the Board of Monarch Financial Holdings, Inc., had approved a quarterly common stock cash dividend. The quarterly cash dividend is $0.08 per share for common shareholders of record on August 8, 2013, payable on August 29, 2013.

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ITEM 2.

MONARCH FINANCIAL HOLDINGS, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Company. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and supplemental financial data.

We generate a significant amount of our income from the net interest income earned by Monarch Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the average amount of interest-earning assets outstanding during the period and the interest rates thereon. Monarch Bank’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of our assets further influences the amount of interest income lost due to non-accrual loans and the amount of additions to the allowance for loan losses.

We also generate income from non-interest sources. Non-interest income sources include fee income from residential and commercial mortgage sales, bank related service charges, fee income from the sale of investment and insurance services, fee income from title services, income from bank owned life insurance (“BOLI”) policies, as well as gains or losses from the sale of investment securities.

This report contains forward-looking statements with respect to our financial condition, results of operations and business. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of our management and on information available at the time these statements and disclosures were prepared. Factors that may cause actual results to differ materially from those expected include the following:


•	General economic conditions may deteriorate and negatively impact the ability of borrowers to repay loans and depositors to maintain balances.


•	Changes in interest rates could reduce income.


•	Competitive pressures among financial institutions may increase.


•	The businesses that we are engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards.


•	New products developed or new methods of delivering products could result in a reduction in our business and income.


•	Adverse changes may occur in the securities market.


•	Other factors described from time to time in our reports with the Securities and Exchange Commission.

This section should be read in conjunction with the description of our “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013.

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are those applications of accounting principles or practices that require considerable judgment, estimation, or sensitivity analysis by management. In the financial service industry, examples, though not an all inclusive list, of disclosures that may fall within this definition are the determination of the adequacy of the allowance for loan losses, valuation of derivatives or securities without a readily determinable market value, and the valuation of the fair value of intangibles and goodwill. Except for the determination of the adequacy of the allowance for loan losses, derivative financial instrument estimations and fair value estimations related to foreclosed real estate, we do not believe there are other practices or policies that require significant sensitivity analysis, judgments, or estimations.

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Our financial statements are prepared in accordance with GAAP. The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Our critical accounting policies are listed below. A summary of our significant accounting policies is set forth in Item 8, Note 1 of our Annual Report on Form 10-K for the year ended December 31, 2013.

Allowance for Loan Losses

Our allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on GAAP guidance which requires that losses be accrued when they have a probability of occurring and are estimable and that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses along with various economic factors and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur may be mitigated. The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified loans. Historical loss information, expected cash flows and fair value of collateral are used to estimate these losses. The unallocated allowance captures losses whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. The use of these values is inherently subjective, and our actual losses could be greater or less than the estimates.

Derivative Financial Instruments

We use derivatives to manage risks related to interest rate movements. Interest rate swap contracts designated and qualifying as cash flow hedges are reported at fair value. The gain or loss on the effective portion of the hedge initially is included as a component of other comprehensive income and is subsequently reclassified into earnings when interest on the related debt is paid. We document our risk management strategy and hedge effectiveness at the inception of and during the term of each hedge. Our interest rate risk management strategy is to stabilize cash flow requirements by maintaining interest rate swap contracts to convert variable-rate debt to a fixed rate. We do not hold or issue derivative financial instruments for trading purposes.

We utilize a "best efforts" delivery program for mortgage loans. With best efforts we commit to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding. This 15 to 90 day commitment is an interest rate lock commitment (IRLC). To protect the Company from changes in interest rate, we enter into loan purchase agreements with third party investors that provide for the investor to purchase loans at the same terms, including interest rate, as committed to the borrower. Under the contractual relationship with these third party investors, the Company is obligated to sell the loan to the investor, and the investor is obligated to buy the loan, only if the loan closes. Accounting guidance requires the Company to treat these commitments as if they were paired with the sale of a notional security bearing similar attributes, thereby creating a derivative.

Periodically, we participate in a “mandatory” delivery program for mortgage loans. Under the mandatory delivery system, loans with interest rate locks are paired with the sale of a notional security bearing similar attributes. Interim income or loss on the pairing of the loans and securities is recorded in mortgage banking income on our income statement. In addition, at the time the loan is delivered to an investor, matched securities are repurchased and a gain or loss on the pairing is recorded in mortgage banking income on our income statement. Management has elected to limit our exposure to this form of delivery to $50 million in outstanding loans. We were not participating in the mandatory delivery program at June 30, 2014 or December 31, 2013.

Fair Value Measurements

Under GAAP we are permitted to choose to measure many financial instruments and certain other items at fair value. The estimation of fair value is significant to certain assets, including loans held-for-sale, available-for-sale securities, and foreclosed real estate owned. These assets are recorded at fair value or lower of cost or fair value, as applicable. The fair values of loans held-for-sale are based on commitments from investors. The fair values of available-for-sale securities are based on published market or dealer quotes for similar securities. The fair values of rate lock commitments are based on net fees currently charged to enter into similar agreements. The fair value of foreclosed real estate owned is estimated based on current appraisals, but may be further adjusted based upon our evaluation of the fair value of similar properties.

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Fair values can be volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates, and market conditions, among others. Since these factors can change significantly and rapidly, fair values are difficult to predict and subject to material changes that could impact our financial condition and results of operation.

RESULTS OF OPERATIONS

Net Income

Our consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, after all significant inter-company transactions have been eliminated. Net income attributable to our non-controlling interests of $121 thousand and $429 thousand are deducted for the quarters ended, and $137 thousand and $713 thousand, respectively, for the six months ended June 30, 2014 and 2013, to arrive at net income attributable to Monarch Financial Holdings, Inc. The ensuing references and ratios are related to net income attributable to Monarch Financial Holdings, Inc., (hereon referred to as "net income") after net income attributable to non-controlling interests has been deducted.

Net Income Attributable to Monarch Financial Holdings, Inc.



	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2014			2013			2014			2013
Net income	$	3,304,495		$	3,495,178		$	5,858,244		$	7,238,210
Less: Net income attributable to non-controlling interests	(120,921		)	(428,540		)	(137,405		)	(713,443		)
Net income attributable to Monarch Financial Holdings, Inc.	$	3,183,574		$	3,066,638		$	5,720,839		$	6,524,767

Net income for the quarter ended June 30, 2014 was $3.2 million, an increase of $117 thousand or 3.8% over the same quarter in 2013. Net income for the first half of 2014 was $5.7 million, a decrease of $804 thousand or 12.3% compared to 2013. Basic and diluted earnings per share for the second quarter of 2014 and 2013 were $0.30 and $0.29, respectively. Basic and diluted earnings per share were $0.54 for the first six months of 2014. Basic earnings per share were $0.66 in the first half of 2013, while diluted earnings per share were $0.62.

Two important and commonly used measures of profitability are return on assets (net income as a percentage of average total assets) and return on equity (net income as a percentage of average stockholders’ equity). Our annualized return on assets (“ROA”) for the three months ended June 30, 2014 was 1.29% compared to 1.19% for the same respective period in 2013. Year to date, our ROA was 1.18% in 2014 compared to 1.23% in 2013. Our annualized return on equity (“ROE”) for the second quarter of 2014 were 12.63% compared to 13.42% in 2013, while ROE for the first six months of 2014 was 11.57% compared to 14.61%, one year prior.

Net interest income declined $211 thousand or 2.2% in the second quarter and $1.2 million or 5.8% in the first half of 2014 compared to 2013. Non-interest income declined $3.1 million or 14.7% in the second quarter and $7.0 million or 18.1% in the first half of 2014 compared to 2013. Non-interest expense declined $3.2 million or 12.1% in the second quarter and $6.3 million or 13.1% in the first half of 2014 compared to 2013. These declines are related to an over 35% decrease in production in our loans held for sale between comparative quarters and year to date. This lower production impacted interest income, with regard to closed loans awaiting delivery to investors, earnings on loan production and commission expenses on the loans.

Our provision for loan losses in all periods presented was zero. We reported net charge offs of $143 thousand in the second quarter of 2014 and recoveries in excess of charge offs of $9 thousand in the first half of 2014. We reported recoveries in excess of charge offs of $532 thousand and $409 thousand in the second quarter and first half of 2013.

Net Interest Income

Net interest income, which is the excess of interest income over interest expense, is a major source of banking revenue. A number of factors influence net interest income, including the interest rates earned on earning assets, and the interest rates paid to obtain funding to support the assets, the average volume of interest-earning assets and interest bearing liabilities, and the mix of interest-earning assets and interest bearing liabilities.

Interest rates have been at a record low since December 2008, when the federal funds rate set by the Federal Reserve Bank’s Federal Open Market Committee was reduced to 0.25%. Wall Street Journal Prime Rate (“WSJ”), which generally moves with the federal funds rate, has been 3.25% since December 2008, as well. With rates low but stable, we believe we have been able to

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position our balance sheet to respond quickly in the future when rates begin to rise, and thereby buffer the potential impact of those rising rates.

Net interest income was $9.6 million in the second quarter of 2014 compared to $9.8 million for the same quarter in 2013, a decrease of $211 thousand or 2.2%. Interest income, which was $10.6 million in the second quarter of 2014, declined $418 thousand when compared to the same quarter of 2013. Interest expense was $977 thousand in 2014 compared to $1.2 million in the second quarter of 2013, a reduction of $207 thousand. Year to date, net interest income was $19.0 million in 2014 compared to $20.2 million, one year prior. Interest income declined $1.8 million in 2014 compared to 2013 while interest expense declined $674 thousand.

Our greatest earning assets are loans which are comprised of two major portfolio classifications: loans held for sale and loans held for investment. The declines in interest income noted in both the second quarter and first half of 2014 compared to 2013 is attributable to decreased earnings on our loans held for sale. Asset yield was 4.61% in the second quarter of 2014 compared to 4.60% in 2013. Year to date asset yield was 4.65% for both periods presented.

Loans held for sale, which are residential mortgages originated by our mortgage division and sold to investors, earn interest while on our books but at rates typically lower than our loans held for investment portfolio. This portfolio is also subject to greater fluctuations in outstanding balances due to a combination of market demand, economic conditions and the prevailing mortgage rates. Interest income on our loans held for sale was $1.3 million, $499 thousand less than the $1.8 million earned in the second quarter of 2013. However, this represents a positive trend and an improvement in production levels over the prior quarter when interest income had declined $2.0 million compared to 2013. Year to date interest on our loans held for sale declined $2.5 million to $2.0 million when compared to $4.5 million in interest income in 2013. Shifts in the directionality of loan volume in this portfolio indicate a return to growth that is evident when comparing the average balances for the periods presented. Average volume in the second quarter of 2014 has increased $46 million over the first quarter of 2014. Conversely, average volume in the second quarter of 2013 had declined $115 million from the first quarter of that year. Balances continued declining in the first half of 2013 to $166.6 million from the record high of $419.1 million at year end 2012. Changes in mortgage rates in the later part of 2013 resulted in a sharp decline in volume that bottomed out in the first quarter of 2014. This is supported by balances at June 30, 2014 of $156.6 million, $56.9 million above $99.7 million at year end 2013 and the improvements noted in average balances. Despite these positive trends and a quarter over quarter and year over year increase in yield, of 83 basis points and 87 basis points to 4.37% and 4.39%, income was adversely impacted by average volume.

Loans held for investment are commercial, real estate, and consumer loans originated and maintained on the Bank's books. Interest income on our loans held for investment portfolio for the second quarter of 2014 increased $49 thousand to $9.1 million. Year to date, interest income increased $553 thousand to $18.6 million. Second quarter yield was 5.22%, a decline of 14 basis points from second quarter 2013. Year to date interest yield has declined 7 basis points to 5.36%. Market competition is strong, creating downward pressure on loan pricing which is impacting earnings. During the first quarter of 2014, we took an interest adjustment of $417 thousand related to the payoff of a loan we had purchased at a discount which had a positive impact on yield.

Interest expense declined $207 thousand in the quarter and $674 thousand in the first half of 2014 compared to 2013, driven by interest savings on our time deposit accounts coupled with lower borrowing expense. Average interest bearing liabilities declined $54 million in the second quarter of 2014 due to an $84.4 million decline in average time deposits. Additional cost savings were the result of rate modifications to our money market savings products. Year to date, average interest bearing liabilities declined $99.2 million primarily due to a $74.8 million decline in time deposits but secondarily due to a $58.3 million decline in borrowings. Growth in our non-interest bearing demand accounts and lower volume in our loans held for sale portfolio have temporarily reduced the need for short term borrowings. The decline in time deposit balances resulted in interest savings of $327 thousand. A $58.4 million decline in borrowings resulted in interest expense savings of $297 thousand. Interest expense on money market savings accounts declined $5 thousand in the quarter and $38 thousand year to date despite roughly $35 million in higher volume. Interest cost declined 7 basis points quarter over quarter and 10 basis points year to date.

For analytical purposes, net interest income is adjusted to a taxable equivalent basis to recognize the income tax savings on tax-exempt assets, such as bank owned life insurance (“BOLI”) and state and municipal securities. A tax rate of 35% was used in both 2014 and 2013 when adjusting interest on BOLI and tax-exempt securities to a fully taxable equivalent basis. The difference between rates earned on interest-earning assets (with an adjustment made to tax-exempt income to provide comparability with taxable income, i.e. the “FTE” adjustment) and the cost of the supporting funds is measured by net interest margin.

Our net interest rate spread on a tax-equivalent basis increased 8 basis points in the quarter to 4.01% and 10 basis points to 4.05% in the first half of 2014 compared to 2013. Our net interest margin for the second quarter and first half of 2014 was 4.18% and 4.22%, respectively. This represents an increase over 2013 of 7 basis points quarter over quarter and 10 basis points year to date from 4.11% and 4.12%.

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Bank Owned Life Insurance (BOLI) has been included in interest earning assets. We purchased $6.0 million in BOLI during the fourth quarter of 2005. The income on BOLI is not subject to federal income tax, giving it a tax-effective yield of 4.85% for the second quarter and first half of 2014 compared to 5.03% in 2013.

In July 2006, we increased capital through the issuance of $10,000,000 in trust preferred securities. These securities are treated as subordinated debt and have been included in borrowings. The cost on trust preferred securities is fixed at 4.86%. In June 2012, we added a short term holding company loan from PNC Bank for $5.0 million. We repaid this line June 7, 2013. The line, which qualified as Tier 1 capital for the Bank, was carried in short term borrowings.

The following tables set forth average balances of total interest earning assets and total interest bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, stockholders’ equity and the related income, expense and corresponding weighted average yields and costs.

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The following is an analysis of net interest income, on a taxable equivalent basis.

NET INTEREST INCOME ANALYSIS



	For Three Months Period Ended June 30, 2014							For Three Months Period Ended June 30, 2013
	Average Balance			Income/ Expense		Yield Rate (1)		Average Balance			Income/ Expense		Yield Rate (1)
ASSETS
Securities, at amortized cost	$	23,835,235		$	97,179	1.64	%	$	16,450,943		$	62,562	1.53	%
Loans, held for investment, net	698,850,584			9,089,071		5.22	%	676,893,847			9,040,004		5.36	%
Loans, held for sale	116,850,723			1,274,498		4.37	%	200,733,403			1,773,692		3.54	%
Federal funds sold	40,546,791			24,179		0.24	%	44,726,993			25,312		0.23	%
Dividend-earning restricted equity securities	3,160,577			22,410		2.84	%	3,786,185			69,225		7.33	%
Deposits in other banks	36,816,672			54,905		0.60	%	15,020,300			9,952		0.27	%
Bank owned life insurance (2)	7,491,315			90,623		4.85	%	7,260,613			91,123		5.03	%
Total earning assets	927,551,897			10,652,865		4.61	%	964,872,284			11,071,870		4.60	%
Less: Allowance for loan losses	(9,147,748		)					(10,822,651		)
Nonperforming loans	8,179,965							3,142,906
Total non-earning assets	66,418,610							75,152,608
Total assets	$	993,002,724						$	1,032,345,147
LIABILITIES and STOCKHOLDERS’ EQUITY
Interest-bearing deposits:
Demand	$	50,993,350		$	21,457	0.17	%	$	51,755,109		$	24,216	0.19	%
Savings	24,191,063			24,617		0.41	%	22,394,665			22,809		0.41	%
Money market savings	370,019,702			359,068		0.39	%	335,915,363			363,834		0.43	%
Time deposits	198,414,649			434,161		0.88	%	282,828,125			610,054		0.87	%
Total interest-bearing deposits	643,618,764			839,303		0.52	%	692,893,262			1,020,913		0.59	%
Borrowings	11,150,214			137,583		4.95	%	15,865,579			163,010		4.12	%
Total interest-bearing liabilities	654,768,978			$	976,886	0.60	%	708,758,841			$	1,183,923	0.67	%
Non-interest-bearing liabilities
Demand deposits	223,598,147							205,779,322
Other non-interest-bearing liabilities	13,543,821							26,169,286
Total liabilities	891,910,946							940,707,449
Stockholders’ equity	101,091,778							91,637,698
Total liabilities and stockholders’ equity	$	993,002,724						$	1,032,345,147
Net interest income (2)				$	9,675,979						$	9,887,947
Interest rate spread (2)(3)						4.01	%						3.93	%
Net interest margin (2)(4)						4.18	%						4.11	%


(1)	Yields are annualized and based on average daily balances.


(2)	Income and yields are reported on a taxable equivalent basis assuming a federal tax rate of 35%, with a $36,968 adjustment for 2014 and a $37,153 adjustment for 2013.


(3)	Represents the differences between the yield on total average earning assets and the cost of total interest-bearing liabilities.


(4)	Represents the ratio of net interest-earnings to the average balance of interest-earning assets.

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NET INTEREST INCOME ANALYSIS - CONTINUED
	For Three Months Period Ended June 30, 2012
	Average Balance			Income/ Expense		Yield Rate
ASSETS
Securities, at amortized cost	$	10,010,901		$	56,130	2.26	%
Loans, held for investment, net	606,213,746			8,590,781		5.70	%
Loans, held for sale	239,558,131			2,262,973		3.80	%
Federal funds sold	14,705,168			8,903		0.24	%
Dividend-earning restricted equity securities	5,768,600			64,974		4.53	%
Deposits in other banks	8,045,470			4,898		0.24	%
Bank owned life insurance	7,037,853			93,786		5.36	%
Total earning assets	891,339,869			11,082,445		5.00	%
Less: Allowance for loan losses	(10,267,253		)
Nonperforming loans	7,120,247
Total non-earning assets	58,867,409
Total assets	$	947,060,272
LIABILITIES and STOCKHOLDERS’ EQUITY
Interest-bearing deposits:
Demand	$	39,702,481		$	20,686	0.21	%
Savings	18,426,781			21,547		0.47	%
Money market savings	288,688,439			456,906		0.64	%
Time deposits	329,426,304			767,765		0.94	%
Total interest-bearing deposits	676,244,005			1,266,904		0.75	%
Borrowings	20,366,663			161,032		3.18	%
Total interest-bearing liabilities	696,610,668			$	1,427,936	0.82	%
Non-interest-bearing liabilities
Demand deposits	151,014,140
Other non-interest-bearing liabilities	20,466,318
Total liabilities	868,091,126
Stockholders’ equity	78,969,146
Total liabilities and stockholders’ equity	$	947,060,272
Net interest income				$	9,654,509
Interest rate spread						4.18	%
Net interest margin						4.36	%

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NET INTEREST INCOME ANALYSIS - CONTINUED
	For the Six Months Ended June 30, 2014							For the Six Months Ended June 30, 2013
	Average Balance			Income/ Expense		Yield Rate (1)		Average Balance			Income/ Expense		Yield Rate (1)
ASSETS
Securities, at amortized cost (2)	$	25,806,711		$	178,474	1.39	%	$	16,188,332		$	125,386	1.56	%
Loans, held for investment, net	698,748,274			18,567,963		5.36	%	669,591,077			18,014,998		5.43	%
Loans, held for sale	93,978,531			2,047,230		4.39	%	258,142,198			4,507,264		3.52	%
Federal funds sold	56,344,596			64,557		0.23	%	26,832,798			30,470		0.23	%
Dividend-earning restricted equity securities	3,389,933			52,410		3.12	%	6,146,976			143,660		4.71	%
Deposits in other banks	33,554,830			90,937		0.55	%	15,031,444			18,094		0.24	%
Bank owned life insurance (2)	7,461,760			179,505		4.85	%	7,231,831			180,480		5.03	%
Total earning assets	919,284,635			21,181,076		4.65	%	999,164,656			23,020,352		4.65	%
Less: Allowance for loan losses	(9,116,606		)					(10,923,015		)
Nonperforming loans	7,231,141							3,238,224
Total non-earning assets	64,572,373							76,025,186
Total assets	$	981,971,543						$	1,067,505,051
LIABILITIES and STOCKHOLDERS’ EQUITY
Interest-bearing deposits:
Demand	$	50,133,899		$	40,389	0.16	%	$	51,242,222		$	50,621	0.20	%
Savings	23,471,002			46,850		0.40	%	22,523,385			46,708		0.42	%
Money market savings	370,700,315			707,968		0.39	%	336,537,953			746,372		0.45	%
Time deposits	199,372,760			878,509		0.89	%	274,173,671			1,206,674		0.89	%
Total interest-bearing deposits	643,677,976			1,673,716		0.52	%	684,477,231			2,050,375		0.60	%
Borrowings	11,162,227			274,282		4.96	%	69,530,376			571,230		1.66	%
Total interest-bearing liabilities	654,840,203			$	1,947,998	0.60	%	754,007,607			$	2,621,605	0.70	%
Non-interest-bearing liabilities
Demand deposits	214,465,246							196,759,323
Other non-interest-bearing liabilities	12,925,687							26,695,205
Total liabilities	882,231,136							977,462,135
Stockholders’ equity	99,740,407							90,042,916
Total liabilities and stockholders’ equity	$	981,971,543						$	1,067,505,051
Net interest income (2)				$	19,233,078						$	20,398,747
Interest rate spread (2)(3)						4.05	%						3.95	%
Net interest margin (2)(4)						4.22	%						4.12	%


(1)	Yields are annualized and based on average daily balances.


(2)	Income and yields are reported on a taxable equivalent basis assuming a federal tax rate of 35%, with a $73,323 adjustment for 2014 and a $73,683 adjustment for 2013.


(3)	Represents the differences between the yield on total average earning assets and the cost of total interest-bearing liabilities.


(4)	Represents the ratio of net interest-earnings to the average balance of interest-earning assets.

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NET INTEREST INCOME ANALYSIS - CONTINUED
	For Six Months Period Ended June 30, 2012
	Average Balance			Income/ Expense		Yield Rate
ASSETS
Securities, at amortized cost	$	9,508,214		$	107,378	2.27	%
Loans, held for investment, net	600,826,545			17,215,184		5.76	%
Loans, held for sale	236,871,457			4,519,606		3.84	%
Federal funds sold	12,202,519			15,162		0.25	%
Dividend-earning restricted equity securities	6,442,483			102,474		3.20	%
Deposits in other banks	7,731,708			8,446		0.22	%
Bank owned life insurance	7,007,491			186,714		5.36	%
Total earning assets	880,590,417			22,154,964		5.06	%
Less: Allowance for loan losses	(9,994,671		)
Nonperforming loans	6,481,464
Total non-earning assets	57,044,843
Total assets	$	934,122,053
LIABILITIES and STOCKHOLDERS’ EQUITY
Interest-bearing deposits:
Demand	$	39,519,620		$	43,052	0.22	%
Savings	17,939,750			42,179		0.47	%
Money market savings	285,694,974			924,159		0.65	%
Time deposits	322,993,452			1,539,301		0.96	%
Total interest-bearing deposits	666,147,796			2,548,691		0.77	%
Borrowings	27,410,170			346,389		2.54	%
Total interest-bearing liabilities	693,557,966			$	2,895,080	0.84	%
Non-interest-bearing liabilities
Demand deposits	144,321,013
Other non-interest-bearing liabilities	18,133,166
Total liabilities	856,012,145
Stockholders’ equity	78,109,908
Total liabilities and stockholders’ equity	$	934,122,053
Net interest income				$	19,259,884
Interest rate spread						4.22	%
Net interest margin						4.40	%

Rate/Volume Analysis

The goal of a rate/volume analysis is to compare two or more periods to determine whether the difference between those periods is the result of changes in rate, or volume, or some combination of the two. This is achieved through a “what if” analysis. We calculate what the potential income would have been in the new period if the prior period rate had remained unchanged, and compare that result to what the income would have been in the prior period if the current rates were in effect. Through the analysis of these income potentials, we are able to determine how much of the change between periods is the impact of differing rates and how much is volume driven.

For discussion purposes, our “Rate/Volume Analysis” and “Net Interest Income Analysis” tables include tax equivalent income on bank owned life insurance (BOLI) and municipal securities that are not in compliance with Generally Accepted Accounting Principals (GAAP). The following table is a reconciliation of our income statement presentation to these tables.

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RECONCILIATION OF NET INTEREST INCOME

TO TAX EQUIVALENT INTEREST INCOME



Non-GAAP	For the Three Months Ended June 30,
	2014		2013		2012
Interest income:
Total interest income	$	10,556,992	$	10,975,487	$	10,983,619
Bank owned life insurance	58,905		59,230		61,899
Tax equivalent adjustment (35% tax rate)
Bank owned life insurance	31,718		31,893		31,887
Municipal securities	5,250		5,260		5,040
Adjusted income on earning assets	10,652,865		11,071,870		11,082,445
Interest expense:
Total interest expense	976,886		1,183,923		1,427,936
Net interest income—adjusted	$	9,675,979	$	9,887,947	$	9,654,509



Non-GAAP	For the Six Months Ended June 30,
	2014		2013		2012
Interest income:
Total interest income	$	20,991,075	$	22,829,357	$	21,958,193
Bank owned life insurance	116,678		117,312		123,231
Tax equivalent adjustment (35% tax rate)
Bank owned life insurance	62,827		63,168		63,483
Municipal securities	10,496		10,515		10,057
Adjusted income on earning assets	21,181,076		23,020,352		22,154,964
Interest expense:
Total interest expense	1,947,998		2,621,605		2,895,080
Net interest income—adjusted	$	19,233,078	$	20,398,747	$	19,259,884

Adjusted net interest income declined approximately $212 thousand and $1.2 million in the second quarter and first six months of 2014 compared to 2013. Interest income declined $419 thousand and $1.8 million quarter over quarter and year to date while interest expense declined $207 thousand and $674 thousand for the same respective periods. Reduced interest expense partially offset the loss of income in the quarter and year to date.

Changes in Net Interest Income (Rate/Volume Analysis)

Net interest income is the product of the volume of average earning assets and the average rates earned, less the volume of average interest-bearing liabilities and the average rates paid. The portion of change relating to both rate and volume is allocated to each of the rate and volume changes based on the relative change in each category.

The decline in net interest income during the second quarter and first half of 2014 compared to 2013 was the result of negative trends in the Company's interest earning assets which out-paced benefits achieved through liability management. Lower volume in loans held for sale portfolio resulted in an $853 thousand reduction in interest income for the quarter and $3.4 million reduction, year to date, which was only partially mitigated by higher rates, for a combined interest income reduction of $499 thousand and $2.5 million, respectively. Conversely, lower rates on our loans held for investment portfolio reduced interest earnings $240 thousand in the quarter and $224 thousand year to date. These reductions were marginally outpaced by income earned due to growth for a combined interest income increase of $49 thousand and $553 thousand in the quarter and year to date.

Interest expense declined in the second quarter of 2014 due to lower volume in time deposits, for a benefit of $185 thousand which was reduced to $176 thousand due to rate. Year to date, interest expense on time deposits declined $372 thousand due to volume which was reduced to $328 thousand due to rate. We have not increased rates on our time deposits. However, many of the larger time deposits that have matured carried lower rates, leaving longer term higher rate deposits in our portfolio thereby

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increasing the overall average rate. A decrease in borrowing volume in the second quarter and both rate and volume year to date reduced interest cost $25 thousand in the quarter and $297 thousand, year to date.

In the second quarter of 2013 compared to 2012, loan growth in our loans held for investment portfolio provided $1.0 million in earnings, but lower interest rates reduced these earnings by $596 thousand. The decline in volume of our loans held for sale portfolio coupled with lower interest rates further reduced earnings $489 thousand for a net reduction in loan income of $40 thousand in the quarter. Reduced rates on money market accounts and time deposits provided a $215 thousand benefit to earnings through reduced expense. Lower volume in time deposits also contributed to earnings through reduced expenses.

In the first six months of 2013 combined growth in our loans held for investment and loans held for sale provided $2.4 million in interest income which was reduced by $1.6 million due to lower rates. Loans held for investment were the source of $800 thousand in interest income growth that was reduced $13 thousand through lower volume and rates in our loans held for sale portfolio. Reduced money market and time deposits rates provided interest savings of $435 thousand and reduced time deposit volume provided additional interest savings.

The following table analyzes the changes in both rate and volume components of net interest income on a tax equivalent basis.

RATE / VOLUME ANALYSIS

(in thousands)



	For the Three Months Ended June 30,
	2014 vs. 2013									2013 vs. 2012
	Interest Increase (Decrease)			Change Attributable to						Interest Increase (Decrease)			Change Attributable to
	Interest Increase (Decrease)			Rate			Volume			Interest Increase (Decrease)			Rate			Volume
Interest income
Securities	$	34		$	4		$	30		$	7		$	(16	)	$	23
Loans held for investment	49			(240		)	289			449			(596		)	1,045
Loans held for sale	(499		)	354			(853		)	(489		)	(139		)	(350		)
Federal funds sold	(1		)	1			(2		)	16			(1		)	17
Dividend-earning restricted equity securities	(47		)	(37		)	(10		)	4			31			(27		)
Deposits in other banks	45			21			24			5			—			5
Bank owned life insurance	—			(3		)	3			(3		)	(6		)	3
Total interest income	$	(419	)	$	100		$	(519	)	$	(11	)	$	(727	)	$	716

Interest expense
Deposits:
Demand	$	(3	)	(3		)	—			$	3		(3		)	6
Savings	2			—			2			2			(2		)	4
Money market	(5		)	(40		)	35			(93		)	(160		)	67
Time	(176		)	9			(185		)	(158		)	(55		)	(103		)
Total deposits	(182		)	(34		)	(148		)	(246		)	(220		)	(26		)
Borrowings	(25		)	29			(54		)	2			42			(40		)
Total interest expense	(207		)	(5		)	(202		)	(244		)	(178		)	(66		)
Net interest income	$	(212	)	$	105		$	(317	)	$	233		$	(549	)	$	782

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	For the Six Months Ended June 30,
	2014 vs. 2013									2013 vs. 2012
	Interest Increase (Decrease)			Change Attributable to						Interest Increase (Decrease)			Change Attributable to
	Interest Increase (Decrease)			Rate			Volume			Interest Increase (Decrease)			Rate			Volume
Interest income
Securities	$	53		$	(15	)	$	68		$	18		$	(28	)	$	46
Loans held for investment	553			(224		)	777			800			(1,227		)	2,027
Loans held for sale	(2,460		)	917			(3,377		)	(13		)	(401		)	388
Federal funds sold	35			1			34			16			(1		)	17
Dividend-earning restricted equity securities	(92		)	(40		)	(52		)	41			46			(5		)
Deposits in other banks	73			37			36			10			1			9
Bank owned life insurance	(1		)	(7		)	6			(7		)	(13		)	6
Total interest income	$	(1,839	)	$	669		$	(2,508	)	$	865		$	(1,623	)	$	2,488

Interest expense
Deposits:
Demand	$	(11	)	(10		)	(1		)	$	8		(4		)	12
Savings	—			(4		)	4			5			(5		)	10
Money market	(38		)	(109		)	71			(178		)	(324		)	146
Time	(328		)	44			(372		)	(332		)	(111		)	(221		)
Total deposits	(377		)	(79		)	(298		)	(497		)	(444		)	(53		)
Borrowings	(297		)	(153		)	(144		)	224			(157		)	381
Total interest expense	(674		)	(232		)	(442		)	(273		)	(601		)	328
Net interest income	$	(1,165	)	$	901		$	(2,066	)	$	1,138		$	(1,022	)	$	2,160

Non-Interest Income

Non-interest income was $18.5 million in the second quarter of 2014, a $3.2 million or 14.7% decline from the second quarter of 2013. Non-interest income for the first half of 2014 was $31.8 million, a $7.0 million or 18.1% decline from the same period in 2013. Mortgage banking income, which was $3.2 million and $7.2 million less for the same respective periods is the source of this reduction. Non-interest income is broken out into more detail in the following table.

NON-INTEREST INCOME



	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2014		2013		2014		2013
Mortgage banking income	$	17,369,228	$	20,572,388	$	29,571,390	$	36,738,324
Service charges and fees	538,579		477,660		1,008,791		928,814
Title company income	167,454		232,423		272,488		486,774
Bank owned life insurance income	58,905		59,230		116,678		117,312
Investment and insurance commissions	335,887		245,524		781,359		452,460
Gain on sale of assets	—		16,295		—		16,295
Other	28,820		70,751		56,818		115,310
	$	18,498,873	$	21,674,271	$	31,807,524	$	38,855,289

Mortgage banking income represents fees from originating and selling residential mortgage loans as well as commercial mortgages through Monarch Mortgage and our wholly owned commercial mortgage banking subsidiary, Monarch Capital, LLC. Mortgage banking income was lower in 2014 due to lower loan volume. The total number of loans and volume closed in the second quarter of 2014 was 1,677 units and $446.9 million compared to 2,232 units and $607.2 million, one year prior. Year to date 2014 the total number of loans and volume closed was 2,780 and $718.1 million compared to 4,266 and $1.1 billion, one

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year prior. Purchased volume was 83% in 2014 compared to 52% in 2013. The average closed loan amount remains in the mid to upper $200 thousand range.

Service charges and fees on deposit accounts increased $61 thousand in the second quarter and $80 thousand in the first six months of 2014 compared to 2013. The primary components of service charges and fees are non-sufficient fund and overdraft fees and ATM transaction fees and merchant service fees. This growth is attributable to growth in our demand deposit products, year over year and increased merchant service income. We have an agreement with a third-party vendor to brand ATMs in Food Lion grocery stores in southeast Virginia and northeast North Carolina. In return for supplying the cash for the machines and paying the machines’ cash servicing fees, we receive a portion of the transaction surcharge, and our customers can withdraw cash from the machines without a fee or transaction surcharge. We have 13 ATMs located at our banking center sites. Combined with our third-party vendor relationship, our network includes 56 active branded ATMs.

Through Monarch Investment, LLC, we own a 75% interest in a title company, Real Estate Security Agency, LLC (RESA), which is being treated as a consolidated entity for accounting purposes. RESA income declined $65 thousand in the second quarter and $214 thousand in the first half of 2014 compared to 2013. Like our mortgage banking division, lower demand has impacted income production.

Investment and insurance income increased $90 thousand in the second quarter and $329 thousand in the first half of 2014 compared to 2013. Monarch Bank Private Wealth ("MBPW") has continued to grow income through the sale of products and services along with increasing the level of assets under their management through affiliation with Raymond James Financial Services, Inc.

Non-interest Expense

The following table summarizes our non-interest expense for the periods indicated:

NON-INTEREST EXPENSE



	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2014		2013		2014		2013
Salaries and employee benefits	$	8,492,446	$	8,502,755	$	16,764,007	$	16,707,830
Commissions and incentives	6,770,022		9,703,820		10,780,986		16,769,296
Loan expense	2,060,570		2,630,295		3,423,711		4,460,732
Occupancy expenses, net of rental income	1,531,668		1,336,345		3,035,515		2,545,521
Furniture and equipment expense	863,420		794,100		1,636,276		1,451,442
Marketing expense	797,908		744,646		1,319,749		1,257,604
Data processing services	476,806		435,771		956,084		836,729
Professional fees	333,735		222,768		583,574		509,857
Telephone	293,451		308,138		604,588		563,062
FDIC Insurance	147,082		92,155		279,348		266,830
Stationery and supplies	131,485		205,880		237,603		373,990
Virginia Franchise Tax	207,869		201,951		409,820		345,803
Postage and shipping	106,283		183,919		241,413		343,710
Travel expense	124,205		139,957		210,656		216,936
ATM expense	88,959		73,524		166,705		144,900
Amortization of intangibles	44,643		44,643		89,286		89,286
Insurance expense	55,146		50,268		111,240		102,933
Title expense	23,093		30,188		37,552		66,917
Other real estate expense	2,597		1,494		9,736		2,598
Loss on sale of other real estate, net	33,263		—		33,263		—
Other	422,333		470,267		822,505		977,529
	$	23,006,984	$	26,172,884	$	41,753,617	$	48,033,505

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Total non-interest expenses decreased $3.2 million in the second quarter and $6.3 million in the first six months of 2014 compared to 2013. Net overhead expense, which is the difference between non-interest income and non-interest expense, improved $10 thousand in the second quarter and $768 thousand in the first half of 2014 compared to 2013.

Employee compensation; in the form of salaries, benefits, commissions and incentives, represent approximately 66% of non-interest expense in 2014 compared to 70% in 2013. The number of full time equivalent employees at June 30, 2014 totaled 659 compared to 681 one year prior. Salaries and benefits were fairly level with prior year due to a stabilized workforce and cost control measures. Commissions and incentives are down $2.9 million or 30.2% in the quarter and $6.0 million or 35.7% year to date due to the lower mortgage productions noted previously.

We continue to reposition and expand our operations to enable us to better serve our clients. We opened a permanent Williamsburg branch which included MBPW in May 2014. We relocated our Monarch Mortgage headquarters and Oceanfront bank office in March 2013. We opened a mortgage and commercial lending office in Newport News in January 2013. Costs associated with occupancy expense, furniture and equipment have increased due to Company growth. The increase in professional fees is due to additional costs related to compliance and regulatory issues. Loan expense has reduced due to lower mortgage volume noted previously.

We only have one property in other real estate at June 30, 2014. This property was moved into other real estate in the second quarter. One property sold in the second quarter and first six months of 2014 at a loss of $33,263. There were no sales of other real estate in the second quarter and first half of 2013. There were no valuation adjustments recorded in either year to date. Expenses related to the maintenance and sale of other real estate were $3 thousand in the second quarter of 2014 and $2 thousand in the second quarter of 2013. Year to date expenses related to the maintenance and sale of other real estate were $10 thousand and $3 thousand in 2014 and 2013, respectively.

The following summary identifies non-interest expenses with the most significant quarter-over-quarter change.



	Change - Increase (Decrease) For the Three Months Ended June 30, 2014					Change - Increase (Decrease) For the Six Months Ended June 30, 2014
	Dollars			Percentage		Dollars			Percentage
Occupancy expense	$	195,323		14.6	%	$	489,994		19.2	%
Professional fees	110,967			49.8	%	73,717			14.5	%
Loan expense	(569,725		)	(21.7	)%	(1,037,021		)	(23.2	)%
Commissions and incentives	(2,933,798		)	(30.2	)%	(5,988,310		)	(35.7	)%

Income Taxes

Our federal income tax provision was $1.7 million in both the second quarter of 2014 and 2013. State income tax provision for the states of Maryland, North Carolina and South Carolina totaled $82 thousand and $113 thousand for the second quarter of 2014 and 2013, respectively. The year to date federal income tax provision was $3.0 million in 2014 and $3.6 million in 2013. The year to date state income tax provision was $200 thousand and 241 thousand for the same respective periods.

BOLI income and certain municipal securities are not subject to federal income tax. We had tax exempt income of $69 thousand in the second quarter of both 2014 and 2013. Year to date tax exempt income was $136 thousand in 2014 compared to $137 thousand in 2013.

Certain expenses related to marketing are non-deductible for tax purposes. These non-deductible expenses totaled $151 thousand and $101 thousand in the second quarter of 2014 and 2013. Year to date, these non-deductible expenses totaled $227 thousand and $166 thousand for 2014 and 2013, respectively.

The table below presents a summary of income taxes and the effective tax rate for quarters ended March 31, 2014 and 2013.

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Income Tax Summary
	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2014			2013			2014			2013
Income tax provision	$	1,767,500		$	1,797,773		$	3,238,740		$	3,791,326
Less: state tax provision	82,007			112,748			199,847			241,301
Federal tax provision	$	1,685,493		$	1,685,025		$	3,038,893		$	3,550,025

Net income before tax	$	5,071,995		$	5,292,951		$	9,096,984		$	11,029,536
Less: Federal tax free income
BOLI	58,905			59,230			116,678			117,312
Municipal securities	9,752			9,768			19,494			19,527
Add: Non-deductible expenses	150,817			101,158			226,912			165,741
Federal taxable income	$	5,154,155		$	5,325,111		$	9,187,724		$	11,058,438

Effective federal tax rate	33.2		%	31.8		%	33.1		%	32.1		%

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

GENERAL

Total assets were $1.023 billion at June 30, 2014, a $7.2 million or 0.7% increase compared to assets of $1.017 billion at December 31, 2013. Loans held for sale increased $56.9 million or 57.0%. Property and equipment increased $2.5 million or 8.7%. Total cash and cash equivalents decreased $18.3 million or 17.5% and loans held for investment, net, decreased $12.5 million or 1.8%. Investment securities declined $25.0 million or 51.3% and restricted equity securities declined $515 thousand or 14.0%.

Our loans held for sale portfolio represents mortgage loans that have been closed and are awaiting investor funding. A majority of our mortgage loans are pre-sold. These loans typically remain on our books for thirty to forty-five days. Outstanding balances, which are dependent on the current mortgage market, the timing of closings, and investor turn around, may fluctuate significantly between periods. With increased production in the second quarter the outstanding balances during the quarter increased $56.9 million.

In May 2014 we completed the construction of our new Williamsburg branch and MBPW center. Property and equipment increased as a result of that construction. Additionally, furniture and equipment were purchased for that location.

Cash and cash equivalents, which fluctuate daily based on our liquidity levels and mortgage settlement activity, decreased $18.3 million. This decrease is due to a $24.2 million decline federal funds sold. The decrease in federal funds sold was utilized to help fund the growth in loans held for sale. Investment securities declined $25.0 million due to $33.6 million in security maturities and calls, net of $8.4 million in purchases. Restricted equity securities include stock in the Federal Reserve, Federal Home Loan Bank and other bankers' banks. The level of stock we retain is subject to evaluation by the various entities and may result in a periodic increase or decrease in share level. Our stock in the Federal Home Loan Bank is impacted by much lower borrowing levels.

Our loans held for investment portfolio which is comprised primarily of commercial loans and and real estate loans has declined $12.5 million due to several large pay-offs in the first half of 2014 despite $95 million in new loan activity. This decline is attributable to a $26.1 million decline in commercial real estate loans.

Total liabilities were $921.1 million at June 30, 2014, an increase of $2.1 million or 0.2% over December 31, 2013 liabilities of $918.9 million. Total deposits, which are our primary liability source, decreased $1.8 million to $891.3 million at June 30, 2014 compared to $893.1 million at year-end 2013. Total borrowings decreased nominally at June 30, 2014 compared to December 31, 2013.

The mix of our deposits outstanding changed favorably with higher cost time deposits declining $36.4 million while non-interest bearing demand deposits increased $33.5 million. Money market accounts increased $2.6 million and savings deposits increased $2.4 million. Interest bearing demand deposits declined $4.0 million.

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Our non-interest bearing deposits represent 27.0% and 23.2% of our total deposits at June 30, 2014 and December 31, 2013, respectively. Commercial and small business checking accounts comprise the largest percentage of non-interest bearing demand deposits. At June 30, 2014, commercial checking accounts increased $22.1 million over December 31, 2013 and at $134.8 million were 56% of non-interest bearing demand. Small business checking accounts increased $727 thousand to $60.3 million, 25% of non-interest bearing demand. We are primarily a business bank and, as such, have focused our efforts on obtaining company operating accounts, which are demand deposit accounts. Attorney escrow accounts at $28.9 million represented 12% of non-interest bearing deposits at June 30, 2014 and increased $8.9 million compare December 31, 2013. Escrow accounts ordinarily house real estate funds, which makes them sensitive to the growth within the real estate market. Our focus on the business sector, coupled with the growth in business operating accounts, has resulted in continued growth in demand deposits.

Interest bearing demand deposits declined $4.0 million from December 31, 2013, primarily in commercial checking. Interest bearing demand deposits represent 7.9% of interest bearing deposits. Money market and time deposits ("CDs") represent roughly 88.3% and savings deposits represent roughly 3.8%, of interest bearing deposits. Money market deposits, which were $377.1 million at June 30, 2014, have increased $2.6 million since December 31, 2013. Brokered money market deposit accounts included in our money market totals at both June 30, 2014 and December 31, 2013 declined $6.7 million since year end. Excluding these accounts, non-brokered money market balances have increased $9.3 million since year end 2013. We are managing money market account growth through pricing of our multi-tiered money market product, while keeping rates attractive and highly competitive in the market. Our current economic environment is still volatile enough to keep many “would be” market investors looking to the safety of insured bank deposits. Money market accounts are the most suitable product for these individuals because rates are higher than demand and savings accounts but they have withdrawal features more flexible than CDs. Therefore, our money market balances may be adversely impacted in the future when the economy is more stable and investors return to higher, but riskier, rate alternatives.

Outstanding CDs declined $36.4 million to $197.7 million through June 30, 2014 compared to December 31, 2013. Included in CDs are brokered CDs which are used along with our brokered money market accounts and Federal Home Loan Bank ("FHLB") borrowings to fund our loans held for sale portfolio. The majority of these brokered CDs are Certificate of Deposit Account Registry Service^® (“CDARS”), which are typically short term, with maturities of between 4 and 13 weeks. However, we also house certain municipal deposits in CDARS because of the additional deposit insurance protection offered by the product. Brokered deposits were $29.1 million less at June 30, 2014 than year end 2013. Our remaining CD portfolio has continued to decline, by design. CD shoppers typically expect higher interest rates. We have focused on relationship pricing for CDs, with non- clients receiving lower rates for CDs than existing clients, thereby encouraging relationships which are beneficial to both the Bank and our clients.

Excluding brokered deposits, our loans held for investment to deposit ratio was 85.2% and 90.5% for June 30, 2014 and December 31, 2013, respectively.

Stockholders’ equity was $102.8 million at June 30, 2014, compared to $97.7 million at December 31, 2013. Components of the increase in stockholders’ equity include net income of $5.6 million, decrease in unrealized losses in other comprehensive income of $260 thousand, exercised stock options of $216 thousand, common stock issued through dividend reinvestment of $164 thousand, stock based compensation expense totaling $419 thousand, common stock dividend payments of $1.6 million, and distributions to non-controlling interests of $240 thousand.

Loans Held for Investment

Our lending activities are our principal source of income. Loans held for investment, net of unearned income, declined $12.5 million or 1.8% in the first six months of 2014. Our allowance for loan losses increased $9 thousand and we had net recoveries of $9 thousand.

The following table provides a breakdown, by segment of our loans held for investment at June 30, 2014 and December 31, 2013.

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LOANS HELD FOR INVESTMENT



	June 30, 2014			December 31, 2013
Commercial	$	109,595,604		$	119,367,962
Real estate
Construction	155,350,359			155,551,690
Residential (1-4 family)	98,572,353			89,846,277
Home equity lines	68,784,781			67,177,011
Multifamily	23,930,936			27,392,561
Commercial	239,078,183			250,178,584
Real estate subtotal	585,716,612			590,146,123
Consumers
Consumer and installment loans	4,500,621			2,911,397
Overdraft protection loans	88,530			71,009
Loans to individuals subtotal	4,589,151			2,982,406
Total gross loans	699,901,367			712,496,491
Unamortized loan costs, net of deferred fees	257,355			174,976
Loans held for investment, net of unearned income	700,158,722			712,671,467
Allowance for loan losses	(9,069,877		)	(9,061,369		)
Total net loans	$	691,088,845		$	703,610,098

Allowance and Provision for Loan Losses

We have certain lending policies and procedures in place, designed to balance loan growth and income with an acceptable level of risk, which management reviews and approves on a regular basis. Our review process is supported by a series of reports related to loan production, loan quality, credit concentrations, policy exceptions, loan delinquencies and non-performing and potential problem loans. We also utilize diversification in our loan portfolio as a means of managing risk.

Inherent losses in our loan portfolio are supported by our allowance for loan losses. Management is responsible for determining the level of the allowance for loan losses, subject to review by our Board of Directors. Among other factors, we consider our historical loss experience, the size and composition of our loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits including impaired loans and our risk-rating-based loan watch list, and local and national economic conditions. The economy of our trade area is well diversified. There are additional risks of future loan losses that cannot be precisely quantified or attributed to particular loans or classes of loans. Since those factors include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate.

To determine the total allowance for loan losses, we estimate the reserves needed by analyzing loans on both, a pooled basis and individually. Our allowance for loan losses consists of amounts applicable to the following three loan types: commercial, real estate, and consumer. In addition, loans within these types are evaluated as a group or on an individual or relationship basis and assigned a risk grade based on the underlying characteristics. Loans are pooled by loan segment with loan type and losses modeled utilizing historical experience by segment, other known and inherent risks, and quantitative techniques which management has determined fit the characteristics of the loan type or segment within that type. We utilize a moving average historical loss "look back" period of four years.

The commercial loan type includes commercial and industrial loans which are usually secured by the assets being financed or other business assets such as accounts receivable or inventory and normally incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand their business.

The real estate loan type includes all loans secured by real estate. This type is further broken down into segments. These segments are: construction loans, residential 1-4 family loans, home equity lines, multifamily loans, and commercial real estate loans. Construction and multifamily loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the completed project. Residential 1-4 family and home equity loan originations utilize analytics to supplement the underwriting process. Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.

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Commercial and real estate portfolio loans are evaluated on an individual or relationship basis and assigned a risk grade at the time the loan is made. Additionally, we perform periodic reviews of the loan or relationship to determine if there have been any changes in the original underwriting which would change the risk grade and/or impact the borrower’s ability to repay the loan.

The consumer loan portfolio includes two classes: consumer and installment loans and overdraft protection loans. These loans, which are in relatively small loan amounts, are spread across many individual borrowers. We utilize analytics to supplement general underwriting. Loans within the consumer type are assigned risk grades and evaluated as a pool, unless specifically identified through delinquency or other signs of credit deterioration, at which time the identified loan is individually evaluated. Additionally, loans that have been specifically identified as a credit risk due to circumstances that may affect the ability of the borrower to repay interest and/or principal are analyzed on an individual basis. Adverse circumstances may include loss of repayment source, deterioration in the estimated value of collateral, elevated trends of delinquencies, and charge-offs.

We evaluate the adequacy of the allowance for loan losses monthly in order to maintain the allowance at a level that is sufficient to absorb probable credit losses. Such factors as the level and trend of interest rates and the condition of the national and local economies are also considered. From time to time, events or economic factors may affect the loan portfolio, causing management to provide additional amounts to, or release balances from, the allowance for loan losses. Our allowance for loan losses is sensitive to risk ratings assigned to individually evaluated loans, economic assumptions, and delinquency trends driving statistically modeled reserves.

There are nine numerical risk grades which are assigned to loans. These risk grades are as follows:



“Pass”	“Watch List”
1 Minimal	6 Special mention
2 Modest	7 Substandard
3 Average	8 Doubtful
4 Acceptable	9 Loss
5 Acceptable with care

The following is a breakdown between pass and watch list loans at June 30, 2014 and December 31, 2013. There were no loans risk graded Doubtful (8) or Loss (9) included in our portfolio at June 30, 2014 or December 31, 2013.

PASS AND WATCH LIST LOANS



	June 30, 2014
			Watch List					Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total	Weighted Average Risk Grade
Commercial	$	107,356,843	$	—	$	2,238,761	109,595,604	3.37
Real estate
Construction	148,703,118		519,603		6,127,638		155,350,359	3.56
Residential (1-4 family)	89,967,818		1,458,384		7,146,151		98,572,353	4.12
Home equity lines	66,972,818		49,314		1,762,649		68,784,781	4.13
Multifamily	21,689,103		1,954,614		287,219		23,930,936	3.48
Commercial	228,854,775		1,686,652		8,536,756		239,078,183	3.76
Real estate subtotal	556,187,632		5,668,567		23,860,413		585,716,612	3.80
Consumers
Consumer and installment loans	4,418,394		—		82,227		4,500,621	4.06
Overdraft protection loans	88,530		—		—		88,530	4.69
Loans to individuals subtotal	4,506,924		—		82,227		4,589,151	4.07
Total gross loans	$	668,051,399	$	5,668,567	$	26,181,401	699,901,367	3.73

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	December 31, 2013
			Watch List						Weighted Average Risk Grade
	Pass		Special Mention		Substandard		Total		Weighted Average Risk Grade
Commercial	$	112,512,939	$	12,891	$	6,842,132	$	119,367,962	3.45
Real estate
Construction	147,478,248		978,247		7,095,195		155,551,690		3.77
Residential (1-4 family)	80,560,400		3,329,470		5,956,407		89,846,277		4.22
Home equity lines	65,790,766		—		1,386,245		67,177,011		4.13
Multifamily	26,078,523		1,005,985		308,053		27,392,561		3.70
Commercial	242,167,855		2,295,326		5,715,403		250,178,584		3.73
Real estate subtotal	562,075,792		7,609,028		20,461,303		590,146,123		3.85
Consumers
Consumer and installment loans	2,823,254		—		88,143		2,911,397		4.10
Overdraft protection loans	71,009		—		—		71,009		4.43
Loans to individuals subtotal	2,894,263		—		88,143		2,982,406		4.11
Total gross loans	$	677,482,994	$	7,621,919	$	27,391,578	$	712,496,491	3.79

Additional regulatory guidance with regard to the specifications of the special mention (6) risk grade, stipulates that loans with this risk grade be treated as transitory and should not remain special mention for more than one year. We continue to monitor and evaluate loans in our special mention risk grade on a monthly basis.

We evaluate the collectability of both principal and interest when assessing the need for a loss accrual. (For additional discussion on this evaluation refer to Note 1 and Note 3 of our 2013 Annual Report on Form10-K.)

This evaluation includes, but is not limited to, the application of a loss factor which is arrived at by using a four-year moving average “look back” at our historical losses. This loss factor is multiplied by the outstanding principal of loans not individually evaluated for impairment to arrive at an overall loss estimate. Environmental factors may also be applied to a class or classes of loans based on management’s subjective evaluation of such conditions as credit quality trends, collateral values, portfolio concentrations, specific industry conditions in the regional economy, regulatory examination results, external audit and loan review findings, and recent loss experiences in particular portfolio classes. Any unallocated portion of the allowance for loan losses reflects management’s attempt to ensure that the overall reserve appropriately reflects a margin for the imprecision necessarily inherent in estimates of credit losses.

The allowance is subject to regulatory examinations and determination as to adequacy. This examination may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies.

We recorded $0 in provision for loan losses in the second quarter and first half of 2014 and 2013. Based on the current economic environment and the composition of our loan portfolio, the level of our charged-off loans combined with our loss experience, we consider our loan loss allowance sufficient to meet the losses inherent in our portfolio.

Loans charged off during second quarter of 2014 totaled $184,601 compared to $279,722 for the same period in 2013. Recoveries totaled $41,378 in the second quarter of 2014 compared to $811,079 for the same period in 2013. The ratio of net charge-offs to average outstanding loans for the second quarter of 2014 was 0.02% compared to (0.08%) in 2013. Year to date the ratio of net charge-offs to average outstanding loans was 0.00% in 2014 and (0.06%) in 2013. A total of $63,366 in specific reserves for loans charged off in the first six months of 2014 were included in our December 31, 2013 loan loss allowance. Specific reserves totaling $625,529 were included in our December 31, 2012 loan loss allowance for loans charged off in the first half of 2013.

In the second quarter of 2014, approximately $122 thousand in loans charged off were related to business failure and $63 thousand were related to residential properties. In the second quarter of 2013, approximately $171 thousand in loans charged off were related to business failure and $109 thousand were related to residential properties. In the first half of 2014, approximately $134 thousand in loans charged off were related to business failure and $63 thousand to residential properties. In the first half of 2013, approximately $171 thousand in loans charged off were related to failed business activities, $640 thousand to residential properties and $23 thousand to consumer losses.

The allowance for loan losses totaled $9,069,877 at June 30, 2014, an increase of $8,508 from December 31, 2013. The ratio of the allowance to loans held for investment, less unearned income, was 1.30% at June 30, 2014, and 1.27% at December 31, 2013. We believe that the allowance for loan losses is adequate to absorb any inherent losses on existing loans in our loan portfolio

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at June 30, 2014. The allowance to loans ratio is supported by the level of non-performing loans, the seasoning of the loan portfolio, and the experience of the lending staff in the market.

LOAN LOSS ALLOWANCE AND LOSS EXPERIENCE



	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2014			2013			2014			2013
Balance, beginning of period	$	9,213,100		$	10,788,281		$	9,061,369		$	10,910,000
Loans charged-off
Commercial	(14,789		)	(171,151		)	(14,789		)	(171,151		)
Real estate
Construction	(106,812		)	—			(106,812		)	—
Residential (1-4 family)	(63,000		)	—			(75,554		)	(57,000		)
Home equity lines	—			(108,571		)	—			(582,480		)
Multifamily	—			—			—			—
Commercial	—			—			—			—
Consumers							—
Consumer and installment loans	—			—			—			(22,759		)
Overdraft protection loans	—			—			—			(416		)
Loans charged-off total	(184,601		)	(279,722		)	(197,155		)	(833,806		)
Recoveries
Commercial	3,300			53,798			91,600			115,277
Real estate
Construction	7,341			728,430			15,931			1,024,914
Residential (1-4 family)	12,254			10,303			20,639			16,205
Home equity lines	18,483			18,548			77,493			66,440
Multifamily	—			—			—			—
Commercial	—			—			—			20,000
Consumers
Consumer and installment loans	—			—			—			587
Overdraft protection loans	—			—			—			21
Loan recoveries total	41,378			811,079			205,663			1,243,444
Net Charge Offs	(143,223		)	531,357			8,508			409,638
Provisions charged to operations	—			—			—			—
Balance, end of period	$	9,069,877		$	11,319,638		$	9,069,877		$	11,319,638

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A summary of our allowance as of June 30, 2014 and December 31, 2013 by segment is as follows:

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES



	June 30, 2014
	Amount			Percentage of loans in each category to total loans
Commercial	$	850,498		15.7	%
Real estate
Construction	1,791,539			22.2	%
Residential (1-4 family)	2,112,024			14.1	%
Home equity lines	1,984,257			9.8	%
Multifamily	68,567			3.4	%
Commercial	1,783,918			34.2	%
Consumers
Consumer and installment loans	100,773			0.6	%
Overdraft protection loans	239			—	%
Unallocated	378,062
	$	9,069,877		100.0	%
Total loans held for investment outstanding *	$	700,158,722
Ratio of allowance for loan losses to total loans held for investment	1.30		%



	December 31, 2013
	Amount			Percentage of loans in each category to total loans
Commercial	$	1,219,255		16.8	%
Real estate
Construction	1,978,320			21.8	%
Residential (1-4 family)	1,685,502			12.6	%
Home equity lines	2,132,916			9.4	%
Multifamily	59,586			3.9	%
Commercial	1,305,131			35.1	%
Consumers
Consumer and installment loans	99,271			0.4	%
Overdraft protection loans	688			—	%
Unallocated	580,700
	$	9,061,369		100.0	%
Total loans held for investment outstanding *	$	712,671,467
Ratio of allowance for loan losses to total loans held for investment	1.27		%



*	Total loans held for investment outstanding includes unamortized loan costs, net of deferred fees of $240,046 at March 31, 2014 and $174,976 at December 31, 2013.

Asset Quality and Non-Performing Loans

We identify specific credit exposures through periodic analysis of our loan portfolio and monitor general exposures from economic trends, market values and other external factors. We maintain an allowance for loan losses, which is available to absorb losses inherent in the loan portfolio. The allowance is increased by the provision for losses and by recoveries from losses. Charged-off loan balances are subtracted from the allowance. The adequacy of the allowance for loan losses is determined on a monthly basis. Various factors as defined in the previous section “Allowance and Provision for Loan Losses” are considered in determining the adequacy of the allowance. Loans are generally placed on non-accrual status after they are past due for 90 days.

Non-performing loans include loans on which interest is no longer accrued, accruing loans that are contractually past due 90 days or more as to principal and interest payments, and loans classified as troubled debt restructurings. Based on this definition total non-performing loans as a percentage of total loans were 1.22% and 1.00% at June 30, 2014 and December 31, 2013. However, all of our troubled debt restructure loans were performing in both periods presented. Excluding performing troubled debt restructure

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this percentage declines to 0.36% and 0.31% at June 30, 2014 and December 31, 2013, respectively. Non-performing assets at June 30, 2014 and December 31, 2013 are presented below.

NON-PERFORMING ASSETS



	Non-Performing Loans
	Over 90 Days and Accruing		Nonaccrual Loans		Accruing Restructured Loans		Total Non-Performing Loans		Other Real Estate Owned		Total Non-Performing Assets
	Over 90 Days and Accruing		Nonaccrual Loans		Accruing Restructured Loans		Total Non-Performing Loans		Other Real Estate Owned		Total Non-Performing Assets
June 30, 2014
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Real estate
Construction	—		116,800		—		116,800		144,000		260,800
Residential (1-4 family)	472,052		1,024,359		875,740		2,372,151		—		2,372,151
Home equity lines	27,355		533,690		—		561,045		—		561,045
Multifamily	—		—		—		—		—		—
Commercial	—		1,352,732		4,022,575		5,375,307		—		5,375,307
Consumers
Consumer and installment loans	—		3,001		79,226		82,227		—		82,227
Overdraft protection loans	—		—		—		—		—		—
Total	$	499,407	$	3,030,582	$	4,977,541	$	8,507,530	$	144,000	$	8,651,530

December 31, 2013
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Real estate
Construction	—		357,561		—		357,561		—		357,561
Residential (1-4 family)	472,052		825,964		263,624		1,561,640		301,963		1,863,603
Home equity lines	—		552,193		—		552,193		—		552,193
Multifamily	—		—		—		—		—		—
Commercial	—		—		4,568,883		4,568,883		—		4,568,883
Consumers
Consumer and installment loans	—		4,352		83,792		88,144		—		88,144
Overdraft protection loans	—		—		—		—		—		—
Total	$	472,052	$	1,740,070	$	4,916,299	$	7,128,421	$	301,963	$	7,430,384



	June 30, 2014		December 31, 2013
Asset Quality Ratios:
Non-accruing nonperforming loans to period end loans	0.50	%	0.31	%
Non-accruing nonperforming assets to total assets	0.36	%	0.25	%
Nonperforming assets to period end assets	0.75	%	0.73	%
Allowance for loan losses to non-accruing nonperforming loans	256.94	%	409.62	%
Nonperforming loans to period end loans	1.03	%	1.00	%

Restructured loans are loans for which it has been determined the borrower is in financial distress and a concession has been made to those terms that would not otherwise have been considered. Restructured loans are evaluated in accordance with applicable accounting guidance as impaired loans. In addition, if it is determined the borrower is unable to perform under the modified terms, further steps, such as a full charge-off or foreclosure may be taken. We did not have any commitments to lend additional funds on restructured loans at June 30, 2014 or December 31, 2013.

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TROUBLED DEBT RESTRUCTURING



	Commercial			Residential 1-4 Family		Real Estate Construction			Consumer			Total

June 30, 2014
Balance beginning of the period	$	—		$	263,624	$	4,568,883		$	83,792		$	4,916,299
Investment in restructured loans
Additions (payments received) during the period	—			612,116		(546,308		)	(4,566		)	61,242
Charge-off during the period	—			—		—			—			—
Moved to other real estate	—			—		—			—			—
Valuation allowance for restructured loans included in charged-off loans	—			—		—			—			—
Additions during the period	—			—		—			—			—
Restructured loans included in impaired loans end of the period	$	—		$	875,740	$	4,022,575		$	79,226		$	4,977,541

December 31, 2013
Balance beginning of the period	$	617,394		$	83,912	$	1,403,739		$	—		$	2,105,045
Investment in restructured loans
Additions (payments received) during the period	(434,724		)	179,712		3,200,000			83,792			3,028,780
Charge-off during the period	(182,670		)	—		(34,856		)	—			(217,526		)
Moved to other real estate	—			—		—			—			—
Valuation allowance for restructured loans included in charged-off loans	—			—		—			—			—
Additions during the period	—			—		—			—			—
Restructured loans included in impaired loans end of the period	$	—		$	263,624	$	4,568,883		$	83,792		$	4,916,299

Recoveries of charged-off balance
June 30, 2014	$	—		$	—	$	—		$	—		$	—
December 31, 2013	$	—		$	—	$	—		$	—		$	—

Other Real Estate

Other real estate is real estate properties acquired through or in lieu of loan foreclosure. At foreclosure, these properties are recorded at their fair value less estimated selling costs as a nonperforming asset, with any write-downs to the carrying value of our investment charged to the allowance for loan loss. After foreclosure, periodic evaluations are performed to determine if any decrease in the fair value less estimated selling costs has occurred. Further adjustments to this fair value are charged to operations, in non-interest expense, when identified. Expenses associated with the maintenance of other real estate are charged to operations, foreclosed property expense, as incurred. When a property is sold, any gain or loss on the sale is recorded as gain or loss on foreclosed property in non-interest expense.

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OTHER REAL ESTATE



	June 30, 2014
	Balance			Number
January 1,	$	301,963		1
Balance moved into other real estate	144,000			1
	445,963			2
Write down of property charged to operations	—
Payments received after foreclosure	—
Properties sold	(301,963		)	(1	)
Balance at June 30, 2014	$	144,000		1
Gross gains of sale of other real estate	$	—
Gross losses on sale of other real estate	(33,263		)
Write down of property charged to operations	—
Rental income, other real estate	—
Other real estate expense	(9,736		)
Foreclosed property (expense) income	$	(42,999	)

	December 31, 2013
	Balance			Number
January 1,	$	—		—
Balance moved into other real estate	397,037			2
	397,037			2
Write down of property charged to operations	—
Payments received after foreclosure	—
Properties sold	(95,074		)	(1	)
Balance at December 31, 2013	$	301,963		1
Gross gains of sale of other real estate	$	—
Gross losses on sale of other real estate	(3,020		)
Write down of property charged to operations	—
Rental income, other real estate	—
Other real estate expense	(7,098		)
Foreclosed property (expense) income	$	(10,118	)

Liquidity

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale of existing assets or the acquisition of additional funds through short-term borrowings. Our liquidity is provided from cash and amounts due from banks, federal funds sold, interest-bearing deposits in other banks, repayments from loans, increases in deposits, lines of credit from the Federal Home Loan Bank and six correspondent banks, and maturing investments. As a result of our management of liquid assets, and our ability to generate liquidity through liability funding, we believe that we maintain overall liquidity sufficient to satisfy our depositors’ requirements and to meet clients’ credit needs. We also take into account any liquidity needs generated by off-balance sheet transactions such as commitments to extend credit, commitments to purchase securities and standby letters of credit.

We monitor and plan our liquidity position for future periods. Liquidity strategies are implemented and monitored by our Asset/Liability Committee (“ALCO”).

Cash, cash equivalents and federal funds sold totaled $86.6 million as of June 30, 2014 compared to $104.9 million as of December 31, 2013. At June 30, 2014, cash, interest bearing bank balances, securities classified as available for sale and federal funds sold were $110.4 million or 11.6% of total earning assets, compared to $153.7 million or 16.1% of total earning assets at December 31, 2013.

In the course of operations, due to fluctuations in loan and deposit levels, we occasionally find it necessary to purchase federal funds on a short-term basis. We maintain unsecured federal funds line arrangements with five other banks, which allow

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us to purchase funds totaling $61.0 million. These lines mature and re-price daily. At June 30, 2014 and December 31, 2013, we had $0 in federal funds purchased outstanding.

We have access to the Federal Reserve Bank of Richmond’s discount window should a liquidity crisis occur. We have not used this facility in the past and consider it a backup source of funds.

We are also members of the Promontory Network and have access to a program through their Certificate of Deposit Account Registry Service^® (“CDARS”) to use their CDARS One Way Buy^SM to purchase cost-effective funding without collateralization (and in lieu of generating funds through “traditional” brokered CDs or the Federal Home Loan Bank). These funds are accessed through a weekly auction. The auction typically takes place on Wednesdays, with next day settlement. There are seven maturities available ranging from 4 weeks to 5 years. If we are allotted funds in the auction, we incur no transaction fees or commissions. Although the process to compete for these deposits is different from the process for traditional brokered CDs, they are still considered brokered for Call Report purposes. These funds, which are included in our Jumbo CDs, are subject to discretionary limitations on volume that we normally would impose on traditional brokered deposits. Based on our “well capitalized” status, we are able to draw up to 30% of assets or $307.2 million from this program at June 30, 2014. We had $13.0 million on our balance sheet from this program at June 30, 2014 and $59.1 million at December 31, 2013.

We have lines of credit with the Federal Home Loan Bank of Atlanta (“FHLB”) that can equal up to 30% of our assets. Our line of credit totaled approximately $161.0 million with $151.9 million available at June 30, 2014. This line is currently reduced by $8.0 million, which has been pledged as collateral for public deposits.

Borrowings outstanding under the combined FHLB lines of credit were $1.1 million at June 30, 2014 and $1.2 million at December 31, 2013. We had the following borrowing advances under our Primary line outstanding as of June 30, 2014 with the following final maturities:



Advance Amount		Expiration Date
$	1,125,492	9/28/2015
$	1,125,492

This advance is a principal reducing credit that matures on September 28, 2015. Terms include 39 quarterly principal payments of $25 thousand beginning December 2005, with a final payment of $1.0 million in September 2015. We utilized this advance to match-fund several long term fixed rate loans. The interest rate for this advance is fixed at 4.96%.

We have no material commitments or long-term debt for capital expenditures at the report date. The only long-term debt is for funding loans.

Off-Balance Sheet Arrangements

We enter into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet transactions recognized as of June 30, 2014 and December 31, 2013 were a line of credit to secure public funds and commitments to extend credit and standby letters of credit issued to customers. The line of credit to secure public funds was from the Federal Home Loan Bank for $8 million at June 30, 2014 and December 31, 2013.

We entered into an interest rate swap agreement with PNC Bank of Pittsburgh, PA on July 29, 2009, for our $10 million Trust Preferred borrowings which carries a floating interest rate of 90 day LIBOR plus 160 basis points. Under the terms of this agreement, at the end of each quarter we will swap our floating rate for a fixed rate of 3.26%. The effective date of this swap is September 30, 2010, with an expiration date of September 30, 2014. This swap will fix our interest cost on our $10 million Trust Preferred borrowings of 4.86% for five years.

Commitments to extend credit, amounted to $167.8 million at June 30, 2014 and $237.9 million at December 31, 2013, represent legally binding agreements to lend to customers with fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future liquidity requirements.

We did not have any outstanding commitments to purchase securities at June 30, 2014 or December 31, 2013.

Standby letters of credit are conditional commitments we issue guaranteeing the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. We had $24.8 million in outstanding standby letters of credit at June 30, 2014 and $19.9 million at December 31, 2013.

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We have thirty-seven non-cancellable leases for premises. The original lease terms are from one to thirty years and have various renewal and option dates.

Capital Resources

We review the adequacy of our capital on an ongoing basis with reference to the size, composition, and quality of our resources and are consistent with regulatory requirements and industry standards. We seek to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, banks must meet specific capital guidelines that involve quantitative measures of the bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weighting, and other factors.

The Bank, as a Virginia banking corporation, may pay dividends only out of retained earnings. In addition, regulatory authorities may limit payment of dividends by any bank, when it is determined that such limitation is in the public interest and necessary to ensure financial soundness of the Bank. Regulatory agencies place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. At June 30, 2014, the amount available was approximately $23.0 million. In 2012 we paid quarterly dividends on our series B noncumulative, perpetual preferred stock of 7.8%, or $0.4875 per share per quarter, which has since been converted to common stock. We paid our first common stock dividend in 2010. We began paying common stock dividends on a quarterly basis in the first quarter of 2012. We paid semi-annual dividends on our common stock in 2011. Below is a table of our dividend history.

In June 2012, we received approval from the Securities and Exchange Commission to begin a Dividend Reinvestment Program ("DRP"). The DRP, which is available to existing shareholders, allows for dividends to be reinvested in Monarch stock. In addition, shareholders may purchase additional shares on a quarterly basis.

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COMMON STOCK DIVIDENDS



Payment Date	Per Share Dividend		Total Dividend
2014
June 13, 2014	$	0.08	$	849,563
February 28, 2014	$	0.07	$	742,447
2013
November 30, 2013	$	0.07	$	733,448
August 30, 2013	$	0.06	$	628,325
May 31, 2013	$	0.06	$	624,443
February 28, 2013	$	0.05	$	453,880
2012
November 30, 2012	$	0.05	$	332,754
August 31, 2012	$	0.05	$	302,161
May 31, 2012	$	0.05	$	299,174
February 28, 2012	$	0.04	$	240,000
2011
November 30, 2011	$	0.08	$	475,531
June 22, 2011	$	0.08	$	477,227

Basel III

In June 2012, the Federal Reserve, the FDIC and the OCC jointly issued proposed rules that would revise the risk-based and leverage capital requirements and the method for calculating risk-weighted assets to be consistent with the agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”). In June 2013, final rules were issued under Basel III which are scheduled to begin transitioning capital requirements January 1, 2015.

Among other things, the final rules establish a new common equity tier 1 (“CET1”) minimum capital requirement and a “capital conservation buffer”. These rules also raise minimum risk-based capital requirements. Basel III establishes a CET1 to risk-weighted assets of 4.5%, and a capital conservation buffer of an additional 2.5%, raising the target CET1 to risk-weighted assets ratio to 7%. It increases banks minimum ratio of Tier 1 capital to risk weighted assets to 6.0%, plus the capital conservation buffer effectively resulting in a minimum Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Institutions that do not maintain the required capital buffer would be subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The Bank's current capital levels meet the definition of well capitalized under full implementation guidelines of the final rules issued under Basel III.

Quantitative measures established by current regulations to ensure capital adequacy require that the Bank maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). As of June 30, 2014, the Bank meets all capital adequacy requirements to which it is subject.

As of June 30, 2014, the Bank was categorized as “well capitalized,” the highest level of capital adequacy. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. The Bank’s actual capital amounts and ratios are also presented in the table as of June 30, 2014 and December 31, 2013.

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RISK BASED CAPITAL



	Actual				For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective
	Amounts		Ratio		Amounts		Ratio		Amounts		Ratio
	(Dollars in Thousands)
As of June 30, 2014
Total Risk-Based Capital Ratio
Consolidated company	$	121,145	14.29	%	$	67,821	8.00	%	N/A		N/A
Bank	$	121,264	14.31	%	$	67,793	8.00	%	$	84,741	10.00	%
(Total Risk-Based Capital to Risk-Weighted Assets)
Tier 1 Risk-Based Capital Ratio
Consolidated company	$	112,075	13.22	%	$	33,911	4.00	%	N/A		N/A
Bank	$	112,194	13.24	%	$	33,895	4.00	%	$	50,843	6.00	%
(Tier 1 Capital to Risk-Weighted Assets)
Tier 1 Leverage Ratio
Consolidated company	$	112,075	11.30	%	$	39,672	4.00	%	N/A		N/A
Bank	$	112,194	11.31	%	$	39,680	4.00	%	$	49,599	5.00	%
(Tier 1 Capital to Average Assets)
As of December 31, 2013
Total Risk-Based Capital Ratio
Consolidated company	$	116,120	13.91	%	$	66,783	8.00	%	N/A		N/A
Bank	$	116,340	13.95	%	$	66,718	8.00	%	$	83,397	10.00	%
(Total Risk-Based Capital to Risk-Weighted Assets)
Tier 1 Risk-Based Capital Ratio
Consolidated company	$	107,059	12.82	%	$	33,391	4.00	%	N/A		N/A
Bank	$	107,279	12.86	%	$	33,359	4.00	%	$	50,038	6.00	%
(Tier 1 Capital to Risk-Weighted Assets)
Tier 1 Leverage Ratio
Consolidated company	$	107,059	10.81	%	$	39,600	4.00	%	N/A		N/A
Bank	$	107,279	10.84	%	$	39,600	4.00	%	$	48,501	5.00	%
(Tier 1 Capital to Average Assets)

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. Our primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of our asset/liability management process, which is governed by policies established by our board of directors that are reviewed and approved annually. Our board of directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Management Committee (“ALCO”). In this capacity, the committee develops guidelines and strategies that govern our asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.

Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with our financial instruments also change, affecting net interest income, the primary component of our earnings. ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While this committee routinely monitors simulated net interest income sensitivity over a rolling 12 month horizon, it also employs additional tools to monitor potential longer-term interest rate risk.

The interest sensitivity position (“gap”) is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. The gap can be managed by repricing assets or liabilities, affected by selling securities available-for-sale, by replacing an asset or liability at maturity, or by adjusting the interest rate or the life of an asset or liability. Matching of assets and liabilities repricing in the same interval helps to hedge the risk and minimize the impact on interest income in periods of rising and falling interest rates.

Generally, positive gaps affect net interest margins and earnings negatively in periods of falling rates, and conversely, higher negative gaps adversely impact net interest margin and earnings in periods of rising rates as a higher volume of liabilities will reprice quicker than assets over the period for which the gap is computed.

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The impact of changing interest rates on loans and deposits is reflected in our financial statements. We believe that our mortgage banking operation, Monarch Mortgage, provides somewhat of a natural interest rate hedge, in that we are interest rate sensitive to a downward change in the prime rate for short term periods. When loan interest rates decline, our earnings will be negatively impacted in our banking operation, but the mortgage company’s volume should increase as the demand for refinancing and purchase money mortgages increase. The reverse should occur in a rising interest rate environment. There have been no material changes in interest rates in the second quarter and first half of June 30, 2014 compared to December 31, 2013.

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ITEM 4. CONTROLS AND PROCEDURES

We maintain a system of internal controls and procedures designed to provide reasonable assurance as to the reliability of our published financial statements and other disclosures included in this report. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us (including our consolidated subsidiaries) required to be included in periodic SEC filings. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date we carried out our evaluation.

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PART II—OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of our operations, we become party to various legal proceedings. Currently, we are not party to any material legal proceedings, and no such proceedings are, to management’s knowledge, threatened against us.

Item 1A. Risk Factors

Our operations are subject to many risks that could adversely affect our future financial condition and performance and, therefore, the market value of our securities, including the risk factors that are outlined in our 2013 Annual Report on Form 10-K. There have been no material changes in our risk factors from those disclosed.

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

None.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

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Item 6. Exhibits



31.1 –	Certification of CEO pursuant to Rule 13a-14(a).
31.2 –	Certification of Principal Financial Officer pursuant to Rule 13a-14(a).
32.1 –	Certification of CEO and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.0 –	Financial statements and schedules in interactive data format.

SIGNATURES

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

MONARCH FINANCIAL HOLDINGS, INC.




/s/ Brad E. Schwartz	Date: August 7, 2014
Brad E. Schwartz Chief Executive Officer
/s/ Lynette P. Harris.	Date: August 7, 2014
Lynette P. Harris Executive Vice President & Chief Financial Officer

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Exhibit 31.1

SECTION 302 CERTIFICATION

I, Brad E. Schwartz, certify that:


1.	I have reviewed this quarterly report on Form 10-Q of Monarch Financial Holdings, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: August 7, 2014 /s/ Brad E. Schwartz _______________

Brad E. Schwartz

Chief Executive Officer

Table of Contents

Exhibit 31.2

SECTION 302 CERTIFICATION

I, Lynette P. Harris, certify that:


1.	I have reviewed this quarterly report on Form 10-Q of Monarch Financial Holdings, Inc.;

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: August 7, 2014 /s/ Lynette P. Harris. ___________________

Lynette P. Harris

Executive Vice President & Chief Financial Officer

Table of Contents

Exhibit 32.1

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Monarch Financial Holdings, Inc. (the "Company") for the period ending June 30, 2014 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), the undersigned Chief Executive Officer and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that based on their knowledge and belief:

(1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Brad E. Schwartz ______________

Brad E. Schwartz,

Chief Executive Officer

/s/ Lynette P. Harris. ___________________

Lynette P. Harris

Executive Vice President & Chief Financial Officer

Date: August 7, 2014

Attached files

Monarch Financial Holdings, Inc. Reports

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