FIRST SOUTH BANCORP INC /VA/ - FORM 10-Q

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EX-31.1 - CERTIFICATION - FIRST SOUTH BANCORP INC /VA/	v386398_ex31-1.htm
EX-32.1 - CERTIFICATION - FIRST SOUTH BANCORP INC /VA/	v386398_ex32.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2014.

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

For the transition period from to .

Commission File Number: 0-22219

FIRST SOUTH BANCORP, INC.

(Exact name of registrant as specified in its charter)

Virginia		56-1999749
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

1311 Carolina Avenue, Washington, North Carolina 27889

(Address of principal executive offices)

(Zip Code)

(252) 946-4178

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)

Large Accelerated Filer ¨	Accelerated Filer ¨
Non-Accelerated Filer ¨	Smaller Reporting Company x
(Do not check if a Smaller Reporting Company)

Indicate by check mark whether registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

Yes ¨ No x

Number of shares of common stock outstanding as of August 13, 2014: 9,598,007.

CONTENTS

		PAGE
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Statements of Financial Condition as of June 30, 2014 (unaudited) and December 31, 2013	1

	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2014 and 2013 (unaudited)	2

	Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2014 and 2013 (unaudited)	3

	Consolidated Statements of Changes in Stockholders' Equity for the Six Months Ended June 30, 2014 and 2013 (unaudited)	4

	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2014 and 2013 (unaudited)	5

	Notes to Consolidated Financial Statements (unaudited)	6

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	27

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35

Item 4.	Controls and Procedures	35

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	36

Item 1A.	Risk Factors	36

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	36

Item 3.	Defaults Upon Senior Securities	36

Item 4.	Mine Safety Disclosures	36

Item 5.	Other Information	36

Item 6.	Exhibits	36

Signatures		37

Exhibits

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Financial Condition

	June 30,			December 31,
	2014			2013
	(unaudited)			(*)
Assets

Cash and due from banks	$	12,375,471		$	11,816,071
Interest-bearing deposits with banks		5,282,836			12,419,244
Investment securities available for sale, at fair value		171,961,212			150,300,079
Investment securities held to maturity		506,740			506,176
Loans held for sale:
Mortgage loans		4,714,812			2,992,017
Total loans held for sale		4,714,812			2,992,017

Loans and leases held for investment		470,001,128			450,960,277
Allowance for loan and lease losses		(7,925,751	)		(7,609,467	)
Net loans and leases held for investment		462,075,377			443,350,810

Premises and equipment, net		11,671,087			11,759,521
Other real estate owned		8,729,188			9,353,835
Federal Home Loan Bank stock, at cost		1,754,000			848,800
Accrued interest receivable		2,418,075			2,334,944
Goodwill		4,218,576			4,218,576
Mortgage servicing rights		1,179,897			1,219,623
Identifiable intangible assets		-			7,860
Income tax receivable		2,628,640			2,901,062
Bank-owned life insurance		14,858,921			11,094,182
Prepaid expenses and other assets		7,172,629			9,599,143

Total assets	$	711,547,461		$	674,721,943

Liabilities and Stockholders' Equity

Deposits:
Non-interest bearing demand	$	97,733,716		$	96,445,049
Interest bearing demand		179,453,432			171,548,658
Savings		85,703,122			69,542,654
Large denomination certificates of deposit		104,313,575			123,492,907
Other time		125,256,744			124,674,588
Total deposits		592,460,589			585,703,856

Borrowed money		25,500,000			-
Junior subordinated debentures		10,310,000			10,310,000
Other liabilities		4,127,134			3,849,944
Total liabilities		632,397,723			599,863,800

Common stock, $.01 par value, 25,000,000 shares authorized; 9,598,007 and 9,653,883 shares outstanding, respectively		95,980			96,539
Additional paid-in capital		35,838,115			35,809,397
Retained earnings		40,297,998			38,849,326
Accumulated other comprehensive income		2,917,645			102,881
Total stockholders' equity		79,149,738			74,858,143

Total liabilities and stockholders' equity	$	711,547,461		$	674,721,943

(*) Derived from audited consolidated financial statements

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

Three and Six Months Ended June 30, 2014 and 2013

(unaudited)

	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2014			2013		2014		2013

Interest income:
Interest and fees on loans	$	5,969,398		$	6,107,467	$	11,898,632	$	12,660,156
Interest on investments and deposits		1,248,271			1,327,449		2,394,082		2,669,046
Total interest income		7,217,669			7,434,916		14,292,714		15,329,202

Interest expense:
Interest on deposits		526,343			625,772		1,086,052		1,296,497
Interest on borrowings		44,428			882		45,112		7,058
Interest on junior subordinated notes		81,359			89,125		161,280		176,340
Total interest expense		652,130			715,779		1,292,444		1,479,895

Net interest income		6,565,539			6,719,137		13,000,270		13,849,307
Provision for credit losses		450,000			-		700,000		400,000
Net interest income after provision for credit losses		6,115,539			6,719,137		12,300,270		13,449,307

Non-interest income:
Deposit fees and service charges		1,139,262			1,076,753		2,066,209		2,095,447
Loan fees and charges		41,425			39,109		78,557		79,618
Mortgage loan servicing fees		250,107			238,038		476,428		633,738
Gain on sale and other fees on mortgage loans		362,016			749,605		648,069		1,519,217
Gain on sale of other real estate, net		33,999			286,593		73,419		334,834
Gain on sale of investment securities		-			280,511		13,509		280,511
Other income		343,775			249,150		732,327		452,175
Total non-interest income		2,170,584			2,919,759		4,088,518		5,395,540

Non-interest expense:
Compensation and fringe benefits		3,823,779			3,857,822		7,627,777		7,691,296
Federal deposit insurance premiums		139,022			236,350		283,620		472,300
Premises and equipment		831,016			749,000		1,657,161		1,485,397
Advertising		105,579			39,116		169,012		82,062
Data processing		568,215			589,620		1,153,808		1,196,037
Amortization of intangible assets		(14,592	)		120,254		108,212		238,319
Other real estate owned expense		107,183			544,889		228,488		717,184
Other		898,027			772,850		1,812,950		1,784,178
Total non-interest expense		6,458,229			6,909,901		13,041,028		13,666,773

Income before income tax expense		1,827,894			2,728,995		3,347,760		5,178,074
Income tax expense		542,062			964,339		959,925		1,847,008

NET INCOME	$	1,285,832		$	1,764,656	$	2,387,835	$	3,331,066

Per share data:
Basic earnings per share	$	0.13		$	0.18	$	0.25	$	0.34
Diluted earnings per share	$	0.13		$	0.18	$	0.25	$	0.34
Dividends per share	$	0.025		$	0.00	$	0.050	$	0.00
Average basic shares outstanding		9,629,040			9,751,271		9,640,736		9,751,271
Average diluted shares outstanding		9,648,158			9,757,338		9,659,572		9,755,758

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income (Loss)

Three and Six Months Ended June 30, 2014 and 2013

(unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2014			2013			2014			2013

Net income	$	1,285,832		$	1,764,656		$	2,387,835		$	3,331,066

Other comprehensive income (loss):
Unrealized holding gains (losses) on securities available for sale		2,355,893			(5,018,543	)		4,818,550			(6,245,509	)
Tax effect		(895,239	)		1,872,632			(1,831,049	)		2,338,879
Unrealized holding gains (losses) on securities available for sale, net of tax		1,460,654			(3,145,911	)		2,987,501			(3,906,630	)

Unrealized loss on interest rate hedge position		(155,526	)		-			(265,099	)		-
Tax effect		59,100			-			100,738			-
Unrealized loss on interest rate hedge position, net of tax		(96,426	)		-			(164,361	)		-

Reclassification adjustment for realized gains included in net income		-			(280,511	)		(13,509	)		(280,511	)
Tax effect		-			108,148			5,133			108,148
Reclassification adjustment for realized gains, net of tax		-			(172,363	)		(8,376	)		(172,363	)

Other comprehensive income (loss), net of tax		1,364,228			(3,318,274	)		2,814,764			(4,078,993	)

Comprehensive income (loss)	$	2,650,060		$	(1,553,618	)	$	5,202,599		$	(747,927	)

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders' Equity

Six Months Ended June 30, 2014 and 2013

(unaudited)

									Accumulated
				Additional					other
	Common			paid-in		Retained			comprehensive
Six Months Ended June 30, 2014	stock			capital		earnings			income, net		Total

Balance at December 31, 2013	$	96,539		$	35,809,397	$	38,849,326		$	102,881	$	74,858,143

Net income							2,387,835					2,387,835

Other comprehensive income, net										2,814,764		2,814,764

Retirement of common shares		(559	)				(456,515	)				(457,074	)

Stock based compensation expense					28,718							28,718

Dividends							(482,648	)				(482,648	)

Balance at June 30, 2014	$	95,980		$	35,838,115	$	40,297,998		$	2,917,645	$	79,149,738

											Accumulated
			Additional								other
	Common		paid-in			Retained		Treasury			comprehensive
Six Months Ended June 30, 2013	stock		capital			earnings		stock			income, net			Total

Balance at December 31, 2012	$	97,513	$	35,811,804		$	65,532,960	$	(31,967,269	)	$	5,178,045		$	74,653,053

Net income							3,331,066								3,331,066

Other comprehensive loss, net												(4,078,993	)		(4,078,993	)

Stock based compensation benefit				(17,094	)										(17,094	)

Balance at June 30, 2013	$	97,513	$	35,794,710		$	68,864,026	$	(31,967,269	)	$	1,099,052		$	73,888,032

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2014 and 2013

(unaudited)

	Six Months Ended
	June 30,
	2014			2013

Cash flows from operating activities:
Net income	$	2,387,835		$	3,331,066
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for credit losses		700,000			400,000
Depreciation		581,496			547,029
Amortization of intangibles		108,212			238,319
Accretion of discounts and premiums on securities, net		487,782			323,725
(Gain) loss on disposal of premises and equipment		1,821			(4,800	)
Gain on sale of other real estate owned		(73,419	)		(334,834	)
Gain on sale of loans held for sale		(282,124	)		(671,610	)
Gain on sale of investment securities available for sale		(13,509	)		(280,511	)
Stock based compensation expense (benefit)		28,718			(17,094	)
Originations of loans held for sale, net		(11,089,816	)		(5,874,776	)
Proceeds from sale of loans held for sale		9,649,145			37,758,220
Other operating activities		830,891			(5,741,988	)
Net cash provided by operating activities		3,317,032			29,672,746
Cash flows from investing activities:
Proceeds from sale of investment securities available for sale		787,500			10,998,497
Proceeds from principal repayments of mortgage-backed securities available for sale		7,341,801			13,245,147
Originations of loans held for investment, net of principal repayments		(20,630,218	)		7,691,823
Proceeds from disposal of other real estate owned		1,914,917			4,235,298
Proceeds from disposal of premises and equipment		-			4,800
Purchases of investment securities available for sale		(25,460,229	)		(28,310,999	)
Purchases of bank-owned life insurance		(3,764,739	)		-
Sale (purchase) of FHLB stock		(905,200	)		1,010,400
Purchase of premises and equipment		(494,883	)		(192,786	)
Net cash provided by (used in) investing activities		(41,211,051	)		8,682,180
Cash flows from financing activities:
Net increase (decrease) in deposit accounts		6,756,733			(11,072,812	)
Net increase (decrease) in FHLB borrowings		25,500,000			(16,500,000	)
Cash paid for dividends		(482,648	)		-
Retirement of common shares		(457,074	)		-
Net cash provided by (used in) financing activities		31,317,011			(27,572,812	)

Increase (decrease) in cash and cash equivalents		(6,577,008	)		10,782,114
Cash and cash equivalents, beginning of period		24,235,315			12,366,389
Cash and cash equivalents, end of period	$	17,658,307		$	23,148,503

Supplemental disclosures:
Other real estate acquired in settlement of loans	$	1,205,651		$	452,881
Cash paid for interest	$	1,252,498		$	1,439,696

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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1. Basis of Presentation. The accompanying unaudited consolidated financial statements are prepared in accordance with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments necessary for fair presentation of the financial position and results of operations for the periods presented are included, none of which are other than normal recurring accruals. The financial statements of First South Bancorp, Inc. (the “Company”) and First South Bank (the “Bank”) are presented on a consolidated basis. The results of operations for the three and six months ended June 30, 2014, are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2014. Certain amounts in the unaudited Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 have been reclassified to conform with the presentation as of and for the respective periods ended June 30, 2014. The reclassifications had no effect on previously reported net income or stockholders’ equity.

Note 2. Earnings Per Share. Basic and diluted earnings per share for the three and six months ended June 30, 2014 and 2013, are based on weighted average shares of common stock outstanding. Diluted earnings per share include the potentially dilutive effects of the Company’s stock option plans. For the three and six months ended June 30, 2014 and 2013, there were 19,118 and 18,836 stock options and 6,067 and 4,487 stock options, respectively, that were dilutive because their exercise prices were less than the average market price of the Company’s common stock.

Note 3. Comprehensive Income. Comprehensive income includes net income and changes in other comprehensive income. The components of other comprehensive income (loss) primarily include net changes in unrealized gains and losses on available for sale securities, and the reclassification of net gains and losses on available for sale securities recognized in income during the respective reporting periods.

Note 4. Investment Securities. The following is a summary of the securities portfolio by major category. The amortized cost and fair value of each category, with gross unrealized gains and losses at June 30, 2014 and December 31, 2013 are summarized as follows:

	June 30, 2014
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities available for sale:	Cost		Gains		Losses		Value
	(In thousands)
Government agencies	$	19,070	$	306	$	22	$	19,354
Mortgage-backed securities		92,911		4,211		178		96,944
Municipal securities		45,973		1,066		194		46,845
Corporate bonds		9,000		7		189		8,818
Total	$	166,954	$	5,590	$	583	$	171,961

	December 31, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities available for sale:	Cost		Gains		Losses		Value
	(In thousands)
Government agencies	$	4,174	$	-	$	73	$	4,101
Mortgage-backed securities		93,143		2,464		154		95,453
Municipal securities		45,781		60		1,949		43,892
Corporate bonds		7,000		-		146		6,854
Total	$	150,098	$	2,524	$	2,322	$	150,300

	June 30, 2014
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities held to maturity:	Cost		Gains		Losses		Value
	(In thousands)
Government agencies	$	507	$	6	$	-	$	513
Total	$	507	$	6	$	-	$	513

	December 31, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities held to maturity:	Cost		Gains		Losses		Value
	(In thousands)
Government agencies	$	506	$	5	$	-	$	511
Total	$	506	$	5	$	-	$	511

The following table summarizes investment securities gross unrealized losses, fair value and length of time the securities were in a continuous unrealized loss position at June 30, 2014 and December 31, 2013. The Company deems these unrealized losses to be temporary and recoverable prior to or at maturity. The Company has the ability and intent to hold the investment securities for a reasonable period of time sufficient for a market price recovery or until maturity.

	June 30, 2014
	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
Government agencies	$	1,010	$	22	$	-	$	-	$	1,010	$	22
Mortgage-backed securities		2,168		121		7,277		57		9,445		178
Municipal securities		629		2		14,145		192		14,774		194
Corporate bonds		1,923		77		3,888		112		5,811		189
Total	$	5,730	$	222	$	25,310	$	361	$	31,040	$	583

	December 31, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
Government agencies	$	4,101	$	73	$	-	$	-	$	4,101	$	73
Mortgage-backed securities		20,387		148		1,136		6		21,523		154
Municipal securities		34,687		1,949		-		-		34,687		1,949
Corporate bonds		6,854		146		-		-		6,854		146
Total	$	66,029	$	2,316	$	1,136	$	6	$	67,165	$	2,322

The following table summarizes the amortized cost and fair values of the investment securities portfolio at June 30, 2014, by contractual maturity. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Less Than One Year		One to Five Years		Five to Ten Years		Over Ten Years
Securities available for sale:	(In thousands)
Government agencies
Amortized cost	$	-	$	-	$	19,070	$	-
Fair value		-		-		19,354		-
Mortgage-backed securities
Amortized cost		102		26,728		40,788		25,293
Fair value		108		27,804		42,181		26,851
Municipal securities
Amortized cost		-		17,030		25,458		3,485
Fair value		-		17,325		26,001		3,519
Corporate bonds
Amortized cost		-		-		9,000		-
Fair value		-		-		8,818		-
Total Amortized cost	$	102	$	43,758	$	94,316	$	28,778
Total Fair value	$	108	$	45,129	$	96,354	$	30,370

	Less Than One Year		One to Five Years		Five to Ten Years		Over Ten Years
Securities held to maturity:	(In thousands)
Government agencies
Amortized cost	$	-	$	507	$	-	$	-
Fair value		-		513		-		-
Total Amortized cost	$	-	$	507	$	-	$	-
Total Fair value	$	-	$	513	$	-	$	-

Mortgage-backed securities with an amortized cost of $4.0 million and $4.7 million, respectively, were pledged as collateral for public deposits at June 30, 2014 and December 31, 2013, respectively. In addition, a government agency bond with an amortized cost of $507,000 and $506,000 was pledged as collateral on a forward starting interest rate swap transaction at June 30, 2014 and December 31, 2013, respectively.

At June 30, 2014, the investment securities portfolio included 48 taxable and tax-exempt debt instruments issued by various U.S. states, counties, cities, municipalities and school districts. The following table is a summary, by U.S. state, of the Company’s investment in the obligations of state and political subdivisions:

	June 30, 2014
	Amortized Cost		Fair Value
Obligations of state and political subdivisions:	(dollars in thousands)
General obligation bonds:
Texas	$	11,350	$	11,736
Pennsylvania		5,766		5,740
New York		4,044		4,070
South Carolina		2,328		2,370
North Carolina		1,703		1,765
Other (7 states)		6,725		6,894
Total general obligation bonds		31,916		32,575
Revenue bonds:
North Carolina		5,025		5,114
New York		2,831		2,821
Texas		2,800		2,799
Pennsylvania		1,722		1,818
Florida		1,679		1,718
Total revenue bonds		14,057		14,270
Total obligations of state and political subdivisions	$	45,973	$	46,845

The largest exposure in general obligation bonds was one bond issued by Ambridge Area School District, Pennsylvania, with a total amortized cost basis of $2.4 million and total fair value of $2.3 million at June 30, 2014. Of this total, $2.4 million in amortized cost and $2.3 million in fair value are guaranteed by an insurance policy issued by Assured Guaranty Municipal Corp.

The following table is a summary of the revenue sources related to the Company’s investment in revenue bonds:

	June 30, 2014
	Amortized Cost		Fair Value
Revenue bonds by revenue source:	(dollars in thousands)
Refunding bonds	$	4,519	$	4,599
Public improvements		3,893		3,909
University and college		2,800		2,799
Pension funding		1,722		1,818
Other		1,123		1,145
Total revenue bonds	$	14,057	$	14,270

The largest single exposure in revenue bonds is an issue from the Philadelphia Authority for Industrial Development in Pennsylvania. The debt is to be repaid by the City of Philadelphia from revenues of pledged assets held and their taxes received. As of June 30, 2014, this issue had an amortized cost of $1.7 million and fair value of $1.8 million.

Prior to purchasing any security, the Bank ensures that the security is “investment grade”. For a security to be investment grade it must: (1) have a low risk of default by the obligor, and (2) expect the full and timely repayment of principal and interest over the expected life. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), certain investments are deemed investment grade. These include: US Treasury securities, Federal Agency securities, Revenue Bonds, and Unlimited-Tax General Obligation Municipals. Other securities undergo a pre-purchase analysis to ensure they are investment grade. To determine if a security is investment grade, if available, management utilizes the ratings of the Nationally Recognized Statistical Rating Organizations (NRSRO). However, they are not the sole basis of determining if a security is investment grade. In addition, on a pre-purchase basis, at least one of the following items pertaining to the obligor is acquired and reviewed as part of the Bank’s internal credit analysis:

Data from debt offerings Prospectus / Offering Circular

Data from regulatory filings (i.e. 10-Q, 10-K, 8-K)

Data available from the obligor’s website (i.e. Annual Reports, Press Releases)

Data obtained from a third party (i.e. Bond Broker, Analyst)

NRSRO report on the initial offering and/or subsequent reviews of the issuer

Other pertinent available financial information

There have been no instances where the NRSRO’s credit rating has significantly differed from that of internal analysis performed.

Note 5. Loans Held for Sale. The Bank originates residential mortgage loans for sale in the secondary market. Pursuant to ASC 825, Financial Instruments, at June 30, 2014 and December 31, 2013, the Bank marked these mortgage loans to market. Mortgage loans held for sale at June 30, 2014 and December 31, 2013, had estimated fair market values of $4.7 million and $3.0 million, respectively.

The Bank originates certain mortgage loans for sale that are approved by secondary investors. Their terms are set by the secondary investor, and they are transferred within 120 days after the Bank initially funds the loans. The Bank issues rate lock commitments to borrowers, and depending on market conditions, may enter into forward contracts with its secondary market investors to minimize interest rate risk related to mortgage loan forward sales commitments. The Bank uses forward contracts to minimize interest rate risk related to mortgage loan forward sales commitments to economically hedge a percentage of the locked-in pipeline. The Bank receives origination fees from borrowers and servicing release premiums from investors that are recognized in income when the loan is sold. The following table summarizes forward contract positions of the Bank at June 30, 2014 and December 31, 2013:

Forward Contracts

June 30, 2014

December 31, 2013

Fair

Notional

Fair

Notional

Value

(In thousands)

Mortgage Loan Forward Sales Commitments

4,435

1,873

Note 6. Loans Held for Investment. The following table summarizes loans held for investment at June 30, 2014 and December 31, 2013:

	June 30, 2014					December 31, 2013
	Amount		Percent of Total			Amount		Percent of Total
	(Dollars in thousands)
Loans Held for Investment
Mortgage loans:
Residential real estate	$	68,097		14.5	%	$	67,426		14.9	%
Residential construction		957		0.2			1,201		0.3
Residential lots and raw land		885		0.2			904		0.2
Total mortgage loans		69,939		14.9			69,531		15.4

Commercial loans and leases:
Commercial real estate		243,542		51.7			227,280		50.3
Commercial construction		30,610		6.5			24,597		5.4
Commercial lots and raw land		23,471		5.0			27,681		6.1
Commercial and Industrial		25,634		5.4			26,108		5.8
Lease receivables		11,650		2.5			8,179		1.8
Total commercial loans and leases		334,907		71.1			313,845		69.4

Consumer loans:
Consumer real estate		18,855		4.0			21,221		4.7
Consumer construction		1,694		0.4			1,549		0.3
Consumer lots and raw land		12,509		2.6			14,726		3.3
Home equity lines of credit		28,361		6.0			27,546		6.1
Consumer other		4,635		1.0			3,547		0.8
Total consumer loans		66,054		14.0			68,589		15.2

Gross loans held for investment		470,900		100.0	%		451,965		100.0	%

Less deferred loan origination fees, net		899					1,005
Less allowance for loan and lease losses		7,926					7,609

Net loans held for investment	$	462,075				$	443,351

The Bank has pledged certain loans secured by one-to-four family residential properties, multifamily residential properties, and commercial properties as collateral for outstanding advances and potential borrowings from the Federal Home Loan Bank of Atlanta (“FHLB”) in the amount of $146.7 million and $98.3 million at June 30, 2014 and December 31, 2013, respectively.

The following tables detail non-accrual loans held for investment, including troubled debt restructured (“TDR”) loans accounted for on a non-accrual status, segregated by class of loans, at June 30, 2014 and December 31, 2013:

	June 30, 2014		December 31, 2013
Non-accrual loans held for investment:	(Dollars in thousands)
Non-TDR loans accounted for on a non-accrual status:
Residential real estate	$	312	$	250
Residential lots and raw land		3		-
Commercial real estate		472		301
Commercial lots and raw land		43		1,020
Commercial and Industrial		-		76
Lease receivables		94		-
Consumer real estate		255		232
Consumer lots and raw land		1,918		40
Home equity lines of credit		56		93
Consumer other		12		2
Total Non-TDR loans accounted for on a non-accrual status	$	3,165	$	2,014

TDR loans accounted for on a non-accrual status:	June 30, 2014			December 31, 2013
Past Due TDRs:	(Dollars in thousands)
Commercial real estate	$	2,528		$	1,649
Commercial construction		-			-
Commercial lots and raw land		724			121
Commercial and Industrial		-			-
Consumer real estate		51			51
Consumer lots and raw land		-			-
Total Past Due TDRs on a non-accrual status		3,303			1,821

Performing TDRs:
Residential real estate		846			859
Commercial real estate		480			145
Commercial construction		-			-
Commercial lots and raw land		-			735
Commercial and Industrial		-			-
Consumer lots and raw land		-			-
Total performing TDRs on non-accrual status		1,326			1,739
Total TDR loans accounted for on a non-accrual status	$	4,629		$	3,650
Total non-accrual loans	$	7,794		$	5,574
Percentage of total loans held for investment, net		1.7	%		1.3	%
Loans over 90 days past due and still accruing		896			420
Other real estate owned	$	8,729		$	9,354
Total non-performing assets	$	17,419		$	15,348

Cumulative interest income not recorded on loans accounted for on a non-accrual status was $160,122 and $149,104 at June 30, 2014 and December 31, 2013, respectively.

The following table presents an age analysis of past due loans held for investment, segregated by class of loans as of June 30, 2014 and December 31, 2013:

Past due loans held for investment:	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Over 90 Days and Accruing
June 30, 2014	(In thousands)
Residential real estate	$	-	$	715	$	663	$	1,378	$	66,719	$	68,097	$	351
Residential construction		-		-		-		-		957		957		-
Residential lots and raw land		-		9		-		9		876		885		-
Commercial real estate		2,158		409		2,151		4,718		238,824		243,542		429
Commercial construction		-		157		-		157		30,453		30,610		-
Commercial lots and raw land		815		38		43		896		22,575		23,471		-
Commercial and Industrial		31		-		-		31		25,603		25,634		-
Lease receivables		-		4		94		98		11,552		11,650		-
Consumer real estate		450		18		195		663		18,192		18,855		4
Consumer construction		-		-		-		-		1,694		1,694		-
Consumer lots and raw land		1,755		-		294		2,049		10,460		12,509		112
Home equity lines of credit		24		9		39		72		28,289		28,361		-
Consumer other		8		3		9		20		4,615		4,635		-
Total	$	5,241	$	1,362	$	3,488	$	10,091	$	460,809	$	470,900	$	896

Past due loans held for investment:	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Over 90 Days and Accruing
December 31, 2013	(In thousands)
Residential real estate	$	1,751	$	1,641	$	404	$	3,796	$	63,630	$	67,426	$	404
Residential construction		-		-		-		-		1,201		1,201		-
Residential lots and raw land		-		-		16		16		888		904		16
Commercial real estate		3,463		1,445		732		5,640		221,640		227,280		-
Commercial construction		-		-		-		-		24,597		24,597		-
Commercial lots and raw land		772		-		733		1,505		26,176		27,681		-
Commercial and Industrial		108		-		76		184		25,924		26,108		-
Lease receivables		5		-		-		5		8,174		8,179		-
Consumer real estate		251		130		199		580		20,641		21,221		-
Consumer construction		-		-		-		-		1,549		1,549		-
Consumer lots and raw land		265		16		40		321		14,405		14,726		-
Home equity lines of credit		116		-		65		181		27,365		27,546		-
Consumer other		1		1		-		2		3,545		3,547		-
Total	$	6,732	$	3,233	$	2,265	$	12,230	$	439,735	$	451,965	$	420

The following table presents information on loans that were considered impaired as of June 30, 2014 and December 31, 2013. Impaired loans include loans modified as a TDR, whether on accrual or non-accrual status. At June 30, 2014, impaired loans included $6.0 million of TDRs, compared to $8.7 million at December 31, 2013.

Impaired Loans-June 30, 2014	Recorded Investment		Contractual Unpaid Principal Balance		Related Allowance		YTD Average Recorded Investment		Interest Income Recognized on Impaired Loans
With no related allowance recorded:	(In thousands)
Residential real estate	$	1,131	$	1,428	$	-	$	1,238	$	26
Commercial real estate		13,238		13,240		-		13,639		371
Commercial construction		2,874		2,874		-		2,898		79
Commercial lots and raw land		3,448		3,455		-		3,957		93
Commercial and Industrial		48		48		-		49		1
Consumer real estate		194		194		-		244		3
Consumer lots and raw land		1,982		2,214		-		731		24
Home equity lines of credit		30		30		-		48		1
Consumer other		95		95		-		95		2
Subtotal:		23,040		23,578		-		22,899		600

With an allowance recorded:
Commercial real estate		3,518		3,554		814		3,412		57
Consumer real estate		214		214		38		144		6
Consumer lots and raw land		568		568		98		570		14
Home equity lines of credit		25		25		5		8		-
Subtotal:		4,325		4,361		955		4,134		77

Totals:
Mortgage		1,131		1,428		-		1,238		26
Commercial		23,126		23,171		814		23,955		601
Consumer		3,108		3,340		141		1,840		50
Grand Total:	$	27,365	$	27,939	$	955	$	27,033	$	677

Impaired Loans-December 31, 2013	Recorded Investment		Contractual Unpaid Principal Balance		Related Allowance		YTD Average Recorded Investment		Interest Income Recognized on Impaired Loans
With no related allowance recorded:	(In thousands)
Residential real estate	$	1,146	$	1,444	$	-	$	1,105	$	48
Commercial real estate		14,039		14,039				18,560		791
Commercial construction		2,973		2,973		-		1,272		48
Commercial lots and raw land		4,805		4,812		-		5,388		249
Commercial and Industrial		49		49		-		87		2
Consumer real estate		300		300		-		403		17
Consumer lots and raw land		108		108		-		277		6
Home equity lines of credit		57		57		-		40		3
Consumer other		95		95		-		101		4
Subtotal:		23,572		23,877		-		27,233		1,168

With an allowance recorded:
Commercial real estate		3,150		3,150		510		2,954		153
Commercial and Industrial		73		73		23		73		-
Consumer real estate		167		167		25		139		2
Consumer lots and raw land		573		573		105		676		29
Subtotal:		3,963		3,963		663		3,842		184

Totals:
Residential		1,146		1,444		-		1,105		48
Commercial		25,089		25,096		533		28,334		1,243
Consumer		1,300		1,300		130		1,636		61
Grand Total:	$	27,535	$	27,840	$	663	$	31,075	$	1,352

Credit Quality Indicators. The Bank assigns a risk grade to each loan in the portfolio as part of the on-going monitoring of the credit quality of the loan portfolio.

Commercial loans are graded on a scale of 1 to 9 as follows:

•

Risk Grade 1 (Excellent) - Loans in this category are considered to be of the highest quality. The borrower(s) has significant financial strength, stability, and liquidity. Proven cash flow is significantly more than required to service current and proposed debt with consistently strong earnings. Collateral position is very strong and a secondary source of repayment is self-evident. Guarantors may not be necessary to support the debt.

•

Risk Grade 2 (Above Average) - Loans are supported by above average financial strength and stability. Cash flow is more than sufficient to meet current demands. Earnings are strong and reliable, but may differ from year to year. Collateral is highly liquid and sufficient to repay the debt in full. Guarantors may qualify for the loan on a direct basis.

•

Risk Grade 3 (Average) - Credits in this group are supported by upper tier industry-average financial strength and stability. Liquidity levels fluctuate and need for short-term credit is demonstrated. Cash flow is steady and adequate to meet demands but can fluctuate. Earnings should be consistent but operating losses have not occurred recently. Collateral is generally pledged at an acceptable loan to value, but the credit can support some level of unsecured exposure. Guarantors with demonstrable financial strength are typically required on loans to business entities, but may not be on loans to individual borrowers.

•

Risk Grade 4 (Acceptable) - Credits in this group are supported by lower end industry-average financial strength and stability. Liquidity levels fluctuate but are acceptable and need for short term credit is demonstrated. Cash flow is adequate to meet demands but can fluctuate. Earnings may be inconsistent but operating losses have not occurred recently. Collateral is generally pledged at an acceptable loan to value. Guarantors with demonstrable financial strength are required on loans to business entities, but may not be on loans to individual borrowers.

•

Risk Grade 5 (Watch) - An asset in this category is one that has been identified by the lender, or credit administration as a loan that has shown some degree of deterioration from its original status. These loans are typically protected by collateral but have potential weaknesses that deserve management’s close attention, but are not yet at a point to become a classified asset. There may be unsecured loans that are included in this category. These are loans that management feels need to be watched more closely than those rated as acceptable and if left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset to warrant including them as classified assets.

•

Risk Grade 6 (Special Mention) - An asset in this category is currently protected by collateral but has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.

•

Risk Grade 7 (Substandard) - A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the debtor(s) or of the collateral pledged, if any. These credits have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility the Bank will sustain some loss if the deficiencies are not corrected.

•

Risk Grade 8 (Doubtful) - A loan graded in this category has all the weaknesses inherent in one graded Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values highly questionable and improbable.

•

Risk Grade 9 (Loss) - A loan graded as Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted. This grade does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

Consumer loans are graded on a scale of 1 to 9 as follows:

•

Risk Grades 1 - 5 (Pass) - Loans in this category generally show little to no signs of weakness or have adequate mitigating factors that minimize the risk of loss. Some of the characteristics of these loans include, but are not limited to, adequate financial strength and stability, adequate cash flow, collateral with acceptable loan to value, additional repayment sources, and reliable earnings.

•

Mortgage loans are graded on a scale of 1 to 9 as follows:

•	Risk Grades 1 - 4 (Pass) - Loans in this category generally show little to no signs of weakness or have adequate mitigating factors that minimize the risk of loss. Some of the characteristics of these loans include, but are not limited to, adequate financial strength and stability, acceptable credit history, adequate cash flow, collateral with acceptable loan to value, additional repayment sources, and reliable earnings.

•	Risk Grade 5 (Pass -Watch) – Watch loans have shown credit quality changes from the original status. These loans are typically protected by collateral but have potential weaknesses that deserve management’s close attention, but are not yet at a point to become a classified asset. These are loans that management feels need to be watched more closely than those rated as Pass and if left uncorrected may result in the deterioration of the repayment prospects for the asset to warrant including them as classified assets.

•

Risk Grade 6 (Special Mention) – Special Mention loans are currently protected by collateral but have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.

•

Risk Grade 7 (Substandard) - Substandard loans are inadequately protected by the sound net worth and paying capacity of the borrower(s). Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

•

Risk Grade 8 (Doubtful) - Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable.

•

Risk Grade 9 (Loss) - Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

The following table presents information on risk ratings of the commercial, consumer, mortgage and lease receivable portfolios, segregated by loan class as of June 30, 2014 and December 31, 2013:

June 30, 2014
Commercial Credit Exposure by Assigned Risk Grade	Commercial Real Estate		Commercial Construction		Commercial Lots and Raw Land		Commercial and Industrial
	(In thousands)
1-Excellent	$	-	$	-	$	-	$	-
2-Above Average		3,175		148		83		626
3-Average		45,226		6,410		1,409		3,647
4-Acceptable		150,436		16,358		11,737		15,097
5-Watch		27,140		3,780		4,255		2,557
6-Special Mention		8,317		1,038		3,736		3,604
7-Substandard		9,248		2,876		2,251		103
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	243,542	$	30,610	$	23,471	$	25,634

June 30, 2014
Consumer Credit Exposure by Assigned Risk Grade	Consumer Real Estate		Consumer Construction		Consumer Lots and Raw Land		Home Equity Lines of Credit		Consumer Other
	(In thousands)
Pass	$	17,808	$	1,694	$	10,226	$	28,124	$	4,508
6-Special Mention		514		-		302		96		9
7-Substandard		533		-		1,981		141		118
8-Doubtful		-		-		-		-		-
9-Loss		-		-		-		-		-
Total	$	18,855	$	1,694	$	12,509	$	28,361	$	4,635

June 30, 2014
Mortgage and Lease Receivable Credit Exposure by Assigned Risk Grade	Residential Real Estate		Residential Construction		Residential Lots and Raw Land		Lease Receivables
	(In thousands)
Pass	$	66,221	$	957	$	882	$	11,556
6-Special Mention		717		-		-		-
7-Substandard		1,159		-		3		94
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	68,097	$	957	$	885	$	11,650

December 31, 2013
Commercial Credit Exposure by Assigned Risk Grade	Commercial Real Estate		Commercial Construction		Commercial Lots and Raw Land		Commercial and Industrial
	(In thousands)
1-Excellent	$	-	$	-	$	-	$	-
2-Above Average		3,148		161		125		579
3-Average		37,492		4,664		1,157		4,831
4-Acceptable		141,942		12,147		12,969		13,011
5-Watch		26,340		3,797		5,388		2,313
6-Special Mention		10,101		3,725		5,019		5,181
7-Substandard		8,257		103		3,023		193
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	227,280	$	24,597	$	27,681	$	26,108

December 31, 2013
Consumer Credit Exposure by Assigned Risk Grade	Consumer Real Estate		Consumer Construction		Consumer Lots and Raw Land		Home Equity Lines of Credit		Consumer Other
	(In thousands)
Pass	$	20,058	$	1,549	$	12,380	$	27,110	$	3,414
6-Special Mention		655		-		2,238		300		18
7-Substandard		508		-		108		136		115
8-Doubtful		-		-		-		-		-
9-Loss		-		-		-		-		-
Total	$	21,221	$	1,549	$	14,726	$	27,546	$	3,547

December 31, 2013
Mortgage and Lease Receivable Credit Exposure by Assigned Risk Grade	Residential Real Estate		Residential Construction		Residential Lots and Raw Land		Lease Receivables
	(In thousands)
Pass	$	64,972	$	1,201	$	899	$	8,161
6-Special Mention		1,345		-		5		18
7-Substandard		1,109		-		-		-
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	67,426	$	1,201	$	904	$	8,179

Note 7. Allowance for Loan and Lease Losses. The following table presents a roll forward summary of activity in the allowance for loan and lease losses (“ALLL”), by loan category, for the six months ended June 30, 2014 and 2013:

	June 30, 2014
	Beginning		Charge-								Ending		Total
	Balance		Offs			Recoveries		Provisions			Balance		Loans
	(In thousands)
Collectively evaluated:
Residential real estate	$	903	$	-		$	-	$	(27	)	$	876	$	66,966
Residential construction		17		-			-		(6	)		11		957
Residential lots and raw land		13		-			-		(1	)		12		885
Commercial real estate		3,647		(1	)		19		63			3,728		226,786
Commercial construction		343		-			1		81			425		27,736
Commercial lots and raw land		415		-			-		(65	)		350		20,023
Commercial and Industrial		430		(3	)		9		(48	)		388		25,586
Lease receivables		113		(1	)		-		115			227		11,650
Consumer real estate		316		-			17		(56	)		277		18,447
Consumer construction		23		-			-		1			24		1,694
Consumer lots and raw land		203		(232	)		-		188			159		9,959
Home equity lines of credit		463		(12	)		7		(18	)		440		28,306
Consumer other		60		(5	)		10		(11	)		54		4,540
Total		6,946		(254	)		63		216			6,971		443,535
Individually evaluated:
Residential real estate		-		-			-		-			-		1,131
Commercial real estate		510		(23	)		5		322			814		16,756
Commercial construction		-		-			1		(1	)		-		2,874
Commercial lots and raw land		-		(104	)		-		104			-		3,448
Commercial and Industrial		23		(49	)		-		26			-		48
Consumer real estate		25		(24	)		-		37			38		408
Consumer lots and raw land		105		-			-		(7	)		98		2,550
Home equity lines of credit		-		(1	)		3		3			5		55
Consumer other		-		-			-		-			-		95
Total		663		(201	)		9		484			955		27,364
Grand Total	$	7,609	$	(455	)	$	72	$	700		$	7,926	$	470,900

	June 30, 2013
	Beginning		Charge-								Ending		Total
	Balance		Offs			Recoveries		Provisions			Balance		Loans
	(In thousands)
Collectively evaluated:
Residential real estate	$	1,178	$	-		$	-	$	(32	)	$	1,146	$	70,886
Residential construction		45		-			-		(5	)		40		2,559
Residential lots and raw land		14		-			-		1			15		920
Commercial real estate		3,342		-			11		(31	)		3,322		190,534
Commercial construction		350		(12	)		-		(62	)		276		16,392
Commercial lots and raw land		504		-			-		57			561		24,936
Commercial and Industrial		353		(14	)		2		48			389		20,846
Lease receivables		136		-			-		20			156		6,722
Consumer real estate		342		(28	)		10		20			344		19,559
Consumer construction		11		-			-		(4	)		7		453
Consumer lots and raw land		547		-			-		(187	)		360		15,084
Home equity lines of credit		490		(11	)		-		(1	)		478		25,511
Consumer other		88		(7	)		13		(9	)		85		4,155
Total		7,400		(72	)		36		(185	)		7,179		398,557
Individually evaluated:
Residential real estate		-		-			-		299			299		2,944
Commercial real estate		35		(127	)		494		133			535		24,465
Commercial construction		-		-			-		-			-		669
Commercial lots and raw land		303		-			11		(59	)		255		6,427
Commercial and Industrial		-		-			-		-			-		126
Consumer real estate		12		(1	)		2		3			16		584
Consumer lots and raw land		110		-			-		200			310		1,155
Home equity lines of credit		-		(1	)		2		9			10		45
Consumer other		-		-			-		-			-		95
Total		460		(129	)		509		585			1,425		36,510
Grand Total	$	7,860	$	(201	)	$	545	$	400		$	8,604	$	435,067

Note 8. Troubled Debt Restructurings. The following table details performing TDR loans at June 30, 2014 and December 31, 2013, segregated by class of financing receivables:

	June 30, 2014			December 31, 2013
	(Dollars in thousands)
Performing TDR loans accounted for on an accrual basis:
Residential real estate	$	-		$	287
Commercial real estate		1,161			1,887
Commercial construction		-			2,762
Commercial lots and raw land		-			-
Commercial and Industrial		11			13
Consumer real estate		167			171
Consumer lots and raw land		64			69
Home equity lines of credit		-			-
Consumer other		13			18
Total performing TDR loans accounted for on an accrual basis	$	1,416		$	5,207
Percentage of total loans, net		0.3	%		1.1	%

The following table presents a roll forward of performing and non-performing TDR loans for the six months ended June 30, 2014:

Performing TDRs	Beginning Balance		Additions (1)		Charge- Offs (2)		Other (3)			Ending Balance
June 30, 2014	(In thousands)
Residential mortgage	$	287	$	-	$	-	$	(287	)	$	-
Commercial		4,662		-		-		(3,491	)		1,171
Consumer		258		-		-		(13	)		245
Total	$	5,207	$	-	$	-	$	(3,791	)	$	1,416

Non-Performing TDRs	Beginning Balance		Additions (1)		Charge- Offs (2)			Other (4)			Ending Balance
June 30, 2014	(In thousands)
Residential mortgage	$	859	$	-	$	-		$	(13	)	$	846
Commercial		2,650		1,459		(15	)		(362	)		3,732
Consumer		51		-		-			-			51
Total	$	3,560	$	1,459	$	(15	)	$	(375	)	$	4,629

Includes new TDRs and increases to existing TDRs.

Post modification charge-offs.

Includes principal payments, paydowns and performing loans previously restructured at market rates that are no longer reported as TDRs.

Includes principal payments, paydowns and loans previously designated as non-performing that are currently performing in compliance with their modified terms.

In determining the allowance for loan and lease losses, the Bank considers TDRs and subsequent defaults in restructuring in its estimate. As a result, the allowance may be increased, adjustments may be made in the allocation of the allowance, or charge-offs may be taken to further write down the carrying value of the loan. The Bank’s primary objective in granting concessions to borrowers having financial difficulties is an attempt to protect as much of its investment as possible. The Bank faces significant challenges when working with borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption periods. While borrowers may experience deterioration in their financial condition, many continue to be creditworthy customers who have the willingness and capacity to repay their debts. In such cases, the Bank finds it mutually beneficial to work constructively with its borrowers, and that prudent restructurings are often in the best interest of the Bank and the borrower.

The Bank offers a variety of TDR programs on a loan-by-loan basis in which, for economic or legal reasons related to an individual borrower’s financial condition, it grants a concession to the borrower that would not otherwise be considered. The restructuring of a troubled loan may include, but is not limited to any one or combination of the following: a modification of the loan terms such as a reduction of the contractual interest rate, principal, payment amount or accrued interest; an extension of the maturity date at a stated interest rate lower than the current market rate for a new debt with similar risks; a change in payment type, e.g. from principal and interest, to interest only with all principal and interest due at maturity; a substitution or acceptance of additional collateral; and a substitution or addition of new debtors for the original borrower.

The Bank’s restructuring success includes but is not limited to any one or combination of the following: improves the prospects for repayment of principal and interest; reduces the prospects of further write downs and charge-offs; reduces the prospects of potential additional foreclosures; helps borrowers to maintain a creditworthy status; and ultimately will reduce the volume of classified, criticized and/or non-accrual loans. The Bank identifies loans for potential restructuring on a loan-by-loan basis using a variety of sources which may include, but is not limited to any one or combination of the following: being approached or contacted by the borrower to modify loan terms; review of borrower’s financial statements indicates borrower may be experiencing financial difficulties; past due payment reports; loans extending past their stated maturity date; and non-accrual loan reports.

On a loan-by-loan basis, the Bank restructures loans that were either on non-accrual basis or on accrual basis prior to restructuring. If a loan was on nonaccrual basis prior to restructuring, it remains on nonaccrual basis until the borrower has demonstrated a willingness and ability to meet the terms and conditions of the restructuring and to make the restructured loan payments, generally for a period of at least six months. The Bank has not immediately placed any restructured loan on accrual status that was on nonaccrual status prior to restructuring. If a restructured loan was on accrual basis prior to restructuring and the Bank expects the borrower to perform to the terms and conditions of the loan after restructuring (i.e. the loan was current, on accrual basis, and the borrower has the ability to make the restructured loan payments), the loan remains on an accrual basis and placement on nonaccrual is not required.

The Bank performs restructurings on certain troubled loan workouts, whereby existing loans are restructured into a multiple note structure (i.e., Note A and Note B structure). The Bank separates a portion of the current outstanding debt into a new legally enforceable note (Note A) that is reasonably assured of repayment and performance according to prudently modified terms. The portion of the debt that is not reasonably assured of repayment (Note B) is adversely classified and charged-off as appropriate. There were no multiple note restructures outstanding as of June 30, 2014 or 2013.

Note 9. Other Real Estate Owned. The following table reflects the changes in other real estate owned (“OREO”) during the six months ended June 30, 2014 and 2013:

	Beginning							Fair Value			End
	of Period		Additions		Sales, net			Adjustments			of Period
	(In thousands)
June 30, 2014
OREO	$	9,354	$	1,206	$	(1,820	)	$	(11	)	$	8,729

June 30, 2013
OREO	$	12,893	$	453	$	(3,901	)	$	(376	)	$	9,069

Fair value adjustments made are recorded in order to adjust the carrying values of OREO properties to estimated fair market values. In most cases, estimated fair market values are derived from an initial appraisal, an updated appraisal or other forms of internal evaluations. In certain instances when a listing agreement is renewed for a lesser amount, carrying values will be adjusted to the lesser fair value amount. Additionally, in certain instances when an offer to purchase is received near the end of a quarterly accounting period for less than the carrying value, and the sale does not close until the next accounting period, the carrying value will be adjusted to the lesser fair value amount.

Note 10. Fair Value Measurement. Fair value is defined as the price that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy prioritizes the inputs of valuation techniques used to measure fair value of nonfinancial assets and liabilities. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of the market observability of the fair value measurement. In order to determine the fair value, the Bank must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the Bank to define the inputs for fair value and level of hierarchy. The Bank groups financial assets at fair value in the three levels listed below based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1: inputs to the valuation methodology are quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. The types of assets carried at Level 1 fair value generally include investments such as U. S. Treasury and U. S. government agency securities.

Level 2: inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets and price quotations can vary substantially either over time or among market makers. The types of assets carried at Level 2 fair value generally include mortgage-backed securities issued by Government Sponsored Enterprises (“GSEs”), municipal bonds, corporate debt securities, mortgage loans held for sale and bank-owned life insurance.

Level 3: inputs to the valuation methodology are unobservable to the extent that observable inputs are not available. Unobservable inputs are developed based on the best information available in the circumstances and might include the Bank’s own assumptions. The Bank shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. The types of assets carried at Level 3 fair value generally include investments backed by non-traditional mortgage loans or certain state or local housing agency obligations, of which the Bank has no such assets or liabilities. Level 3 also includes impaired loans and other real estate owned.

The following table presents assets measured at fair value on a recurring basis as of June 30, 2014 and December 31, 2013:

	Fair Value			Quoted Prices In Active Markets for Identical Assets		Significant Observable Inputs-Other			Significant Unobservable Inputs
	(In thousands)
Description	6/30/14			Level 1		Level 2			Level 3
Securities available for sale:
Government securities	$	19,354		$	19,354	$	-		$	-
Mortgage-backed securities		96,944			-		96,944			-
Municipal securities		46,845			-		46,845			-
Corporate bonds		8,818			-		8,818			-
Mortgage loans held for sale		4,715			-		4,715			-
Bank-owned life insurance		14,859			-		14,859			-
Forward starting interest rate swap		(301	)		-		(301	)		-
Total June 30, 2014	$	191,234		$	19,354	$	171,880		$	-

Description	12/31/13			Level 1		Level 2			Level 3
Securities available for sale:
Government securities	$	4,101		$	4,101	$	-		$	-
Mortgage-backed securities		95,453			-		95,453			-
Municipal securities		43,892			-		43,892			-
Corporate bonds		6,854			-		6,854			-
Mortgage loans held for sale		2,992			-		2,992			-
Bank-owned life insurance		11,094			-		11,094			-
Forward starting interest rate swap		(36	)		-		(36	)		-
Total December 31, 2013	$	164,350		$	4,101	$	160,249		$	-

The following table presents assets measured at fair value on a non-recurring basis as of June 30, 2014 and December 31, 2013:

	Fair Value		Quoted Prices In Active Markets for Identical Assets		Significant Observable Inputs-Other		Significant Unobservable Inputs
	(In thousands)
Description	6/30/14		Level 1		Level 2		Level 3
Impaired loans, net	$	26,410	$	-	$	-	$	26,410
Other real estate owned		8,729		-		-		8,729
Total June 30, 2014	$	35,139	$	-	$	-	$	35,139

Description	12/31/13			Level 1		Level 2		Level 3
Impaired loans, net	$	26,872	$	-	$	-	$	26,872
Other real estate owned		9,354		-		-		9,354
Total December 31, 2013	$	36,226	$	-	$	-	$	36,226

Impaired loans at June 30, 2014 and December 31, 2013 includes $20.5 million and $22.7 million, respectively, of loans identified as impaired, even though an impairment analysis calculated pursuant to ASC 310-10-35 resulted in no impairment loss recognition.

Quoted market price for similar assets in active markets is the valuation technique for determining fair value of securities available for sale and held to maturity. Unrealized gains on available for sale securities are included in the “accumulated other comprehensive income” component of the Stockholders’ Equity section of the Consolidated Statements of Financial Condition. The estimated fair value of loans held for sale is based on commitments from investors within the secondary market for loans with similar characteristics.

The Company does not record loans held for investment at fair value on a recurring basis. However, when a loan is considered impaired an impairment write down is taken based on the loan’s estimated fair value. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those loans not requiring a write down represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans, and are not included above.

Impaired loans where a write down is taken based on fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as non-recurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company classifies the impaired loan as non-recurring Level 3.

OREO is recorded at lower of cost or fair value upon transfer of the loans to foreclosed assets, based on the appraised market value of the property. OREO is reviewed quarterly and values are adjusted as determined appropriate. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is impaired below the appraised value and there is no observable market price, the Company classifies the foreclosed asset as non-recurring Level 3. Fair value adjustments of $11,200 were made to OREO during both the three and six months ended June 30, 2014, compared to $375,701 made during both the three and six months ended June 30, 2013.

Net gains realized on sales of OREO and included in earnings for the three and six months ended June 30, 2014 and 2013, respectively, are reported in other revenues as follows:

		Three Months Ended 6/30/14				Three Months Ended 6/30/13				Six months Ended 6/30/14				Six months Ended 6/30/13
Net gains on sales of OREO		$	33,999			$	286,593			$	73,419			$	334,834

No liabilities were measured at fair value on a recurring or non-recurring basis at June 30, 2014 or December 31, 2013.

Note 11. Fair Value of Financial Instruments. The following table represents the recorded carrying values, estimated fair values and the fair value hierarchy within which the fair value measurements of the Company’s financial instruments are categorized at June 30, 2014 and December 31, 2013:

	Level in	June 30, 2014						December 31, 2013
	Fair Value	Estimated			Carrying			Estimated			Carrying
	Hierarchy	Fair Value			Amount			Fair Value			Amount
		(In thousands)
Financial assets:
Cash and due from banks	Level 1	$	12,375		$	12,375			11,816		$	11,816
Interest-bearing deposits in other banks	Level 1		5,283			5,283			12,419			12,419
Securities available for sale	Level 2		171,961			171,961			150,300			150,300
Securities held to maturity	Level 2		513			507			511			506
Loans held for sale	Level 2		4,715			4,715			2,992			2,992
Loans and leases HFI, net, less impaired loans	Level 2		441,357			435,665			419,472			416,479
Impaired loans HFI, net	Level 3		26,410			26,410			26,872			26,872
Stock in FHLB of Atlanta	Level 2		1,754			1,754			849			849
Accrued interest receivable	Level 2		2,418			2,418			2,335			2,335
Mortgage servicing rights	Level 3		2,496			1,180			3,409			1,220
Bank-owned life insurance	Level 2		14,859			14,859			11,094			11,094
Forward starting interest rate swap	Level 2		(301	)		(301	)		(36	)		(36	)

Financial liabilities:
Deposits	Level 2	$	592,596		$	592,461		$	587,158			585,704
Borrowed money:
Advances from FHLB	Level 2		25,500			25,500			-			-
Junior subordinated debentures	Level 2		10,310			10,310			10,310			10,310

Fair values have been estimated using data which management considers as the best available, and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimation methodologies used by the Bank were as follows:

Cash and Due from banks and Interest –Bearing Deposits in Other Banks: The carrying amounts for cash and due from banks and interest bearing deposits in other banks are equal to their fair value. Fair value hierarchy Input level 1.

Investment Securities Available for Sale and Held to Maturity: The estimated fair value of investment securities is provided in Note 4 of the Notes to Consolidated Financial Statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Fair value hierarchy Input level 2.

Loans Held for Sale. The estimated fair value of loans held for sale is based on commitments from investors within the secondary market for loans with similar characteristics. Fair value hierarchy Input level 2.

Loans and Leases Held for Investment, Net, less Impaired Loans: Fair values are estimated for portfolios of loans and leases held for investment with similar financial characteristics. Loans and leases are segregated by collateral type and by fixed and variable interest rate terms. The fair value of each category is determined by discounting scheduled future cash flows using current interest rates offered on loans or leases with similar characteristics. Fair value hierarchy Input level 2.

Impaired Loans Held for Investment, Net: Fair values for impaired loans and leases are estimated based on discounted cash flows or underlying collateral values, where applicable. Fair value hierarchy Level 3.

Stock in Federal Home Loan Bank of Atlanta: The fair value for FHLB stock approximates carrying value, based on the redemption provisions of the Federal Home Loan Bank. Fair value hierarchy Input level 2.

Deposits and Advances from FHLB: The fair value of demand deposits is the amount payable on demand at the reporting date. The fair values of certificates of deposits and FHLB advances are estimated using the rates currently offered for similar instruments with similar remaining maturities. Fair value hierarchy Input level 2.

Accrued Interest Receivable and Junior Subordinated Debentures: The carrying amount of accrued interest receivable and junior subordinated debentures approximates fair value because of the short maturities of these instruments. Fair value hierarchy Input level 2.

Mortgage Servicing Rights (“MSRs”): The fair value of MSRs is estimated for those loans sold with servicing retained. The loans are stratified into pools by product type and within product type by interest rate and maturity. The fair value of the MSR is based upon the present value of estimated future cash flows using current market assumptions for prepayments, servicing costs and other factors. Fair value hierarchy Input level 3.

Bank-Owned Life Insurance: The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the issuer. Fair value hierarchy Input level 2.

Forward Starting Interest Rate Swap: The Company has entered into a forward starting pay-fixed receive-floating swap to hedge our $10.0 million of floating rate Trust Preferred debt. The primary objective of the swap is to minimize future interest rate risk. The effective date of the swap is December 30, 2014. Fair value hierarchy Input level 2.

Financial Instruments with Off-Balance Sheet Risk: With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.

Note 12. Deposits. The following table presents the distribution of the Bank’s deposit accounts as of June 30, 2014 and December 31, 2013:

	6/30/14		12/31/13
	(In thousands)
Demand accounts:
Non-interest bearing checking	$	97,734	$	96,445
Interest bearing checking		133,512		128,161
Money market		45,942		43,388
Savings accounts		85,703		69,543
Certificate accounts		229,570		248,167
Total deposits	$	592,461	$	585,704

At June 30, 2014, the scheduled maturities of certificate accounts were as follows:

	Less than $100,000		$100,000 or more		Total
	(In thousands)
Three months or less	$	26,810	$	21,618	$	48,428
Over three months through one year		45,353		34,386		79,739
Over one year through three years		38,941		34,872		73,813
Over three years to five years		14,152		13,438		27,590
Total time deposits	$	125,256	$	104,314	$	229,570

The aggregate amount of time deposits with balances of $100,000 or more was $104,313,575 and $123,492,907 at June 30, 2014 and December 31, 2013, respectively.

Note 13. Stock-Based Compensation. The Company had two stock-based compensation plans at June 30, 2014. The shares outstanding are for grants under the Company’s 1997 Stock Option Plan (the “1997 Plan”) and the 2008 Equity Incentive Plan (the “2008 Plan”). The 1997 Plan matured on April 8, 2008 and no additional options may be granted under the 1997 Plan. At June 30, 2014, the 1997 Plan had 42,750 granted unexercised stock option shares. At June 30, 2014, the 2008 Plan includes 132,500 granted unexercised stock option shares, 13,900 granted nonvested restricted stock award shares and 809,850 shares available to be granted.

Stock Option Grants. Options granted under the 2008 Plan are granted at the closing price of the Company’s common stock on the NASDAQ Stock Market on the date of grant. Stock options expire ten years from the date of grant and vest over service periods ranging from one year to five years. The Company settles stock option exercises with authorized unissued shares. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is based on the U.S. Treasury rate for the expected life at the time of grant. Volatility is based on the average volatility of the Company based upon previous trading history. The expected life and forfeiture assumptions are based on historical data. Dividend yield is based on the yield at the time of the option grant. During the quarter ended June 30, 2014, 1,000 options were granted, compared to none granted during the quarter ended June 30, 2013. The average fair value per share of options granted in the quarter ended June 30, 2014 was $4.09.

A summary of option activity under the Plans as of June 30, 2014 and 2013, and changes during the three and six month periods ended June 30, 2014 and 2013, respectively, is presented below:

	Options Outstanding			Price		Aggregate Intrinsic Value
Quarter Ended June 30, 2014:
Outstanding at December 31, 2013		160,375		$	11.84
Granted		18,000			8.36
Forfeited		(2,250	)		6.52
Expired		(1,875	)		19.88
Exercised		-			-
Outstanding at March 31, 2014		174,250			11.46	$	257,090
Granted		1,000			8.06
Forfeited		-			-
Expired		-			-
Exercised		-			-
Outstanding at June 30, 2014		175,250			11.44	$	197,365
Vested and Exercisable at June 30, 2014		111,450		$	14.47	$	74,109

Quarter Ended June 30, 2013:
Outstanding at December 31, 2012		154,004		$	12.86
Granted		-			-
Forfeited		-			-
Expired		-			-
Exercised		-			-
Outstanding at March 31, 2013		154,004			12.86	$	87,520
Granted		22,500			6.52
Forfeited		(8,000	)		12.77
Expired		-			-
Exercised		-			-
Outstanding at June 30, 2013		168,504			12.02	$	84,100
Vested and Exercisable at June 30, 2013		108,004		$	15.72	$	18,910

The following weighted-average assumptions were used for grants awarded in the three and six months ended June 30, 2014 and 2013:

	Three Months Ended 6/30/14			Three Months Ended 6/30/13			Six Months Ended 6/30/14			Six Months Ended 6/30/13
Dividend growth rate		1.0	%		0.0	%		1.0	%		0.0	%
Expected volatility		53.0	%		37.1	%		53.0	%		37.1	%
Average risk-free interest rate		1.85	%		1.40	%		1.85	%		1.40	%
Expected lives - years		6			6			6			6

The following table summarizes additional information about the Company’s outstanding options and exercisable options as of June 30, 2014, including weighted-average remaining contractual term expressed in years ("Life") and weighted average exercise price (“Price”):

	Outstanding						Exercisable
Range of Exercise Pricel	Shares		Life		Price		Shares		Price
$4.00 – 10.00		94,500		8.05	$	5.97		30,700	$	5.58
$10.01 – 17.00		31,500		4.46		11.57		31,500		11.57
$17.01 – 26.00		39,750		3.02		20.36		39,750		20.36
$26.01 – 34.00		9,500		2.19		28.14		9,500		28.14
		175,250		5.94	$	11.44		111,450	$	14.47

A summary of nonvested option shares as of June 30, 2014 and 2013, and vesting changes during the three and six months ended June 30, 2014 and 2013, is presented below:

	Shares			Price
Period Ended June 30, 2014:
Nonvested at December 31, 2013		58,750		$	5.38
Granted		18,000			8.36
Forfeited		(2,250	)		6.52
Vested		(7,000	)		5.40
Nonvested at March 31, 2014		67,500			6.14
Granted		1,000			8.06
Forfeited		-			0.00
Vested		(4,700	)		6.21
Nonvested at June 30, 2014		63,800		$	6.16

Period Ended June 30, 2013:
Nonvested at December 31, 2012		50,166		$	5.68
Granted		-			0.00
Forfeited		-			0.00
Vested		(11,166	)		8.87
Nonvested at March 31, 2013		39,000			4.77
Granted		22,500			6.52
Forfeited		-			0.00
Vested		(1,000	)		5.05
Nonvested at June 30, 2013		60,500		$	5.42

There were no income tax benefits realized from the exercise of stock options for the three and six months ended June 30, 2014 or 2013. There was also no intrinsic value for options exercised during the three and six months ended June 30, 2014 or 2013, as no options were exercised during the respective periods.

Total compensation expense charged to income for stock options was $8,359 and $16,613, respectively, for the three and six months ended June 30, 2014, compared to net compensation benefit credited to income of $26,369 and $17,094, respectively, for the three and six months ended June 30, 2013. As of June 30, 2014, total unrecognized compensation cost on granted unexercised shares was $132,540, and is expected to be recognized during the next five years.

Restricted Stock Awards. The Company measures the fair value of restricted shares based on the price of its common stock on the grant date and compensation expense is recorded over the vesting period. During the three and six months ended June 30, 2014, none and 13,900 restricted stock awards, respectively, were granted with a four year vesting period. Total compensation expense recognized for restricted stock awards for the three and six months ended June 30, 2014 was $7,263 and $12,105, respectively. As of June 30, 2014, there was $104,099 of total unrecognized compensation cost related to nonvested restricted stock granted under the 2008 Plan, which will be recognized over a remaining period of 3.5 years.

A summary of nonvested restricted stock awards as of June 30, 2014 and vesting changes during the three and six months ended June 30, 2014 is presented below:

	Shares		Price
Nonvested at December 31, 2013		-	$	-
Granted		13,900		8.36
Vested		-		-
Forfeited		-		-
Nonvested at March 31, 2014		13,900	$	8.36
Granted		-		-
Vested		-		-
Forfeited		-		-
Nonvested at June 30, 2014		13,900	$	8.36

The following table reflects the combined impact of fair value compensation cost recognition for stock options and restricted stock awards on income before income taxes, net income, basic earnings per share and diluted earnings per share for the three and six month periods ended June 30, 2014 and 2013, respectively:

	Three Months Ended 6/30/14			Three Months Ended 6/30/13		Six Months Ended 6/30/14			Six Months Ended 6/30/13
Increase (decrease) net income before income taxes	$	(15,622	)	$	26,369	$	(28,718	)	$	17,094
Increase (decrease) net income	$	(13,758	)	$	26,369	$	(25,498	)	$	17,094
Increase (decrease) basic earnings per share	$	0.00		$	0.00	$	0.00		$	0.00
Increase (decrease) diluted earnings per share	$	0.00		$	0.00	$	0.00		$	0.00

Note 14. Regulatory Capital. The Bank is subject to various regulatory capital requirements administered by federal and state 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 the Bank's financial statements. Management believes, as of June 30, 2014, that the Bank meets all capital adequacy requirements to which it is subject. The Company’s most significant asset is its investment in the Bank. Consequently, the information concerning capital ratios is essentially the same for the Company and the Bank.

The Bank's actual regulatory capital amounts and ratios as of June 30, 2014, and December 31, 2013, are listed below:

	June 30, 2014					December 31, 2013
	Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Total Risk Based Capital (to Risk Weighted Assets)	$	82,402		16.1	%	$	81,213		16.8	%
Tier 1 Capital (to Risk Weighted Assets)		75,993		14.9	%		75,150		15.6	%
Tier 1 Leverage Capital (to Average Assets)		75,993		10.9	%		75,150		11.2	%

Note 15. Recent Accounting Pronouncements. The following summarizes Accounting Standards Updates (“ASU”) recently issued by the Financial Accounting Standards Board (“the FASB”) and their expected impact on the Company. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This ASU provides guidance on financial statement presentation of unrecognized tax benefits when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists. This ASU was effective for fiscal years and interim periods beginning on or after December 15, 2013, and it has not had an impact on the Company’s consolidated financial statements.

In January 2014, the FASB issued ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects. This ASU provides guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The guidance permits reporting entities to make an accounting policy election to account for investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. This ASU is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. This ASU clarifies when an in substance repossession or foreclosure occurs, that is, when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. This ASU is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

In April 2014, the FASB issued ASU 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this ASU change the criteria for reporting discontinued operations of all public and nonpublic entities. The amendments also require new disclosures about discontinued operations and disposals of components of an entity that do not qualify for discontinued operations reporting. This ASU is effective prospectively for annual periods beginning on or after December 15, 2014, and interim periods within annual periods beginning on or after December 15, 2015. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

In June 2014, the FASB issued ASU 2014-11, Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The amendments in this ASU require that repurchase-to-maturity transactions be accounted for as secured borrowings consistent with the accounting for other repurchase agreements. In addition, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty (a repurchase financing), which will result in secured borrowing accounting for the repurchase agreement. The amendments require an entity to disclose information about transfers accounted for as sales in transactions that are economically similar to repurchase agreements, in which the transferor retains substantially all of the exposure to the economic return on the transferred financial asset throughout the term of the transaction. In addition the amendments require disclosure of the types of collateral pledged in repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions and the tenor of those transactions. This ASU is effective for first interim or annual periods beginning after December 15, 2014. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

In June 2014, the FASB issued ASU 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved After the Requisite Service Period. Some share-based payment awards that require a specific performance target to be achieved before the employee can benefit from the award, also require an employee to render service until the performance target is achieved. In some cases, the terms of an award may provide that the performance target could be achieved after an employee completes the requisite service period. That is, the employee would be entitled to benefit from the award regardless of whether the employee is rendering service on the date the performance target is achieved. Some entities account for those performance targets as performance conditions that affect the vesting of the award and, therefore, do not reflect the performance target in the estimate of the grant-date fair value. Others treat them as non-vesting conditions that affect the grant date fair value of the award. The amendments in this ASU apply to reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target can be achieved after the requisite service period. This ASU is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2015. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

Note 16. Interest Rate Hedging. The Company has executed certain strategies targeted at hedging the impact of rising interest rates on its future earnings. The Company has entered into a forward starting pay-fixed receive-floating swap to hedge our $10.0 million of floating rate Trust Preferred debt. The primary objective of the swap is to minimize future interest rate risk. The effective date of the swap is December 30, 2014, and it has a five year term.

In addition, the Bank has entered into forward starting advances with the FHLB of Atlanta to receive $20.0 million of fixed rate long-term funding. There are a total four advances of $5.0 million each. The advances have various effective and maturity dates, with the first advance beginning in April of 2014. At June 30, 2014, the Bank has taken down $15.0 million of these fixed rate long-term advances at a weighted average cost of 1.98%.

Note 17. Reclassifications. Certain amounts in the unaudited Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 have been reclassified to conform with the presentation for the Three and Six Months Ended June 30, 2014. The reclassifications had no effect on previously reported net income.

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

First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock and owning 100% of the stock of First South Bank (the "Bank") and operating through the Bank a commercial banking business. The discussion below focuses primarily on the Bank's results of operations. The Bank has one significant operating segment, providing commercial and retail banking services to its markets located in the state of North Carolina. The Company’s common stock is traded on the NASDAQ Global Select Market under the symbol "FSBK".

Comparison of Financial Condition at June 30, 2014, and December 31, 2013. Total assets increased to $711.5 million at June 30, 2014, from $674.7 million at December 31, 2013. Earning assets increased to $652.5 million at June 30, 2014 from $617.2 million at December 31, 2013. The ratio of earning assets to total assets was 91.7% at June 30, 2014, compared to 91.5% at December 31, 2013. The increase in total assets and earning assets was primarily the result of growth in investment securities available for sale and in loans and leases held for investment.

Interest-bearing deposits with banks declined to $5.3 million at June 30, 2014, from $12.4 million at December 31, 2013. Overnight deposits are available to fund securities purchases, loan originations, deposit withdrawals, liquidity management activities and daily operations of the Bank.

Investment securities available for sale increased to $172.0 million at June 30, 2014, from $150.3 million at December 31, 2013. During the six months ended June 30, 2014, there were $25.5 million of purchases, $788,000 of sales, $7.3 million of principal repayments, a $4.8 million increase in unrealized holding gains, and $488,000 of net accretion of premiums and discounts. The Bank may sell investment securities and securitize mortgage loans held for sale into mortgage-backed securities in order to support a more balanced sensitivity to future interest rate changes and to support adequate liquidity levels. Investment securities held to maturity were $507,000 and $506,000 at June 30, 2014 and December 31, 2013, respectively. During the six months ended June 30, 2014, the Bank implemented a leverage strategy to add bonds to the investment portfolio of similar quality, structure and duration that is intended to enhance income generation capabilities. See “Note 4. Investment Securities” of “Notes to Consolidated Financial Statements (Unaudited)” for additional disclosure information.

Total loans held for sale increased to $4.7 million at June 30, 2014, from $3.0 million at December 31, 2013, reflecting the net effect of current mortgage lending activity. During the six months ended June 30, 2014, there were $9.6 million of loan sales, $11.1 million of loan originations net of principal payments and $282,000 of net realized gains. Proceeds from mortgage loan sales are primarily used to fund the Bank’s liquidity needs, including loan originations, deposit withdrawals, repayment of borrowings, investment purchases and general bank operations. Loans serviced for others declined to $315.7 million at June 30, 2014, from $325.4 million at December 31, 2013, as principal repayments exceeded the volume of new loan sales. See “Note 5. Loans Held for Sale” of “Notes to Consolidated Financial Statements (Unaudited)” for additional disclosure information.

Total loans and leases held for investment increased by $19.0 million during the current six month period, to $470.0 million at June 30, 2014, from $451.0 million at December 31, 2013. This increase reflects our fourth consecutive quarterly increase of growth in loans and leases held for investment. During the six months ended June 30, 2014, there were $20.6 million of originations net of principal payments, $384,000 of net charge-offs, $700,000 of provisions for credit losses and $1.2 million of transfers to other real estate owned (“OREO”).

Improving asset quality metrics continues as a key component of the Bank’s short-term and long-term performance objectives. Loans held for investment on nonaccrual status, including restructured loans (“TDRs”) on nonaccrual status increased to $7.8 million at June 30, 2014, from $5.6 million at December 31, 2013. The increase in non-accrual loans included a $1.7 million relationship for which an agreement has been negotiated and is anticipated to be resolved during the 2014 third quarter. The ratio of loans held for investment on nonaccrual status to total loans held for investment was 1.6% at June 30, 2014, compared to 1.2% at December 31, 2013.

Loans are generally placed on nonaccrual status, and accrued unpaid interest is reversed, when management determines that collectability of interest, but not necessarily principal, is doubtful. Generally, this occurs when payments are delinquent in excess of 90 days. Consumer loans more than 180 days past due are generally charged off or a specific allowance is provided for any expected loss. All other loans are charged off when management concludes that they are uncollectible. Management has thoroughly evaluated all nonperforming loans and believes they are either well collateralized or adequately reserved. However, there can be no assurance in the future that regulators, increased risks in the loan portfolio, adverse changes in economic conditions or other factors will not require additional adjustments to the allowance for loan and lease losses. Aside from the loans identified on nonaccrual status, there were no loans at June 30, 2014 where known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the borrowers to comply with their current loan repayment terms.

Allowance for Loan and Lease Losses. The Bank maintains the allowance for loan and lease losses (“ALLL”) at levels management believes is adequate to absorb probable losses inherent in the loan and lease portfolio. The Bank has developed policies and procedures for assessing the adequacy of the ALLL that reflect the assessment of credit risk and impairment analysis. This assessment includes an analysis of qualitative and quantitative trends in the levels of classified loans. In developing this analysis, the Bank relies on historical loss experience, estimates and exercises judgment in assessing credit risk. Future assessments of credit risk may yield different results, depending on changes in the qualitative and quantitative trends, which may require adjustments in the ALLL. The Bank uses various modeling, calculation methods and estimation tools for measuring credit risk and performing impairment analysis, which is the basis used in developing the ALLL. The factors supporting the ALLL do not diminish the fact that the entire ALLL is available to absorb probable losses in the loan and leases portfolio. The Bank’s principal focus is on the adequacy of the ALLL. Based on the overall credit quality of the loan and lease portfolio, management believes the ALLL is adequate and has been established pursuant to generally accepted accounting principles, and has taken into account the views of its regulators and the current economic environment.

The assessment of the ALLL adequacy includes an analysis of actual historical loss percentages of both classified and pass loans, as well as qualitative risk factors allocated among specific categories of loans. In developing this analysis, the Bank relies on actual loss history for the most recent eight quarters and uses management’s best judgment in assessing credit risk. The assessment of qualitative factors includes various subjective components assessed in terms of basis points used in determining the overall ALLL adequacy. The evaluation of qualitative risk factors will result in a positive or negative adjustment to the ALLL methodology. Adjustments for each qualitative risk component may range from +25 basis points to -10 basis points. A component score of 0 basis points indicates no effect on the ALLL. A component rating of +25 basis points indicates the assessed maximum potential of increased risk to the ALLL adequacy. A -10 basis point component rating indicates the most positive effect on the ALLL. Management reassesses the ALLL methodology quarterly, and believes their accounting decisions remain accurate. However, there can be no assurance in the future that regulators, increased risks in the loan and lease portfolio, changes in economic conditions and other factors will not require additional adjustments to the ALLL. There were no changes in accounting policy and methodology used to estimate the ALLL during the six months ended June 30, 2014.

The ALLL was $7.9 million at June 30, 2014, compared to $7.6 million at December 31, 2013, reflecting provisions for credit losses and net charge-offs. During the six months ended June 30, 2014, there were $700,000 of provisions for credit losses and $384,000 of net charge-offs. The ratio of the ALLL to loans and leases held for investment was 1.69% at both June 30, 2014 and December 31, 2013, respectively. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)”and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” for additional disclosure information.

Based on an impairment analysis of loans held for investment, there were $27.4 million of loans classified as impaired, net of $574,000 in write-downs at June 30, 2014, compared to $27.5 million classified as impaired, net of $305,000 in write-downs at December 31, 2013. At June 30, 2014 and December 31, 2013, the ALLL included $955,000 and $663,000 specifically provided for impaired loans, respectively. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan arrangement. All collateral-dependent loans are measured for impairment based on the fair value of the collateral, while uncollateralized loans and other loans determined not to be collateral dependent are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payments status, borrowers’ financial data and borrowers’ operating factors such as cash flows, operating income or loss, and various other matters. See “Note 6. Loans Held for Investment”, “Note 7. Allowance for Loan and Lease Losses” and “Note 8. Troubled Debt Restructurings” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

OREO acquired from foreclosures declined to $8.7 million at June 30, 2014, from $9.4 million at December 31, 2013. During the six months ended June 30, 2014, there were $1.8 million of disposals, $11,200 of valuation adjustments and $1.2 million of additions. OREO consists of residential and commercial properties, developed lots and raw land. The Bank believes the adjusted carrying values of these properties are representative of their fair market values, although there can be no assurances that ultimate sales will be equal to or greater than the carrying values. See “Note 9. Other Real Estate Owned” and “Note 10. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

The Bank’s investment in bank-owned life insurance (“BOLI”) increased to $14.9 million at June 30, 2014, from to $11.1 million at December 31, 2013. The Bank intends to utilize the investment returns from the BOLI to recover a portion of the cost of providing benefit plans to our employees.

Prepaid expenses and other assets declined to $7.2 million at June 30, 2014, from $9.6 million at December 31, 2013, primarily reflecting a $1.8 million reduction in net deferred tax assets associated with the unrealized holding gains on investment securities available for sale. See “Consolidated Statements of Comprehensive Income” for additional information.

Total deposits increased to $592.5 million at June 30, 2014, from $585.7 million at December 31, 2013. For the current six month period, non-maturity deposits (personal and business checking accounts and money market accounts) and savings accounts increased by $25.4 million to $362.9 million at June 30, 2014, from $337.5 million at December 31, 2013, and were partially offset by an $18.6 million decline in certificates of deposit (“CDs”). CDs declined to $229.6 million, or 38.8% of total deposits at June 30, 2014, from $248.2 million, or 42.4% of total deposits at December 31, 2013. The Bank attempts to manage its cost of deposits by monitoring the volume and rates paid on maturing CDs in relationship to current funding needs and market interest rates. The Bank did not renew all maturing CDs during the six months ended June 30, 2014, but was able to reprice some of the maturing CDs at lower rates, and a portion migrated to non-maturity deposits within the Bank. See “Note 12. Deposits” of “Notes to Consolidated Financial Statements (Unaudited)” and “Interest Expense” below for additional information regarding deposits and the cost of funds.

There were $25.5 million of FHLB advances outstanding at June 30, 2014, compared to none at December 31, 2013, reflecting $10.5 million of short-term advances, and $15.0 million of fixed rate long-term funding acquired in connection with a strategy targeted at hedging the potential impact of rising interest rates on future earnings. The Bank uses FHLB borrowings as a supplemental funding source for earning asset growth, for providing an effective means of managing its overall cost of funds, or to manage its exposure to interest rate risk. See “Note 16. Interest Rate Hedging” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Stockholders' equity increased to $79.1 million at June 30, 2014, from $74.9 million at December 31, 2013. This increase reflects the $2.4 million of net income earned for the six months ended June 30, 2014 and a $2.8 million increase in accumulated other comprehensive income; net of $483,000 cash dividend payments, and $457,000 used to acquire 55,876 shares of the Company’s common stock pursuant to an announced repurchase plan. See "Consolidated Statements of Changes in Stockholders' Equity" for additional information.

Accumulated other comprehensive income increased to $2.9 million at June 30, 2014, from $103,000 at December 31, 2013, reflecting an increase in the mark-to-market adjustment in net unrealized gains in the available for sale investment securities portfolio, based on current market prices. See “Consolidated Statements of Comprehensive Income” and “Note 3. Comprehensive Income” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

The tangible equity to assets ratio was 10.53% at June 30, 2014, compared to 10.47% at December 31, 2013. There were 9,598,007 common shares outstanding at June 30, 2014, compared to 9,653,883 at December 31, 2013. The tangible book value per common share increased to $7.81 at June 30, 2014, from $7.32 at December 31, 2013.

The Bank is subject to various regulatory capital requirements administered by its federal and state banking regulators. As of June 30, 2014, the Bank's regulatory capital ratios were in excess of all regulatory requirements and the Bank’s regulatory capital position is categorized as well capitalized. There are no conditions or events since June 30, 2014 that management believes have changed the Bank's well capitalized category. See “Note 14. Regulatory Capital” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Comparison of Operating Results – Three and Six months ended June 30, 2014 and 2013. Net income for the three months ended June 30, 2014 declined to $1.3 million, or $0.13 per diluted common share, from net income of $1.8 million, or $0.18 per diluted common share earned for the comparative 2013 three month period. Net income for the six months ended June 30, 2014 declined to $2.4 million, or $0.25 per diluted common share, compared to net income of $3.3 million, or $0.34 per diluted common share earned for the first six months of 2013.

When compared to the three and six months ended June 30, 2013, net income for the three and six months ended June 30, 2014 was primarily impacted by decreases in net interest income, non-interest income and additional loan loss provision expense; and was partially offset by decreases in non-interest expenses and income tax expense. The decreases in non-interest income were primarily attributed to lower volumes of sales of mortgage loans, OREO and investment securities and the related reduced amounts of net gains recognized.

Interest Income. Interest income declined to $7.2 million and $14.3 million for the three and six months ended June 30, 2014, from $7.4 million and $15.3 million for the comparative 2013 periods. The year-over-year decline in interest income is due primarily to a decline in yields on earning assets, and secondarily to changes in the composition and volume of our earning asset base. The tax equivalent yield on average earning assets declined to 4.56% and 4.61% for the three and six months ended June 30, 2014, from 4.75% and 4.88% for the three and six months ended June 30, 2013. Average earning assets increased to $644.1 million for the three months ended June 30, 2014, from $629.5 million for the comparable 2013 three month period; while, average earning assets declined marginally to $633.8 million for the six months ended June 30, 2014, from $634.1 million for the comparable 2013 six month period.

Interest Expense. Interest expense declined to $652,000 and $1.3 million for the three and six months ended June 30, 2014, from $716,000 and $1.5 million for the comparative 2013 periods, reflecting a reduction in interest rates paid between the comparative reporting periods, as well as changes in the mix and volume of average interest-bearing liabilities. The cost of average interest-bearing liabilities improved to 0.49% and 0.50% for the three and six months ended June 30, 2014, from 0.56% and 0.57% for the three and six months ended June 30, 2013. The Bank was able to improve its cost of interest-bearing liabilities by a combination of the growth in lower cost non-maturity deposits, pricing new CDs and repricing maturing CDs in the lower interest rate environment and the use of lower costing borrowed money as a supplemental funding source. While a portion of higher priced maturing longer-term CDs left the Bank, the residual renewed into lower priced CDs or migrated to non-maturity deposit products within the Bank. Average interest-bearing liabilities increased to $527.5 million for the three months ended June 30, 2014, from $513.7 million for the comparable 2013 three month period; while, average interest-bearing liabilities declined to $515.0 million for the six months ended June 30, 2014, from $519.7 million for the comparable 2013 six month period. Average noninterest-bearing demand deposits increased to $95.1 million and $95.7 million for the three and six months ended June 30, 2014, compared to $92.1 million and $90.9 million for the comparable 2013 three and six month periods.

Net Interest Income. Net interest income declined to $6.6 million and $13.0 million for the three and six months ended June 30, 2014, from $6.7 million and $13.8 million for the three and six months ended June 30, 2013. The tax equivalent net interest margin declined to 4.16% and 4.20% for the three and six months ended June 30, 2014, from 4.30% and 4.41% for the comparative 2013 three and six month periods. While the Bank has taken steps to help protect it against the potential impacts of a rising rate environment, we anticipate that should interest rates remain unchanged, the repricing of higher yielding long-term assets, coupled with the issuance of organic loan growth in this current low rate environment may result in continued compression of our asset yields and net interest margin. As noted above, we have added defensive investments to our investment portfolio so that our balance sheet is better poised to respond to future increases in interest rates.

Yield/Cost Analysis. The following table contains comparative information relating to the Company’s average balance sheet and reflects the yield on average earning assets and the average cost of interest-bearing liabilities for the three and six months ended June 30, 2014 and 2013, presented on a tax equivalent yield basis. Tax equivalent yields related to certain investment securities exempt from federal income tax are stated on a fully taxable basis, using a 34% federal tax rate and reduced by a disallowed portion of the tax exempt interest income. Average balances are derived from average daily balances. The interest rate spread represents the difference between the tax equivalent yield on average earning assets and the cost of average interest-bearing liabilities. The tax equivalent net interest margin represents tax adjusted net interest income divided by average earning assets.

Yield/Cost Analysis	Quarter Ended June 30, 2014							Quarter Ended June 30, 2013
					(Dollars in thousands)
					Average							Average
	Average				Yield/			Average				Yield/
	Balance		Interest		Cost			Balance		Interest		Cost
Interest earning assets:
Loans receivable	$	470,710	$	5,970		5.04	%	$	443,707	$	6,108		5.52	%
Investments and deposits (1) (5)		173,364		1,248		3.28	%		185,839		1,327		2.97	%
Total earning assets (1)		644,074		7,218		4.56	%		629,546		7,435		4.75	%
Nonearning assets (6)		61,319							59,351
Total assets	$	705,393						$	688,897
Interest bearing liabilities:
Deposits	$	494,747		526		.43	%	$	502,071		626		.50	%
Borrowings		22,430		45		.78	%		1,296		1		.31	%
Junior subordinated debentures		10,310		81		3.12	%		10,310		89		3.45	%
Total interest-bearing liabilities		527,487		652		.49	%		513,677		716		.56	%
Noninterest bearing demand deposits		95,131		0		.00	%		92,056		0		.00	%
Total sources of funds		622,618		652		.42	%		605,730		716		.47	%
Other liabilities and stockholders’ equity:
Other liabilities		4,051							6,413
Stockholders' equity		78,724							76,754
Total liabilities and stockholders' equity	$	705,393						$	688,897
Net interest income			$	6,566						$	6,719
Interest rate spread (1) (2)						4.07	%						4.19	%
Net funding spread (1) (3)						4.14	%						4.28	%
Net interest margin (1) (4)						4.16	%						4.30	%
Ratio of earning assets to interest bearing liabilities						122.10	%						123.91	%

Yield/Cost Analysis	Six Months Ended June 30, 2014							Six Months Ended June 30, 2013
					(Dollars in thousands)
					Average							Average
	Average				Yield/			Average				Yield/
	Balance		Interest		Cost			Balance		Interest		Cost
Interest earning assets:
Loans receivable	$	465,611	$	11,898		5.10	%	$	455,994	$	12,660		5.60	%
Investments and deposits (1) (5)		168,234		2,394		3.26	%		178,092		2,669		3.10	%
Total earning assets (1)		633,845		14,292		4.61	%		634,086		15,329		4.88	%
Nonearning assets (6)		58,655							61,267
Total assets	$	692,500						$	695,353
Interest bearing liabilities:
Deposits	$	492,748		1,086		.44	%	$	503,897		1,297		.52	%
Borrowings		11,917		45		.75	%		5,445		7		.26	%
Junior subordinated debentures		10,310		161		3.11	%		10,310		176		3.44	%
Total interest-bearing liabilities		514,975		1,292		.50	%		519,652		1,480		.57	%
Noninterest bearing demand deposits		95,662		0		.00	%		90,854		0		.00	%
Total sources of funds		610,637		1,292		.43	%		610,506		1,480		.48	%
Other liabilities and stockholders’ equity:
Other liabilities		4,160							6,887
Stockholders' equity		77,703							77,960
Total liabilities and stockholders' equity	$	692,500						$	695,353
Net interest income			$	13,000						$	13,849
Interest rate spread (1) (2)						4.11	%						4.31	%
Net funding spread (1) (3)						4.18	%						4.40	%
Net interest margin (1) (4)						4.20	%						4.41	%
Ratio of earning assets to interest bearing liabilities						123.08	%						123.50	%

(1)

Yield shown as a tax-adjusted yield.

(2)

The difference between the yield on average earning assets and the cost of average interest-bearing liabilities.

(3)

The difference between the yield on average earning assets and the cost of average funding sources, including demand accounts.

(4)

Net interest income (tax adjusted basis), divided by average earning assets.

(5)

Average balance based on Amortized Cost.

(6)

Average balance includes unrealized gain (loss) on investment securities.

Provision for Credit Losses. The Bank's methodology for determining its provision for credit losses includes amounts specifically allocated to credits that are individually determined to be impaired, as well as general provisions allocated to groups of loans that have not been individually assessed for impairment. The Bank recorded $450,000 and $700,000 of provisions for credit losses in the three and six months ended June 30, 2014, compared to none and $400,000, respectively, recorded in the three and six months ended June 30, 2013. The reduction in year-to-date provisions for credit losses is attributable to the improvement in asset quality previously discussed. Provisions for credit losses are necessary to maintain the ALLL at a level that management believes is adequate to absorb probable future losses in the loan portfolio. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)” and “Allowance for Loan and Lease Losses” and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” included herein for additional disclosure information.

Noninterest Income. Total noninterest income declined to $2.2 million and $4.1 million for the three and six months ended June 30, 2014, from $2.9 million and $5.4 million for the three and six months ended June 30, 2013. Noninterest income consists of deposit fees and service charges; loan fees and charges; mortgage loan servicing fees; gain on sale and other fees on mortgage loans, gain on investment securities and OREO sales; and other miscellaneous income. Fees and service charges on deposits, and fees on loans and loan servicing fees earned during each period are influenced by the volume of deposits and loans outstanding, the volume of the various types of deposit and loan account transactions processed, the volume of loans serviced for others and the collection of related fees and service charges.

Deposit fees and service charges totaled $1.1 million and $2.1 million, respectively, for both the three and six months ended June 30, 2014 and 2013. Deposit fees and service charges represented 52.5% and 50.5%, respectively, of total non-interest income for the three and six months ended June 30, 2014, compared to 36.9% and 38.8%, respectively, for the three and six months ended June 30, 2013. We anticipate additional service charge revenue from deposits going forward as we focus on growing our deposit base through new product offerings and customer acquisition.

Gain on sale and other fees on mortgage loans declined to $362,000 and $648,000 for the three and six months ended June 30, 2014, from $750,000 and $1.5 million for the comparative 2013 three and six month periods. Loan fees and charges and mortgage loan servicing fees totaled $292,000 and $555,000 for the three and six months ended June 30, 2014, compared to $277,000 and $713,000 for the respective 2013 three and six month periods. The Bank has experienced a recent slowdown in mortgage lending activity, due to increases in mortgage rates from their historic low levels and the current economic environment, resulting in reduced revenue generated from the sale and servicing of mortgage loans and loan fees and charges during the respective 2014 reporting periods.

The Bank may sell or securitize fixed-rate residential mortgage loans to reduce interest rate and credit risk exposure, and to provide a more balanced sensitivity to future interest rate changes, while retaining certain other held for sale mortgage loans for future securitization into available for sale mortgage-backed securities. Proceeds from mortgage loan sales provide liquidity to support the Bank’s operating, financing and lending activities.

Gains on sales of investment securities available for sale were none and $14,000 for the three and six months ended June 30, 2014, compared to $281,000 for both the respective 2013 three and six month periods. The investment securities sold during 2013 were low coupon mortgage-backed securities that would not perform as well as alternative investments in a rising rate environment. Proceeds from investment securities sales also provide liquidity to support the Bank’s operating, financing and lending activities.

Included in other noninterest income is revenue from Bank-owned life insurance (BOLI) investments. BOLI earnings increased to $132,000 and $265,000 for the three and six months ended June 30, 2014, from $50,000 and $85,000 for the comparative 2013 three and six month periods. The Bank intends to utilize the investment returns from the BOLI to recover a portion of the cost of providing benefit plans to our employees.

Net gains recognized from the sale of OREO were $34,000 and $73,000 for the three and six months ended June 30, 2014, compared to $287,000 and $335,000 for the three and six months ended June 30, 2013, as the Bank continues in its efforts of disposing of these nonperforming assets. See “Note 9. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Total core non-interest income, excluding net gains and losses from OREO and securities sales, was $2.1 million and $4.0 million for the three and six months ended June 30, 2014, compared to $2.4 million and $4.8 million for the respective 2013 three and six month periods.

Noninterest Expense. Total noninterest expense declined to $6.5 million and $13.0 million for the three and six months ended June 30, 2014, from $6.9 million and $13.7 million for the respective 2013 three and six month periods. The year-over-year variation in noninterest expenses was primarily attributable to a significant reduction in OREO valuation and maintenance expenses, as well as lower deposit insurance premiums.

Compensation and fringe benefits, the largest component of noninterest expense, declined marginally to $3.8 million and $7.6 million for the three and six months ended June 30, 2014, from $3.9 million and $7.7 million for the respective 2013 three and six month periods, reflecting efforts placed on managing human resources expense. The Bank will continue managing staffing levels to ensure it meets ongoing customer needs and to support future growth.

FDIC insurance assessments declined to $139,000 and $284,000 for the three and six months ended June 30, 2014, from $236,000 and $472,000 for the respective 2013 three and six month periods, reflecting a reduction in the deposit insurance assessment calculation base.

Data processing costs were $568,000 and $1.2 million for the three and six months ended June 30, 2014, compared to $590,000 and $1.2 million for the respective 2013 three and six month periods. Data processing costs fluctuate in conjunction with changes in the number of customer accounts and transaction activity volumes.

Expenses attributable to ongoing maintenance, property taxes and insurance and valuation adjustments for OREO properties declined to $107,000 and $228,000 for the three and six months ended June 30, 2014, from $545,000 and $717,000 for the respective 2013 three and six month periods.

Premises and equipment, advertising, amortization of intangibles and other expense in aggregate, were relatively consistent during the respective three and six month reporting periods.

Income Taxes. Income tax expense declined to $542,000 and $960,000 for the three and six months ended June 30, 2014, from $964,000 and $1.8 million for the respective 2013 three and six month periods. The effective income tax rates were 29.66% and 28.67% for the three and six months ended June 30, 2014, compared to 35.34% and 35.67% for the respective 2013 three and six month periods. The increased investment in tax-exempt municipal bonds has resulted in lowering the Company’s income tax burden. See “Critical Accounting Policies” below for additional information.

Key Performance Ratios. Some of our key performance ratios are return on average assets (“ROA”), return on average equity (“ROE”) and efficiency. ROA was .73% and .70% for the three and six months ended June 30, 2014, compared to 1.03% and .97% for the three and six months ended June 30, 2013. ROE was 6.61% and 6.27% for the three and six months ended June 30, 2014, compared to 9.22% and 8.62% for the three and six months ended June 30, 2013. The efficiency ratio measures the proportion of net operating revenues that are absorbed by overhead expenses. The efficiency ratio (noninterest expenses as a percentage of net interest income plus noninterest income) was 72.77% and 75.17% for the three and six months ended June 30, 2014, compared to 71.69% and 71.01% for the three and six months ended June 30, 2013.

Liquidity and Capital Resources. Liquidity generally refers to the Bank's ability to generate adequate amounts of funds to meet its cash needs. Adequate liquidity guarantees that sufficient funds are available to meet deposit withdrawals, fund future loan commitments, maintain adequate reserve requirements, pay operating expenses, provide funds for debt service, and meet other general commitments. FDIC policy requires banks to maintain an average daily balance of liquid assets in an amount which it deems adequate to protect the safety and soundness of the bank. The FDIC currently has no specific level which it requires.

At June 30, 2014, the Bank had cash, deposits in banks, investment securities and loans held for sale totaling $194.8 million, compared to $178.0 million at December 31, 2013. The Bank calculates its liquidity position under policy guidelines based on liquid assets in relationship to deposits and short-term borrowings. Based on its calculation guidelines, the Bank’s liquidity ratio was 31.75% at June 30, 2014, compared to 28.74% at December 31, 2013, which management believes is adequate.

The Bank believes it can meet future liquidity needs with existing funding sources. The Bank's primary sources of funds are deposits, principal payments on loans and mortgage-backed securities, earnings and funds provided from operations, the ability to borrow from the FHLB of Atlanta and other lines of credit, and the availability of loans and investment securities held for sale. At June 30, 2014, the Bank had $109.3 million of credit availability with the FHLB, of which there was lendable collateral value totaling $77.5 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit. In addition, at June 30, 2014, the Bank had $70.0 million of pre-approved, but unused lines of credit.

The FDIC requires banks to meet a minimum leverage capital requirement of Tier 1 capital (consisting of retained earnings and common stockholders’ equity, less any intangible assets) to average total assets ratio of 4%. The FDIC also requires banks to meet a ratio of total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 capital. The Bank was in compliance with all regulatory capital requirements at June 30, 2014, and December 31, 2013. See “Note 14. Regulatory Capital” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

In July 2013, the Board of Governors of the Federal Reserve System announced its approval of a final rule to implement the Basel III regulatory capital reforms, among other changes required by the Dodd-Frank Act. The framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, taking into account the impact of risk. The final rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%, as well as a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The rule also raises the minimum Tier 1 capital to risk-weighted assets ratio from 4% to 6% and includes a minimum leverage ratio of 4% for all banking institutions. For the largest, most internationally active banking organizations, the rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures. In terms of quality of capital, the final rule emphasizes common equity Tier 1 capital and implements strict eligibility criteria for regulatory capital instruments. It also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. The phase-in for smaller banking organizations, such as the Company and the Bank, begins in January 2015, while the phase-in period for larger banks started in January 2014. Management is evaluating the impact of the implementation of these new regulatory capital standards on the Company and the Bank.

Critical Accounting Policies. The Company has identified the policies below as critical to its business operations and the understanding of its results of operations. The impact and any associated risks related to these policies on the Company’s business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results.

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. Estimates affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Loan Impairment and Allowance for Loan and Lease Losses. A loan or lease is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. The Bank uses several factors in determining if a loan or lease is impaired. The internal asset classification procedures include a thorough review of significant loans, leases and lending relationships and include the accumulation of related data. This data includes loan and lease payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc.

The ALLL is increased by charges to income and decreased by charge-offs, net of recoveries. Management's periodic evaluation of the adequacy of the ALLL is based on past loan and lease loss experience, known and inherent risks in loans and leases and unfunded loan commitments, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the ALLL in accordance with accounting principles generally accepted in the United States of America and has taken into account the views of its regulators and the current economic environment, there can be no assurance in the future that regulators or risks in its loans and leases portfolio will not require additional adjustments to the ALLL.

Income Taxes. Deferred tax asset and liability balances are determined by application to temporary differences in the tax rate expected to be in effect when taxes will become payable or receivable. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

Off-Balance Sheet Arrangements. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The Company's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Forward Looking Statements. The Private Securities Litigation Reform Act of 1995 states that disclosure of forward looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward looking statements by corporate management. This Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward looking statements that involve risk and uncertainty. In order to comply with terms of the safe harbor, the Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from anticipated results or other expectations expressed in the Company's forward looking statements. There are risks and uncertainties that may affect the operations, performance, development, growth projections and results of the Company's business. They include, but are not limited to, economic growth, interest rate movements, timely development of technology enhancements for products, services and operating systems, the impact of competitive products, services and pricing, customer requirements, regulatory changes and similar matters. Readers of this report are cautioned not to place undue reliance on forward looking statements that are subject to influence by these risk factors and unanticipated events, as actual results may differ materially from management's expectations.

Item 3. Quantitative and Qualitative Disclosures about Market Risk. Smaller reporting companies are not required to provide information required by this item.

Item 4. Controls and Procedures. As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level.

In addition, there have been no changes in the Company’s internal control over financial reporting (to the extent that elements of internal control over financial reporting are subsumed within disclosure controls and procedures) identified in connection with the evaluation described in the above paragraph that occurred during the Company’s last fiscal quarter, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item l. Legal Proceedings: The Company is currently not engaged in any material legal proceedings. From time to time, the Bank is a party to legal proceedings within the ordinary course of business wherein it enforces its security interest in loans, and other matters of similar nature.

Item 1A. Risk Factors: Smaller reporting companies are not required to provide information required by this item.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds: The following table sets forth information regarding the Company's repurchases of its common stock during the quarter ended June 30, 2014:

Period	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan		Maximum Number of Shares Yet to Be Purchased Under the Plan

April 2014 Beginning date: April 1 Ending date: April 30		-		-		-		388,172

May 2014 Beginning date: May 1 Ending date: May 31		38,626	$	8.19		38,626		349,546

June 2014 Beginning date: June 1 Ending date: June 30		15,250	$	8.15		15,250		334,296

Shares may be purchased under a repurchase program announced on October 29, 2013. Under this program, the Company announced that it may purchase up to 487,560 shares of its common stock. The average price per share includes commissions of $0.05 per share.

Item 3. Defaults Upon Senior Securities: Not applicable

Item 4. Mine Safety Disclosures: Not applicable.

Item 5. Other Information: Not applicable

Item 6. Exhibits: The following exhibits are filed herewith:

Number		Title
31.1		Rule 13a-14(a) Certification of Chief Executive Officer

31.2		Rule 13a-14(a) Certification of Chief Financial Officer

32		Section 1350 Certification

101		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Statements of Financial Condition as of June 30, 2014 (unaudited) and December 31, 2013; (ii) Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2014 and 2013 (unaudited); (iii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2014 and 2013 (unaudited); (iv) Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2014 and 2013 (unaudited); (v) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2014 and 2013 (unaudited); and (vi) Notes to Consolidated Financial Statements (unaudited) as of June 30, 2014 and December 31, 2013, and for the Three and Six Months Ended June 30, 2014 and 2013.

SIGNATURES

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

	FIRST SOUTH BANCORP, INC.

	By:	/s/ Scott C. McLean
		Scott C. McLean
		Executive Vice President
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

		Date: August 13, 2014

FIRST SOUTH BANCORP INC /VA/ - FORM 10-Q - August 13, 2014

Attached files

FIRST SOUTH BANCORP INC /VA/ Reports