BAY BANKS OF VIRGINIA INC - FORM 10-Q

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EX-31.1 - EX-31.1 - BAY BANKS OF VIRGINIA INC	d929895dex311.htm
EX-31.2 - EX-31.2 - BAY BANKS OF VIRGINIA INC	d929895dex312.htm
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2015

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

COMMISSION FILE NUMBER: 0-22955

BAY BANKS OF VIRGINIA, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


VIRGINIA		54-1838100
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)		(I.R.S. EMPLOYER IDENTIFICATION NO.)

100 SOUTH MAIN STREET, KILMARNOCK, VA		22482
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)		(ZIP CODE)

(804) 435-1171

(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. x yes ¨ no

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

4,787,856 shares of common stock on July 31, 2015

FORM 10-Q

For the interim period ending June 30, 2015

INDEX


PART I - FINANCIAL INFORMATION

ITEM 1.	FINANCIAL STATEMENTS

	CONSOLIDATED BALANCE SHEETS JUNE 30, 2015 (UNAUDITED) AND DECEMBER 31, 2014	3

	CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2015 AND 2014 (UNAUDITED)	4

	CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2015 AND 2014 (UNAUDITED)	5

	CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE SIX MONTHS ENDED JUNE 30, 2015 (UNAUDITED)	5

	CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2015 AND 2014 (UNAUDITED)	6

	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)	7

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	26

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	32

ITEM 4.	CONTROLS AND PROCEDURES	32

PART II - OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	32

ITEM 1A.	RISK FACTORS	32

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	33

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	33

ITEM 4.	MINE SAFETY DISCLOSURES	33

ITEM 5.	OTHER INFORMATION	33

ITEM 6.	EXHIBITS	33

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED BALANCE SHEETS


	June 30, 2015			December 31, 2014 (1)
(Dollars in thousands)	(unaudited)
ASSETS
Cash and due from banks	$	5,880		$	6,181
Interest-bearing deposits		20,605			14,784
Federal funds sold		2,187			119
Securities available-for-sale, at fair value		47,056			42,604
Restricted securities		2,261			2,430
Loans receivable, net of allowance for loan losses of $3,439 and $3,205		313,442			295,242
Loans held for sale		709			—
Premises and equipment, net		11,731			11,882
Accrued interest receivable		1,237			1,197
Other real estate owned, net		2,624			2,791
Bank owned life insurance		7,473			7,348
Goodwill		2,808			2,808
Mortgage servicing rights		632			596
Other assets		3,082			2,504

*Total assets*	$	421,727		$	390,486


LIABILITIES
Noninterest-bearing deposits	$	61,073		$	63,308
Savings and interest-bearing demand deposits		152,794			122,502
Time deposits		119,734			121,775

*Total deposits*		333,601			307,585

Securities sold under repurchase agreements		8,787			6,012
Federal Home Loan Bank advances		30,000			35,000
Subordinated debt, net of issuance costs		6,841			—
Other liabilities		2,911			2,651

*Total liabilities*		382,140			351,248


SHAREHOLDERS’ EQUITY

Common stock ($5 par value; authorized - 10,000,000 shares; outstanding - 4,787,856 and 4,817,856 shares, respectively)		23,939			24,089
Additional paid-in capital		2,776			2,777
Retained earnings		13,968			13,293
Accumulated other comprehensive loss, net		(1,096	)		(921	)

*Total shareholders’ equity*		39,587			39,238


*Total liabilities and shareholders’ equity*	$	421,727		$	390,486

(1)	Derived from the audited consolidated financial statements.

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)


	For the three months ended						For the six months ended
(Dollars in thousands except per share amounts)	June 30, 2015			June 30, 2014			June 30, 2015			June 30, 2014
INTEREST INCOME
Loans, including fees	$	3,715		$	3,279		$	7,390		$	6,440
Securities:
Taxable		141			85			275			179
Tax-exempt		86			96			174			194
Interest-bearing deposit accounts		13			4			21			8

Total interest income		3,955			3,464			7,860			6,821


INTEREST EXPENSE
Deposits		570			449			1,086			907
Federal funds purchased		—			1			—			1
Securities sold under repurchase agreements		2			2			4			4
Subordinated debt		42			—			42			—
FHLB advances		87			85			172			185

Total interest expense		701			537			1,304			1,097

Net interest income		3,254			2,927			6,556			5,724

Provision for loan losses		205			97			270			262

Net interest income after provision for loan losses		3,049			2,830			6,286			5,462


NON-INTEREST INCOME
Income from fiduciary activities		171			175			392			387
Service charges and fees on deposit accounts		226			244			449			487
VISA-related fees		62			61			109			150
Other service charges and fees		256			267			517			507
Secondary market lending income		140			68			238			179
Increase in cash surrender value of life insurance		62			44			125			91
Net gains (losses) on sale of securities available for sale		6			(16	)		2			(17	)
Other real estate losses		(41	)		(249	)		(80	)		(219	)
Net (losses) gains on the disposal of fixed assets		(7	)		—			(7	)		138
Other income		42			30			57			34

Total non-interest income		917			624			1,802			1,737


NON-INTEREST EXPENSES
Salaries and employee benefits		1,840			1,597			3,888			3,184
Occupancy expense		442			354			877			712
Software maintenance		145			137			290			275
Bank franchise tax		50			47			98			94
VISA expense		33			38			64			108
Telephone expense		33			52			66			108
FDIC assessments		64			72			129			138
Foreclosure property expense		11			28			21			59
Consulting expense		90			70			165			169
Other expense		908			772			1,663			1,428

Total non-interest expenses		3,616			3,167			7,261			6,275


Net income before income taxes		350			287			827			924

Income tax expense		56			27			152			204


Net income	$	294		$	260		$	675		$	720


*Basic Earnings Per Share*
Average basic shares outstanding		4,802,032			4,818,733			4,805,922			4,818,311
Earnings per share, basic	$	0.06		$	0.05		$	0.14		$	0.15

*Diluted Earnings Per Share*
Average diluted shares outstanding		4,819,322			4,836,783			4,819,487			4,832,416
Earnings per share, diluted	$	0.06		$	0.05		$	0.14		$	0.15

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)


	For the three months ended June 30,						For the six months ended June 30,
(Dollars in thousands)	2015			2014			2015			2014

Net income	$	294		$	260		$	675		$	720
Other comprehensive (loss) income:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during the period		(564	)		335			(264	)		825
Deferred tax benefit (expense)		192			(112	)		90			(280	)
Reclassification of net securities (gains) losses recognized in net income		(6	)		16			(2	)		17
Deferred tax expense (benefit)		2			(6	)		1			(6	)

Unrealized (losses) gains adjustment, net of tax		(376	)		233			(175	)		556

Defined benefit pension plan:
Net periodic pension cost (benefit)		3			(5	)		4			(11	)
Net pension (loss) gain		(3	)		5			(4	)		11
Deferred tax benefit		—			—			—			—

Defined benefit pension plan adjustment, net of tax		—			—			—			—

Post retirement benefit plan:
Net periodic cost		13			12			26			23
Net loss		(13	)		(12	)		(26	)		(23	)
Deferred tax benefit		—			—			—			—

Post retirement benefit plan adjustment, net of tax		—			—			—			—

Total other comprehensive (loss) income		(376	)		233			(175	)		556

Comprehensive (loss) income	$	(82	)	$	493		$	500		$	1,276

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)


(Dollars in thousands, except share data or amounts)	Shares of Common Stock			Common Stock			Additional Paid-in Capital			Retained Earnings		Accumulated Other Comprehensive Loss			Total Shareholders’ Equity
Six Months ended June 30, 2015
Balance at beginning of period		4,817,856		$	24,089		$	2,777		$	13,293	$	(921	)	$	39,238
Net income		—			—			—			675		—			675
Other comprehensive income		—			—			—			—		(175	)		(175	)
Stock repurchase		(30,000	)		(150	)		(18	)		—		—			(168	)
Stock-based compensation expense		—			—			17			—		—			17


Balance at end of period		4,787,856		$	23,939		$	2,776		$	13,968	$	(1,096	)	$	39,587

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)


	For the Six Months Ended June 30,
(Dollars in thousands)	2015			2014
Cash Flows From Operating Activities
Net income	$	675		$	720
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		478			377
Net amortization and accretion of securities		179			200
Amortization of subordinated debt issuance costs		1			—
Provision for loan losses		270			262
Stock compensation expense		17			20
(Gain) loss on securities available-for-sale		(2	)		17
Increase in OREO valuation allowance		72			127
Loss on sale of other real estate		8			92
Loss (gain) on disposal of fixed assets		7			(138	)
Mortgage servicing rights		(36	)		(3	)
Loan originations for sale		(5,801	)		(4,361	)
Loan sales		5,200			4,263
Gain on sold loans		(109	)		(96	)
Increase in cash surrender value of life insurance		(125	)		(91	)
(Increase) decrease in accrued income and other assets		(136	)		185
Increase (decrease) in other liabilities		270			(176	)

Net cash provided by operating activities		968			1,398


Cash Flows From Investing Activities
Proceeds from maturities and principal paydowns of available-for-sale securities		1,595			1,741
Proceeds from sales and calls of available-for-sale securities		2,324			3,331
Purchase of bank owned life insurance		—			(2,001	)
Purchases of available-for-sale securities		(8,815	)		(2,751	)
Sales (purchases) of restricted securities		169			(342	)
Increase in federal funds sold		(2,068	)		(84	)
Loan (originations) and principal collections, net		(18,480	)		(8,287	)
Proceeds from sale of other real estate		99			371
Purchases of premises and equipment		(737	)		(375	)
Proceeds from the sale of premises and equipment		—			311

Net cash used in investing activities		(25,913	)		(8,086	)


Cash Flows From Financing Activities
Increase in demand, savings, and other interest-bearing deposits		28,057			355
Net decrease in time deposits		(2,041	)		(1,616	)
Repurchase of common stock		(168	)		—
Issuance of subordinated debt, net		6,842			—
Net increase (decrease) in securities sold under repurchase agreements		2,775			(128	)
(Decrease) increase in Federal Home Loan Bank advances		(5,000	)		10,000

Net cash provided by financing activities	$	30,465		$	8,611


Net increase in cash and due from banks		5,520			1,923
Cash and due from banks at beginning of period		20,965			15,689

Cash and due from banks at end of period	$	26,485		$	17,612


Supplemental Schedule of Cash Flow Information
Cash paid for:
Interest	$	1,251		$	1,109

Income taxes		390			341

Non-cash investing and financing:
Unrealized (loss) gain on investment securities		(264	)		825

Change in fair value of pension and post-retirement obligation		—			—

Loans transferred to other real estate owned		129			197

Loans originated to facilitate sale of OREO		118			605

Changes in deferred taxes resulting from OCI transactions		90			286

See Notes to Consolidated Financial Statements.

Notes to Consolidated Financial Statements (Unaudited)

Note 1:

General

Bay Banks of Virginia, Inc. (the “Company”) owns 100% of the Bank of Lancaster (the “Bank”), 100% of Bay Trust Company, Inc. (the “Trust Company”) and 100% of Steptoes Holdings, LLC (“Steptoes Holdings”). The consolidated financial statements include the accounts of the Bank, the Trust Company, Steptoes Holdings and Bay Banks of Virginia, Inc.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to the general practices within the banking industry. In management’s opinion, all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year or for any other interim periods. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

Note 2:

Significant Accounting Policies

Loans

The Company grants mortgage loans on real estate; commercial and industrial loans; and consumer and other loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans on real estate. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market areas.

Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, and charge-offs. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the related loan yield over the contractual term of the loan, adjusted for early pay-offs, where applicable.

The accrual of interest is generally discontinued at the time a loan is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Payments received for loans no longer accruing interest are applied to the unpaid principal balance. Loans greater than 90 days past due may remain on accrual status if the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are charged off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual and past due policies are materially the same for all types of loans.

All interest accrued but not collected for loans that are placed on non-accrual or charged off are reversed against interest income. Any interest received on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well secured and in the process of collection.

Allowance for loan losses (“ALL”)

The ALL reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the ALL each quarter. To determine the total ALL, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and homogenous pools of loans analyzed on a segmented basis. Considerations include historical experience, the nature and volume of the loan portfolio, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing local and national economic conditions, and internal policies and procedures including credit risk management and underwriting. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available.

The ALL calculation methodology’s historical loss factor period is considered the length of a business cycle. The business cycle, upon which the historical loss factor is based, was believed to have begun in the fourth quarter of 2008. During the third quarter of 2013, management determined that the business cycle had ended given noticeable national economic improvement and local real estate market stabilization. The historical loss factor is now based on that business cycle of 19 quarters, compared to the previous averaging period that had been growing each quarter based on the business cycle that began in 2008. The change in methodology during the third quarter of 2013 produced an immaterial change in the ALL calculation.

Management employs a risk rating system to evaluate and consistently categorize loan portfolio credit risk. Loans assigned risk rating grades include all commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250 thousand with chronic delinquency, and troubled debt restructures. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades are evaluated as new information becomes available for each borrowing relationship or at least quarterly. All other loans not specifically assigned a risk rating grade are monitored as a discrete pool of loans generally based on delinquency status. Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention and any collateral may not be fully adequate to secure the loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The ALL consists of specific, general, and unallocated components. The specific component is determined by identifying impaired loans (as described below) then evaluating each one to calculate the amount of impairment. Impaired loans measured for impairment generally include: (1) non-accruing Special mention, Substandard and Doubtful loans in excess of $250,000; (2) Substandard and Doubtful loans in excess of $500,000; (3) Special Mention loans in excess of $500,000 if any of the loans in the relationship are more than 30 days past due or if the borrower has filed for bankruptcy; and (4) all troubled debt restructurings (“TDRs”). A specific allowance arises when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component collectively evaluates smaller commercial loans, residential mortgages and consumer loans, grouped into segments and classes. Historical loss experience is calculated and applied to each segment or class, then adjusted for qualitative factors. Qualitative factors include changes in the local and national economic outlook, including unemployment, interest rates, inflation rates and real estate trends; the level and trend of past due and nonaccrual loans; strength of policies and procedures; and oversight of credit risk and quality of underwriting. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained if needed to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

The specific component of the ALL calculation accounts for the loan loss reserve necessary on impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not considered impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Accrual of interest may or may not be discontinued for any given impaired loan. Impairment is measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Because large groups of smaller balance homogeneous loans are collectively evaluated for impairment, the Company does not generally separately identify smaller balance individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a troubled debt restructuring agreement.

The general component of the ALL calculation collectively evaluates groups of loans in segments or classes, as noted above. The segments are: (1) Mortgage loans on real estate; (2) Commercial and industrial loans; and (3) Consumer and other loans. The segment for Mortgage loans on real estate is disaggregated into the following classes: (1) Construction, land and land development; (2) Farmland; (3) Residential first mortgages; (4) Residential revolving and junior mortgages; (5) Commercial mortgages (non-owner-occupied); and (6) Commercial mortgages (owner-occupied). Loans in segment 1 are secured by real estate. Loans in segments 2 and 3 are secured by other types of collateral or are unsecured. A given segment or class may not reflect the purpose of a loan. For example, a business owner may provide his residence as collateral for a loan to his company, in which case the loan would be grouped in a residential mortgage class. Historical loss factors are calculated for the prior 19 quarters by segment and class, and then applied to the current balances in each segment and class. Finally, qualitative factors are applied to each segment and class.

Construction and development loans carry risks that the project will not be finished according to schedule or according to budget and the value of the collateral, at any point in time, may be less than the principal amount of the loan. These loans also bear the risk that the general contractor may face financial pressure unrelated to the project. Loans secured by land, farmland and residential mortgages carry the risk of continued credit-worthiness of the borrower and changes in value of the underlying real estate collateral. Commercial mortgages and commercial and industrial loans carry risks associated with the profitable operation of a business and its related cash flows. Additionally, commercial and industrial loans carry risks associated with the value of collateral other than real estate which may depreciate over time. Consumer loans carry risks associated with the continuing credit-worthiness of the borrower and are more likely than real estate loans to be adversely affected by divorce, unemployment, personal illness or bankruptcy of an individual. Consumer loans secured by automobiles carry risks associated with rapidly depreciating collateral. Consumer loans include credit cards, which are unsecured.

The summation of the specific, general and unallocated components results in the total estimated ALL. Management may also include an unallocated component to cover uncertainties in the level of probable losses. This estimate is inherently subjective and actual losses could be greater or less than the estimates.

Additions to the ALL are made by charges to earnings through the provision for loan losses. Charge-offs result from credit exposures deemed to be uncollectible and the ALL is reduced by these. Recoveries of previously charged off amounts are credited back to the ALL. Charge-off policies are materially the same for all types of loans.

Mortgage servicing rights (“MSRs”)

MSRs are included on the consolidated balance sheet and recorded at fair value on an ongoing basis. Changes in the fair value of the MSRs are recorded in the results of operations. A fair value analysis of MSRs is performed on a quarterly basis.

Note 3:

Amendments to the Accounting Standards Codification

In April 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-03, “Interest – Imputation of Interest” (Subtopic 835-30) which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction of the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments. ASU 2015-03 is effective for periods beginning after December 15, 2015. The Company has adopted the guidance during the second quarter of 2015 and it did not have a material impact on the Company’s consolidated financial statements.

In January 2015, the FASB issued ASU 2015-01, “Income Statement – Extraordinary and Unusual Items.” ASU 2015-01 eliminates the concept of extraordinary items. However, the presentation and disclosure requirements for items that are either unusual in nature or infrequent in occurrence remain and will be expanded to include items that are both unusual in nature and infrequent in occurrence. ASU 2015-01 is effective for periods beginning after December 15, 2015. ASU 2015-01 is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2014, the FASB issued ASU 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.” This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supercedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014. However, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (Topic 606). The amendments in this ASU modify the guidance companies use to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other standards. The ASU requires that entities apply a specific method to recognize revenue reflecting the consideration expected from customers in exchange for the transfer of goods and services. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. Entities are also required to disclose significant judgments and changes in judgments for determining the satisfaction of performance obligations. Most revenue associated with financial instruments, including interest and loan origination fees, is outside the scope of the guidance. On April 1, 2015, the FASB voted to issue an exposure draft to delay the effective date of ASU 2014-09 for one year. The proposal would delay the effective date for public companies to annual reporting periods beginning after December 15, 2017 including interim periods therein. Adoption would be permitted as of the original effective date of annual reporting periods beginning after December 15, 2016. The Company is evaluating the impact that ASU 2014-09 will have on its consolidated financial statements.

Note 4:

Securities

The aggregate amortized costs and fair values of the available-for-sale securities portfolio are as follows:


(Dollars in thousands)
Available-for-sale securities June 30, 2015	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Corporate bonds	$	200	$	—	$	—		$	200
U.S. Government agencies		21,375		67		(69	)		21,373
State and municipal obligations		23,447		100		(306	)		23,241
Certificates of deposits		2,232		10		—			2,242

	$	47,254	$	177	$	(375	)	$	47,056


Available-for-sale securities December 31, 2014	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
U.S. Government agencies	$	16,969	$	33	$	(37	)	$	16,965
State and municipal obligations		23,335		226		(160	)		23,401
Certificates of deposits		2,232		8		(2	)		2,238

	$	42,536	$	267	$	(199	)	$	42,604

Gross realized gains and gross realized losses on sales and calls of securities were as follows:


	For the three months ended June 30,						For the six months ended June 30,
(Dollars in thousands)	2015			2014			2015			2014
Gross realized gains	$	24		$	5		$	24		$	5
Gross realized losses		(18	)		(21	)		(22	)		(22	)

Net realized gains (losses)	$	6		$	(16	)	$	2		$	(17	)


Aggregate proceeds	$	1,710		$	2,039		$	2,324		$	3,331

Average yields (taxable equivalent) on securities were 2.41% and 2.36% for the three months ended June 30, 2015 and 2014, respectively, and 2.40% and 2.37% for the six months ended June 30, 2015 and 2014, respectively.

Securities with a market value of $11.9 million and $8.5 million were pledged as collateral for repurchase agreements and for other purposes as required by law as of June 30, 2015 and December 31, 2014, respectively. As of June 30, 2015 and December 31, 2014, all the securities pledged to repurchase agreements were state and municipal obligations. All the repurchase agreements had remaining contractual maturities that were overnight and continuous. Securities sold under repurchase agreements were $8.8 million and $6.0 million as of June 30, 2015 and December 31, 2014, respectively, and included in liabilities on the consolidated balance sheets. The securities pledged to each agreement are reviewed daily and can be changed at the option of the Bank with minimal risk of loss due to changes in fair value.

Securities in an unrealized loss position at June 30, 2015 and December 31, 2014, by duration of the unrealized loss, are shown below. The unrealized loss positions were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All agency securities, states and municipal securities and certificates of deposit are investment grade or better and their losses are considered temporary. Management does not intend to sell the securities and does not expect to be required to sell the securities. Furthermore, all amortized cost bases are expected to be recovered. Bonds with unrealized loss positions at June 30, 2015 included 13 federal agencies and 41 municipals. Bonds with unrealized loss positions at December 31, 2014 included 29 municipals, 13 federal agencies and three certificates of deposit. The tables are shown below.


(Dollars in thousands)	Less than 12 months				12 months or more				Total
June 30, 2015	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	5,297	$	51	$	1,871	$	18	$	7,168	$	69
States and municipal obligations		8,238		143		3,372		163		11,610		306

Total temporarily impaired securities	$	13,535	$	194	$	5,243	$	181	$	18,778	$	375


	Less than 12 months				12 months or more				Total
December 31, 2014	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	1,499	$	4	$	3,532	$	33	$	5,031	$	37
States and municipal obligations		412		5		9,006		155		9,418		160
Certificates of deposit		742		2		—		—		742		2

Total temporarily impaired securities	$	2,653	$	11	$	12,538	$	188	$	15,191	$	199

The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $1.6 million and $1.9 million at June 30, 2015 and December 31, 2014, respectively. The Company also had an investment in Federal Reserve Bank of Richmond (“FRB”) stock which totaled $460 thousand and $382 thousand at June 30, 2015 and December 31, 2014, respectively. The investments in both FHLB and FRB stock are required investments related to the Bank’s membership with the FHLB and FRB. These securities do not have a readily determinable fair value as their ownership is restricted, and they lack an active market for trading. Additionally, per charter provisions related to the FHLB and FRB stock, all repurchase transactions of such stock must occur at par. Accordingly, these securities are carried at cost, and are periodically evaluated for impairment. The Company’s determination as to whether its investment in FHLB and FRB stock is impaired is based on management’s assessment of the ultimate recoverability of its par value rather than recognizing temporary declines in its value. The determination of whether the decline affects the ultimate recoverability of the investments is influenced by available information regarding various factors. These factors include, among others, the significance of the decline in net assets of the issuing banks as compared to the capital stock amount reported by these banks, and the length of time a decline has persisted; commitments by such banks to make payments required by law or regulation and the level of such payments in relation to the operating performance of the issuing bank; and the overall liquidity position of the issuing bank. Based on its most recent analysis of publicly available information regarding the financial condition of the issuing banks, management concluded that no impairment existed in the carrying value of FHLB and FRB stock.

Note 5:

Loans

The following is a summary of the balances of loans:


(Dollars in thousands)	June 30, 2015			December 31, 2014

Mortgage loans on real estate:
Construction, Land and Land Development	$	43,894		$	43,048
Farmland		1,080			1,128
Commercial Mortgages (Non-Owner Occupied)		21,918			20,534
Commercial Mortgages (Owner Occupied)		36,441			33,326
Residential First Mortgages		150,222			135,267
Residential Revolving and Junior Mortgages		26,362			25,400
Commercial and Industrial loans		31,001			34,002
Consumer Loans		5,623			5,349

Total loans		316,541			298,054
Net unamortized deferred loans costs		340			393
Allowance for loan losses		(3,439	)		(3,205	)

Loans, net	$	313,442		$	295,242

The recorded investment in past due and non-accruing loans is shown in the following table. A loan past due by more than 90 days is generally placed on nonaccrual unless it is both well secured and in the process of collection.


(Dollars in thousands) Loans Past Due and Nonaccruals June 30, 2015	30-89 Days Past Due		90 Days or More Past Due and Still Accruing		Nonaccruals		Total Past Due and Nonaccruals		Current		Total Loans
Construction, Land and Land Development	$	47	$	67	$	768	$	882	$	43,012	$	43,894
Farmland		—		—		—		—		1,080		1,080
Commercial Mortgages (Non-Owner Occupied)		—		—		1,045		1,045		20,873		21,918
Commercial Mortgages (Owner Occupied)		1,098		—		1,495		2,593		33,848		36,441
Residential First Mortgages		1,383		323		900		2,606		147,616		150,222
Residential Revolving and Junior Mortgages		152		—		115		267		26,095		26,362
Commercial and Industrial		39		—		124		163		30,838		31,001
Consumer Loans		48		5		—		53		5,570		5,623

Total	$	2,767	$	395	$	4,447	$	7,609	$	308,932	$	316,541


Loans Past Due and Nonaccruals December 31, 2014	30-89 Days Past Due		90 Days or More Past Due and Still Accruing		Nonaccruals		Total Past Due and Nonaccruals		Current		Total Loans
Construction, Land and Land Development	$	64	$	—	$	669	$	733	$	42,315	$	43,048
Farmland		—		—		—		—		1,128		1,128
Commercial Mortgages (Non-Owner Occupied)		—		—		—		—		20,534		20,534
Commercial Mortgages (Owner Occupied)		—		—		566		566		32,760		33,326
Residential First Mortgages		1,270		—		359		1,629		133,638		135,267
Residential Revolving and Junior Mortgages		6		—		31		37		25,363		25,400
Commercial and Industrial		96		—		228		324		33,678		34,002
Consumer Loans		66		14		101		181		5,168		5,349

Total	$	1,502	$	14	$	1,954	$	3,470	$	294,584	$	298,054

Note 6:

Allowance for Loan Losses

Allowance for Loan Losses

A disaggregation of and an analysis of the change in the allowance for loan losses by segment is shown below.


(Dollars in thousands)	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer Loans			Total
For the Three Months Ended June 30, 2015
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,763		$	315		$	169		$	3,247
(Charge-offs)		—			—			(54	)		(54	)
Recoveries		5			—			36			41
Provision		121			105			(21	)		205

Ending Balance	$	2,889		$	420		$	130		$	3,439


Individually evaluated for impairment	$	801		$	122		$	—		$	923
Collectively evaluated for impairment		2,088			298			130			2,516

	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer Loans			Total
For the Three Months Ended June 30, 2014
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,497		$	248		$	205		$	2,950
(Charge-offs)		(75	)		—			(12	)		(87	)
Recoveries		8			—			5			13
Provision		159			(37	)		(25	)		97

Ending Balance	$	2,589		$	211		$	173		$	2,973


Individually evaluated for impairment	$	724		$	—		$	32		$	756
Collectively evaluated for impairment		1,865			211			141			2,217


(Dollars in thousands)	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer Loans			Total
For the Six Months Ended June 30, 2015
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,778		$	323		$	104		$	3,205
(Charge-offs)		(1	)		—			(86	)		(87	)
Recoveries		10			—			41			51
Provision		102			97			71			270

Ending Balance	$	2,889		$	420		$	130		$	3,439


	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer Loans			Total
For the Six Months Ended June 30, 2014
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,465		$	256		$	204		$	2,925
(Charge-offs)		(214	)		—			(21	)		(235	)
Recoveries		14			—			7			21
Provision		324			(45	)		(17	)		262

Ending Balance	$	2,589		$	211		$	173		$	2,973

Loan receivables evaluated for impairment individually and collectively by segment as of June 30, 2015 and December 31, 2014 are as follows:


(Dollars in thousands) As of June 30, 2015	Mortgage Loans on Real Estate		Commercial and Industrial		Consumer Loans		Total
Individually evaluated for impairment	$	9,645	$	122	$	3	$	9,770
Collectively evaluated for impairment		270,272		30,879		5,620		306,771


Total Gross Loans	$	279,917	$	31,001	$	5,623	$	316,541


As of December 31, 2014	Mortgage Loans on Real Estate		Commercial and Industrial		Consumer Loans		Total
Individually evaluated for impairment	$	6,842	$	—	$	16	$	6,858
Collectively evaluated for impairment		251,861		34,002		5,333		291,196


Total Gross Loans	$	258,703	$	34,002	$	5,349	$	298,054

Internal Risk Rating Grades

Internal risk rating grades are generally assigned to commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250,000 with chronic delinquency, and TDRs, as shown in the following table. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades (refer to Note 2) are evaluated as new information becomes available for each borrowing relationship or at least quarterly.


(Dollars in thousands) As of June 30, 2015	Construction, Land and Land Development		Farmland		Commercial Mortgages (Non-Owner Occupied)		Commercial Mortgages (Owner Occupied)		Commercial and Industrial		Total
Grade:
Pass	$	36,215	$	1,080	$	18,546	$	27,518	$	29,267	$	112,626
Watch		5,497		—		1,703		3,299		1,228		11,727
Special mention		1,102		—		—		3,484		273		4,859
Substandard		1,080		—		1,669		2,140		233		5,122
Doubtful		—		—		—		—		—		—

Total	$	43,894	$	1,080	$	21,918	$	36,441	$	31,001	$	134,334


As of December 31, 2014	Construction, Land and Land Development		Farmland		Commercial Mortgages (Non-Owner Occupied)		Commercial Mortgages (Owner Occupied)		Commercial and Industrial		Total
Grade:
Pass	$	34,913	$	1,128	$	16,426	$	23,967	$	31,041	$	107,475
Watch		5,649		—		3,770		4,430		2,492		16,341
Special mention		1,403		—		—		2,789		154		4,346
Substandard		1,083		—		338		2,140		315		3,876
Doubtful		—		—		—		—		—		—

Total	$	43,048	$	1,128	$	20,534	$	33,326	$	34,002	$	132,038

Loans not assigned internal risk rating grades are comprised of smaller residential mortgages and smaller consumer loans. Payment activity of these loans is reviewed monthly by management. However, some of these loans are graded when the borrower’s total exposure to the Bank exceeds the limits noted above. Loans are considered to be nonperforming when they are delinquent by 90 days or more or non-accruing and credit risk is primarily evaluated by delinquency status, as shown in the table below.


(Dollars in thousands)			Residential
As of June 30, 2015 PAYMENT ACTIVITY STATUS	Residential First Mortgages (1)		Revolving and Junior Mortgages (2)		Consumer Loans (3)		Total
Performing	$	148,999	$	26,247	$	5,618	$	180,864
Nonperforming		1,223		115		5		1,343

Total	$	150,222	$	26,362	$	5,623	$	182,207


As of December 31, 2014 PAYMENT ACTIVITY STATUS	Residential First Mortgages (4)		Residential Revolving and Junior Mortgages (5)		Consumer Loans (6)		Total
Performing	$	134,908	$	25,369	$	5,234	$	165,511
Nonperforming		359		31		115		505

Total	$	135,267	$	25,400	$	5,349	$	166,016

(1)	Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $1.9 million as of June 30, 2015.

(2)	Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $216 thousand as of June 30, 2015.

(3)	Consumer Loans which have been assigned a risk rating grade of Substandard were zero as of June 30, 2015.

(4)	Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $2.1 million as of December 31, 2014.

(5)	Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $219 thousand as of December 31, 2014.

(6)	Consumer Loans which have been assigned a risk rating grade of Substandard totaled $1 thousand as of December 31, 2014.

Impaired Loans

The following tables show the Company’s recorded investment and the customers’ unpaid principal balances for impaired loans, with the associated allowance amount, if applicable, as of June 30, 2015 and December 31, 2014, along with the average recorded investment and interest income recognized for the three and six months ended June 30, 2015 and 2014, respectively.


(Dollars in thousands)	As of June 30, 2015						As of December 31, 2014
IMPAIRED LOANS
	Recorded Investment		Customers’ Unpaid Principal Balance		Related Allowance		Recorded Investment		Customers’ Unpaid Principal Balance		Related Allowance
With no related allowance:
Construction, land and land development	$	448	$	452	$	—	$	450	$	452	$	—
Residential First Mortgages		1,957		1,981		—		1,568		1,584		—
Residential Revolving and Junior Mortgages (1)		50		50		—		50		50		—
Commercial Mortgages (Non-owner occupied)		1,309		1,309		—		264		264		—
Commercial Mortgages (Owner occupied)		1,936		1,969		—		1,887		1,916		—
Commercial and Industrial		—		—		—		—		—		—
Consumer (2)		3		3		—		5		5		—

		5,703		5,764		—		4,224		4,271		—


With an allowance recorded:
Construction, land and land development		270		292		128		277		292		144
Residential First Mortgages		2,154		2,154		356		2,173		2,173		437
Residential Revolving and Junior Mortgages (1)		173		173		83		173		173		84
Commercial Mortgages (Non-owner occupied)		—		—		—		—		—		—
Commercial Mortgages (Owner occupied)		1,348		1,356		234		—		—		—
Commercial and Industrial		122		122		122		—		—		—
Consumer (2)		—		—		—		11		11		11

		4,067		4,097		923		2,634		2,649		676


Total Impaired Loans:
Construction, land and land development		718		744		128		727		744		144
Residential First Mortgages		4,111		4,135		356		3,741		3,757		437
Residential Revolving and Junior Mortgages (1)		223		223		83		223		223		84
Commercial Mortgages (Non-owner occupied)		1,309		1,309		—		264		264		—
Commercial Mortgages (Owner occupied)		3,284		3,325		234		1,887		1,916		—
Commercial and Industrial		122		122		122		—		—		—
Consumer (2)		3		3		—		16		16		11

	$	9,770	$	9,861	$	923	$	6,858	$	6,920	$	676

(1)	Junior mortgages include equity lines.

(2)	Includes credit cards.


	For the three months ended				For the three months ended
	June 30, 2015				June 30, 2014
(Dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Construction, land and land development	$	449	$	—	$	451	$	1
Residential First Mortgages		1,761		18		1,042		10
Residential Revolving and Junior Mortgages (1)		50		1		—		—
Commercial Mortgages (Non-owner occupied)		786		14		264		4
Commercial Mortgages (Owner occupied)		1,552		18		1,917		20
Commercial and Industrial		—		—		—		—
Consumer (2)		4		—		—		—

		4,602		51		3,674		35


With an allowance recorded:
Construction, land and land development		272		1		288		1
Residential First Mortgages		2,160		26		2,186		26
Residential Revolving and Junior Mortgages (1)		173		2		174		2
Commercial Mortgages (Non-owner occupied)		—		—		—		—
Commercial Mortgages (Owner occupied)		1,026		8		—		—
Commercial and Industrial		123		—		—		—
Consumer (2)		—		—		38		1

		3,754		37		2,686		30


Total
Construction, land and land development		721		1		739		2
Residential First Mortgages		3,921		44		3,228		36
Residential Revolving and Junior Mortgages (1)		223		3		174		2
Commercial Mortgages (Non-owner occupied)		786		14		264		4
Commercial Mortgages (Owner occupied)		2,578		26		1,917		20
Commercial and Industrial		123		—		—		—
Consumer (2)		4		—		38		1

	$	8,356	$	88	$	6,360	$	65

(1)	Junior mortgages include equity lines.

(2)	Includes credit cards.


	For the six months ended June 30, 2015				For the six months ended June 30, 2014
(Dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Construction, land and land development	$	449	$	—	$	452	$	2
Residential First Mortgages		1,696		36		1,046		21
Residential Revolving and Junior Mortgages (1)		50		2		—		—
Commercial Mortgages (Non-owner occupied)		612		18		264		8
Commercial Mortgages (Owner occupied)		1,429		27		1,924		42
Commercial and Industrial		—		—		—		—
Consumer (2)		4		—		—		—

		4,240		83		3,686		73


With an allowance recorded:
Construction, land and land development		274		2		242		1
Residential First Mortgages		2,164		52		2,190		47
Residential Revolving and Junior Mortgages (1)		173		4		174		4
Commercial Mortgages (Non-owner occupied)		—		—		—		—
Commercial Mortgages (Owner occupied)		919		12		—		—
Commercial and Industrial		82		—		—		—
Consumer (2)		—		—		38		2

		3,612		70		2,644		54


Total
Construction, land and land development		723		2		694		3
Residential First Mortgages		3,860		88		3,236		68
Residential Revolving and Junior Mortgages (1)		223		6		174		4
Commercial Mortgages (Non-owner occupied)		612		18		264		8
Commercial Mortgages (Owner occupied)		2,348		39		1,924		42
Commercial and Industrial		82		—		—		—
Consumer (2)		4		—		38		2

	$	7,852	$	153	$	6,330	$	127

(1)	Junior mortgages include equity lines.

(2)	Includes credit cards.

Smaller non-accruing loans and non-accruing loans that are not graded because they are included in homogenous pools generally do not meet the criteria for impairment testing, and are therefore excluded from impaired loan disclosures. At June 30, 2015 and December 31, 2014, non-accruing loans excluded from impaired loan disclosure totaled $591 thousand and $663 thousand, respectively. If interest on these non-accruing loans had been accrued, such income would have approximated $4 thousand and $6 thousand during the three months ended June 30, 2015 and 2014, respectively, and $8 thousand and $13 thousand during the six months ended June 30, 2015 and 2014, respectively.

Loan Modifications

Loans modified as TDRs are considered impaired and are individually evaluated for the amount of impairment in the ALL. The following table presents, by segments of loans, information related to loans modified as TDRs during the three and six months ended June 30, 2015 and 2014.


	For the three months ended						For the three months ended
	June 30, 2015						June 30, 2014
(Dollars in thousands) TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Construction, land and land development (1)		—	$	—	$	—		2	$	282	$	282

(1)	Modifications were an extension of loan terms.


	For the six months ended						For the six months ended
	June 30, 2015						June 30, 2014
(Dollars in thousands) TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Construction, land and land development (1)		—	$	—	$	—		2	$	282	$	282
Commercial mortgages (Owner occupied) (2)		1		105		124		—		—		—

(1)	Modifications were an extension of loan terms.

(2)	Modifications were capitalization of interest.


(Dollars in thousands)	For the three months ended June 30, 2015				For the three months ended June 30, 2014
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment		Number of Loans		Recorded Investment
Residential revolving and junior mortgages		—	$	—		1	$	75

(Dollars in thousands)	For the six months ended June 30, 2015				For the six months ended June 30, 2014
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment		Number of Loans		Recorded Investment
Residential revolving and junior mortgages		—	$	—		1	$	75
Commercial mortgages (Owner occupied)		1		124		—		—

Other Real Estate Owned

The table below details the properties included in other real estate owned (“OREO”) as of June 30, 2015 and December 31, 2014. There was one collateralized consumer residential mortgage loan with a balance of $28 thousand in the process of foreclosure as of June 30, 2015. The property was foreclosed on August 3, 2015.


	As of June 30, 2015				As of December 31, 2014
(Dollars in thousands)	No. of Properties		Carrying Value		No. of Properties		Carrying Value
Residential		7	$	1,407		10	$	1,559
Land lots		7		442		13		587
Convenience stores		2		234		2		234
Restaurant		1		107		1		107
Commercial properties		2		434		1		304

Total		19	$	2,624		27	$	2,791

Included in other assets as of June 30, 2015, was one residential property purchased in 2013 from a related party with a value of $724 thousand and a former branch, which was closed April 30, 2015, with a value of $398 thousand. As of December 31, 2014, the residential property was included in other assets and had a value of $771 thousand. Both properties are being marketed for sale.

Note 7:

Earnings per share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock.


	For the three months ended								For the six months ended
	June 30, 2015				June 30, 2014				June 30, 2015				June 30, 2014
	Average Shares		Per share Amount		Average Shares		Per share Amount		Average Shares		Per share Amount		Average Shares		Per share Amount
Basic earnings per share		4,802,032	$	0.06		4,818,733	$	0.05		4,805,922	$	0.14		4,818,311	$	0.15
Effect of dilutive securities:
Stock options		17,290				18,050				13,565				14,105

Diluted earnings per share		4,819,322	$	0.06		4,836,783	$	0.05		4,819,487	$	0.14		4,832,416	$	0.15

For the three months ended June 30, 2015 and 2014, options on 54,733 and 62,588 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive. For the six months ended June 30, 2015 and 2014, options of 68,473 and 68,828 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive.

Note 8:

Stock-Based Compensation

On June 28, 2013, the Company registered with the Securities and Exchange Commission a new stock-based compensation plan, which superseded all other plans. There are 370,500 shares available for grant under this plan at June 30, 2015.

Stock-based compensation expense related to stock awards was zero for both the three month periods ended June 30, 2015 and 2014 and during the six month periods ended June 30, 2015 and 2014 was $17 thousand and $20 thousand, respectively. Compensation expense for stock options is the estimated fair value of options on the date granted using the Black-Scholes Model amortized on a straight-line basis over the vesting period of the award. There was no unrecognized compensation expense related to stock options as of June 30, 2015.

Options for a total of 7,500 shares were granted and vested during the six months ended June 30, 2015. The aggregate fair value of options granted during the six months ended June 30, 2015 was $17 thousand. Options for a total of 7,000 shares were granted and vested during the six months ended June 30, 2014. The aggregate fair value of options granted during the six months ended June 30, 2014 was $20 thousand.

The variables used in these calculations of the fair value of the options are as follows:


	For the six months ended June 30,
	2015			2014
Risk free interest rate (5 year Treasury)		1.52	%		2.70	%
Expected dividend yield		0.0	%		0.0	%
Expected term (years)		5			5
Expected volatility		47.1	%		51.4	%

Stock option activity for the six months ended June 30, 2015 (unaudited) is summarized below:


	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)		Aggregate Intrinsic Value (1)
Options outstanding, January 1, 2015		190,419		$	7.02		6.2
Granted		7,500			5.37
Forfeited		—			—
Exercised		—			—
Expired		(7,734	)		14.43

Options outstanding and exercisable, June 30, 2015		190,185		$	6.66		6.1	$	94,373

(1)

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on June 30, 2015. This amount changes based on changes in the market value of the Company’s common stock.

Note 9:

Employee Benefit Plans

The Company has a non-contributory, defined benefit pension plan for full-time employees who were over 21 years of age and vested in the plan as of December 31, 2012, when the plan was frozen. Each participant’s account balance grows based on monthly interest credits. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act.

The Company sponsors a post-retirement benefit plan covering current and future retirees who acquire age 55 and 10 years of service or age 65 and 5 years of service. The post-retirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses. The plan is unfunded and funded as benefits are due.

Components of Net Periodic (Benefit) Cost


(Dollars in thousands)	Pension Benefits						Post-Retirement Benefits
Six months ended June 30,	2015			2014			2015		2014
Service cost	$	—		$	—		$	11	$	8
Interest cost		66			71			15		15
Expected return on plan assets		(99	)		(101	)		—		—
Amortization of unrecognized net loss		—			19			—		—
Recognized net actuarial loss		37			—			—		—

Net periodic (benefit) cost	$	4		$	(11	)	$	26	$	23

The Company expects to make no contribution to its pension plan and $5 thousand to its post-retirement benefit plan during the remainder of 2015. The Company has contributed $5 thousand towards the post-retirement plan during the first six months of 2015.

Note 10:

Long Term Debt

FHLB Debt

As of June 30, 2015, the Bank had FHLB debt consisting of five advances (see table below). A $5 million advance with an interest rate of 2.69% matured in May 2014 and was replaced with a new $5 million three month LIBOR-based floating rate advance. One of these advances was repaid in the second quarter of 2015. Two $5 million advances were drawn in June 2014 and two $5 million advances were drawn in October 2014, all of which were fixed rate advances.

The five advances are shown in the following table.


Description	Balance		Originated		Current Interest Rate			Maturity Date

Adjustable Rate Hybrid	$	10,000,000		4/12/2013		2.65590	%		4/13/2020
Fixed Rate Credit		5,000,000		10/20/2014		0.47000	%		4/20/2016
Fixed Rate Credit		5,000,000		10/20/2014		0.30000	%		10/20/2015
Fixed Rate Credit		5,000,000		5/20/2015		0.37000	%		2/22/2016
Adjustable Rate Credit		5,000,000		6/18/2015		0.30080	%		9/19/2016

	$	30,000,000

Advances on the FHLB lines are secured by a blanket lien on qualified 1 to 4 family residential real estate loans. Immediate available credit, as of June 30, 2015, was $44.2 million against a total line of credit of $78.2 million.

As of June 30, 2015 and December 31, 2014, the Company had $30.0 million and $35.0 million, respectively, in FHLB debt outstanding with a weighted average interest rate of 1.13% and 0.96%, respectively.

Subordinated Debt

On May 28, 2015, the Company entered into a Subordinated Note Purchase Agreement (the “Purchase Agreement”) with twenty-nine accredited investors under which the Company issued an aggregate of $7,000,000 of subordinated notes (the “Notes”) to the accredited investors. The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the right to redeem the Notes, in whole or in part, without premium or penalty, at any time on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.


(Dollars in thousands)	Balance as of June 30, 2015
6.5% Subordinated Debt	$	7,000
Less: Issuance costs		(159	)

	$	6,841

Bank Dividends

One source of funds available to the Company is the payment of dividends by the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval from the Bank’s regulators.

Note 11.

Regulatory Capital Requirements and Restrictions

10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets. The capital conservation buffer requirement will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

The Company’s and the Bank’s actual capital amounts and ratios as of June 30, 2015 and December 31, 2014, are presented in the following tables:


	Actual					Minimum Capital Requirement					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
(Dollars in Thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of June 30, 2015:
Total Risk Based Capital (to Risk Weighted Assets)
Consolidated	$	49,097		16.90	%	$	23,242		8.00	%		N/A		N/A
Bank of Lancaster		40,498		14.08	%		23,010		8.00	%	$	28,763		10	%

Tier 1 Capital (to Risk Weighted Assets)
Consolidated		38,817		13.36	%		11,621		6.00	%		N/A		N/A
Bank of Lancaster		37,059		12.88	%		11,505		6.00	%	$	17,258		6	%

Common Equity Tier 1 Capital (to Risk Weighted Assets)
Consolidated		38,817		13.36	%		11,621		4.50	%		N/A		N/A
Bank of Lancaster		37,059		12.88	%		11,505		4.50	%	$	14,381		5	%

Tier 1 Capital (to Average Assets)
Consolidated		38,817		9.52	%		16,307		4.00	%		N/A		N/A
Bank of Lancaster		37,059		9.17	%		16,162		4.00	%	$	20,203		5	%


	Actual					Minimum Capital Requirement					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
(Amounts in Thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2014:
Total Risk Based Capital (to Risk Weighted Assets)
Consolidated	$	41,445		15.02	%	$	22,074		8.00	%		N/A		N/A
Bank of Lancaster		36,446		13.30	%		21,927		8.00	%	$	27,409		10	%

Tier 1 Capital (to Risk Weighted Assets)
Consolidated		38,240		13.86	%		11,037		4.00	%		N/A		N/A
Bank of Lancaster		33,241		12.13	%		10,964		4.00	%	$	16,445		6	%

Tier 1 Capital (to Average Assets)
Consolidated		38,240		10.36	%		14,770		4.00	%		N/A		N/A
Bank of Lancaster		33,241		9.07	%		14,664		4.00	%	$	18,329		5	%

Note 12:

Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:


Level 1 –		Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 –		Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 –		Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available-for-sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Defined benefit plan assets: Defined benefit plan assets are recorded at fair value on an annual basis at year end.

Mortgage servicing rights: MSRs are recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations. A model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool and applies a discount rate to each pool. Loans are segregated into 14 pools based on each loan’s term and seasoning (age). All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Service costs were assumed to be $6.00 per loan as of June 30, 2015 and $5.75 per loan as of December 31, 2014. Prepayment speeds are determined primarily based on the average interest rate of the loans in each pool. The prepayment scale used is the Public Securities Association (“PSA”) model, where “100% PSA” means prepayments are zero in the first month, then increase by 0.2% of the loan balance each month until reaching 6.0% in month 30. Thereafter, the 100% PSA model assumes an annual prepayment of 6.0% of the remaining loan balance. The average PSA speed assumption in the fair value model is 156% and 184% as of June 30, 2015 and December 31, 2014, respectively. A discount rate of 11.0% was then applied to each pool as of June 30, 2015 and 10.0% as of December 31, 2014. This discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. MSRs are classified as Level 3.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2015 and December 31, 2014:


(Dollars in thousands)			Fair Value Measurements at June 30, 2015 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	200	$	—	$	—	$	200
U. S. Government agencies		21,373		1,366		20,007		—
State and municipal obligations		23,241		—		23,241		—
Certificates of deposit		2,242		—		2,242		—

Total securities available-for-sale:	$	47,056	$	1,366	$	45,490	$	200


Mortgage servicing rights	$	632	$	—	$	—	$	632

Defined benefit plan assets:
Cash and cash equivalents	$	3	$	3	$	—	$	—
Mutual funds - fixed income		1,178		1,178		—		—
Mutual funds - equity		1,751		1,751		—		—

Total defined benefit plan assets	$	2,932	$	2,932	$	—	$	—


			Fair Value Measurements at December 31, 2014 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
U. S. Government agencies	$	16,965	$	845	$	16,120	$	—
State and municipal obligations		23,401		—		23,401		—
Certificates of deposit		2,238		—		2,238		—

Total securities available-for-sale:	$	42,604	$	845	$	41,759	$	—


Mortgage servicing rights	$	596	$	—	$	—	$	596


Defined benefit plan assets:
Cash and cash equivalents	$	4	$	4	$	—	$	—
Mutual funds - fixed income		1,139		1,139		—		—
Mutual funds - equity		1,754		1,754		—		—

Total defined benefit plan assets	$	2,897	$	2,897	$	—	$	—

The reconciliation of items using Level 3 inputs is as follows:


(Dollars in thousands)	MSRs		Corporate Bonds
Balance, January 1, 2015	$	596	$	—
Purchases		—		200
Impairments		—		—
Fair value adjustments		36		—
Sales		—		—

Balance, June 30, 2015	$	632	$	200

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Any given loan may have multiple types of collateral. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: OREO is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. The initial fair value of OREO is based on an appraisal done at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest income on the Consolidated Statements of Income.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis at the end of the respective period.


			Fair Value Measurements at June 30, 2015 Using
(Dollars in thousands) Description	Balance as of June 30, 2015		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,144	$	—	$	—	$	3,144
Other real estate owned, net		2,624		—		—		2,624

			Fair Value Measurements at December 31, 2014 Using
Description	Balance as of December 31, 2014		Level 1		Level 2		Level 3
Impaired Loans, net	$	1,958	$	—	$	—	$	1,958
Other real estate owned, net		2,791		—		—		2,791

The following table displays quantitative information about Level 3 Fair Value Measurements as of June 30, 2015:

(Dollars in thousands)

Balance as of
June 30, 2015

Valuation
Technique

Unobservable
Input

Range
(Weighted
Average)

Impaired Loans, net

3,144

Discounted appraised value

Selling Cost

10% - 25% (13%)

Lack of Marketability

25% - 75 (52%)

Other real estate owned, net

2,624

Discounted appraised value

Selling Cost

3% - 13% (5%)

Lack of Marketability

7% - 20% (10%)

The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2014:

(Dollars in thousands)

Balance as of
December 31, 2014

Valuation
Technique

Unobservable
Input

Range
(Weighted
Average)

Impaired Loans, net

1,958

Discounted appraised value

Selling Cost

10% - 20% (10%)

Lack of Marketability

25% - 75% (53%)

Other real estate owned, net

2,791

Discounted appraised value

Selling Cost

3% - 13% (5%)

Lack of Marketability

7% - 20% (11%)

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.


					Fair Value Measurements at June 30, 2015 Using
(Dollars in thousands) Description	Balance as of June 30, 2015		Fair Value as of June 30, 2015		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	5,880	$	5,880	$	5,880	$	—	$	—
Interest-bearing deposits		20,605		20,605		20,605		—		—
Federal funds sold		2,187		2,187		2,187		—		—
Securities available-for-sale		47,056		47,056		1,366		45,490		200
Restricted securities		2,261		2,261		—		—		2,261
Loans, net		313,442		319,343		—		—		319,343
Loans held for sale		709		709		—		—		709
Accrued interest receivable		1,237		1,237		—		1,237		—
Mortgage servicing rights		632		632		—		—		632

Financial Liabilities:
Non-interest-bearing liabilities	$	61,073	$	61,073	$	61,073	$	—	$	—
Savings and other interest-bearing deposits		152,794		152,503		—		152,503		—
Time deposits		119,734		121,026		—		—		121,026
Securities sold under repurchase agreements		8,787		8,787		—		8,787		—
FHLB advances		30,000		30,911		—		30,911		—
Subordinated debt		6,841		7,000		—		—		7,000
Accrued interest payable		201		201		—		201		—

					Fair Value Measurements at December 31, 2014 Using
(Dollars in thousands) Description	Balance as of December 31, 2014		Fair Value as of December 31, 2014		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	6,181	$	6,181	$	6,181	$	—	$	—
Interest-bearing deposits		14,784		14,784		14,784		—		—
Federal funds sold		119		119		119		—		—
Securities available-for-sale		42,604		42,604		845		41,759		—
Restricted securities		2,430		2,430		—		—		2,430
Loans, net		295,242		300,481		—		—		300,481
Accrued interest receivable		1,197		1,197		—		1,197		—
Mortgage servicing rights		596		596		—		—		596

Financial Liabilities:
Non-interest-bearing liabilities	$	63,308	$	63,308	$	63,308	$	—	$	—
Savings and other interest-bearing deposits		122,502		122,502		—		122,502		—
Time deposits		121,775		122,662		—		—		122,662
Securities sold under repurchase agreements		6,012		6,012		—		6,012		—
FHLB advances		35,000		35,951		—		35,951		—
Accrued interest payable		149		149		—		149		—

The carrying amounts of cash and due from banks, interest-bearing deposits, federal funds sold or purchased, accrued interest receivable, loans held for sale and non-interest-bearing deposits, are payable on demand, or are of such short duration that carrying value approximates market value.

Securities available-for-sale are carried at quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

MSRs are carried at fair value. As described above, a valuation model is used to determine fair value. This model utilizes a discounted cash flow analysis with servicing costs and prepayment assumptions based on comparable instruments and a discount rate.

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does not consider the lack of liquidity and uncertainty in the market that would affect the valuation.

Time deposits are presented at estimated fair value by discounting the future cash flows using interest rates offered for deposits of similar remaining maturities.

As a result of being issued and sold at the end of May 2015, the fair value of the Company’s subordinated debt is estimated at its sales price of par less issuance costs.

The fair value of the FHLB advances is estimated by discounting the future cash flows using the current interest rates offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At June 30, 2015 and December 31, 2014, the fair value of loan commitments and standby letters of credit was immaterial and therefore, they are not included in the table above.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 13:

Changes in Accumulated Other Comprehensive Income (Loss)

The balances in accumulated other comprehensive income (loss) are shown in the following tables:


	For the Three Months Ended June 30, 2015
(Dollars in thousands)	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Balance April 1, 2015	$	246		$	(966	)	$	(720	)
Change in net unrealized holding losses on securities, before reclassification, net of tax benefit of $192		(372	)		—			(372	)
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $2		(4	)		—			(4	)

Balance June 30, 2015	$	(130	)	$	(966	)	$	(1,096	)


	For the Three Months Ended June 30, 2014
(Dollars in thousands)	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Balance April 1, 2014	$	(468	)	$	(382	)	$	(850	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $112		223			—			223
Reclassification for previously unrealized net losses recognized in income, net of tax benefit of $6		10			—			10

Balance June 30, 2014	$	(235	)	$	(382	)	$	(617	)


	For the Six Months Ended June 30, 2015
(Dollars in thousands)	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Balance January 1, 2015	$	45		$	(966	)	$	(921	)
Change in net unrealized holding losses on securities, before reclassification, net of tax benefit of $90		(174	)		—			(174	)
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $1		(1	)		—			(1	)

Balance June 30, 2015	$	(130	)	$	(966	)	$	(1,096	)


	For the Six Months Ended June 30, 2014
(Dollars in thousands)	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Balance January 1, 2014	$	(791	)	$	(382	)	$	(1,173	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $280		545			—			545
Reclassification for previously unrealized net losses recognized in income, net of tax benefit of $6		11			—			11

Balance June 30, 2014	$	(235	)	$	(382	)	$	(617	)

Reclassification for previously unrealized (losses) gains and impairments on securities are reported in the Consolidated Statements of Income as follows. No unrealized gains (losses) on pension and post-employment related costs were reclassified to the Consolidated Statements of Income in the three and six months ended June 30, 2015 and 2014.

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Three Months Ended

Holding Losses on Securities


(In thousands)	June 30, 2015			June 30, 2014
Net gains (losses) on sale of securities available-for-securities	$	6		$	(16	)
Tax (expense) benefit		(2	)		6

Impact on net income	$	4		$	(10	)

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Six Months Ended

Holding Losses on Securities


(In thousands)	June 30, 2015			June 30, 2014
Net gains (losses) on sale of securities available-for-securities	$	2		$	(17	)
Tax (expense) benefit		(1	)		6

Impact on net income	$	1		$	(11	)

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

The following discussion is intended to assist in understanding the results of operations and the financial condition of Bay Banks of Virginia, Inc. This discussion should be read in conjunction with the above consolidated financial statements and the notes thereto.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, expansion activities, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

EXECUTIVE SUMMARY

Results for the first six months of 2015 are highlighted by continued success of the Company’s expansion into the Richmond, Virginia market and the completion of a $7.0 million subordinated debt offering. In March 2015, the Bank opened a third retail branch in the Richmond market in Chesterfield County. In June 2015, the Bank converted its Hartfield, Virginia loan production office into a retail office. This office is located in Middlesex County. Core earnings and growth remain priorities. The capital position remains solid.

Total assets have grown by $31.2 million, or 8.0%, during the first six months of 2015, to $421.7 million. Two of the three new Richmond branches currently have negative contributions to earnings, causing the year-over-year decline in net income to $666 thousand from $720 thousand. However, net interest income, which management considers to be a component of core earnings, grew by $832 thousand for the six-month period ended June 30, 2015 compared to the 2014 comparable period. Return on average assets was 0.33% for the first six months of 2015 compared to 0.44% for the same period in 2014. Return on average equity was 3.39% for the first six months of 2015 compared to 3.84% for the same period in 2014.

The in-house loan portfolio grew by $18.4 million, or 6.2%, during the first six months of 2015. Loans originated and sold to Fannie Mae generated growth of $2.7 million in the portfolio of loans serviced for Fannie Mae since December 31, 2014. The servicing portfolio totals $67.4 million as of June 30, 2015 compared to $64.7 million as of December 31, 2014 and $60.9 million as of June 30, 2014.

In April 2015, the Bank consolidated the branch operations of its three Lancaster County, Virginia offices into two offices, with all Kilmarnock branch operations now based in the main office of the Bank. The branch consolidation is expected to save the Company approximately $85 thousand annually. The branch building located at 432 N. Main Street, Kilmarnock, Virginia is for sale.

The net interest margin decreased to 3.59% for the first six months of 2015 compared to 3.87% for the same period in 2014. As this low rate environment continues, loan and investment yields continue to decline, but increased loan balances have resulted in increased interest income, resulting in the improved net interest income noted above.

Finally, the Company’s core capital levels and regulatory ratios remain well above what is considered “well capitalized” by the Company’s regulators.

For more information, visit the Company’s website at www.baybanks.com. Information contained on the Company’s website is not a part of this report.

EARNINGS SUMMATION

For the three months ended June 30, 2015 and 2014, net income was $294 thousand and $260 thousand, respectively, an increase of $34 thousand or 13.1% from 2015 to 2014. Diluted earnings per average share for the three months ended June 30, 2015 and 2014 were $0.06 and $0.05, respectively. Annualized return on average assets was 0.29% for the three months ended June 30, 2015 compared to 0.31% for the three months ended June 30, 2014. Annualized return on average equity was 2.96% and 2.72% for the three months ended June 30, 2015 and 2014, respectively.

For the six months ended June 30, 2015 and 2014, net income was $675 thousand and $720 thousand, respectively, a decrease of $45 thousand or 6.3% from 2015 to 2014. During the first quarter of 2014, the Company recognized a gain of $138 thousand on the sale of its former Heathsville branch. Diluted earnings per average share for the six months ended June 30, 2015 and 2014 were $0.14 and $0.15, respectively. Annualized return on average assets was 0.34% for the six months ended June 30, 2015 compared to 0.44% for the six months ended June 30, 2014. Annualized return on average equity was 3.44% and 3.84% for the six months ended June 30, 2015 and 2014, respectively.

RESULTS OF OPERATIONS

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of assets which earn interest. Changes in the volume and mix of assets which earn interest and liabilities that bear interest, the associated yields and rates, and the volume of non-performing assets have an effect on net interest income, the net interest margin, and net income.

FOR THE THREE MONTHS ENDED JUNE 30, 2015 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2014

NET INTEREST INCOME


Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in Thousands)	Three months ended 6/30/2015							Three months ended 6/30/14
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	28,979	$	141		1.95	%	$	20,042	$	85		1.70	%
Tax-exempt investments (1)		16,400		132		3.22	%		18,719		144		3.08	%

Total investments		45,379		273		2.41	%		38,761		229		2.36	%

Gross loans (2)		309,695		3,715		4.80	%		257,575		3,279		5.09	%
Interest-bearing deposits		22,900		13		0.23	%		6,676		4		0.24	%
Federal funds sold		703		—		0.05	%		469		—		0.06	%

Total Interest Earning Assets	$	378,677	$	4,001		4.23	%	$	303,481	$	3,512		4.63	%


INTEREST-BEARING LIABILITIES:
Savings deposits	$	42,774	$	19		0.18	%	$	43,510	$	17		0.16	%
NOW deposits		42,228		15		0.14	%		42,905		16		0.15	%
Time deposits => $100,000		55,340		212		1.54	%		43,736		192		1.76	%
Time deposits < $100,000		56,494		199		1.41	%		50,489		197		1.57	%
Time deposits - Wholesale		7,686		8		0.42	%		419		1		0.51	%
Money market deposit accounts		56,972		117		0.82	%		26,872		26		0.39	%

Total Deposits		261,494		570		0.87	%		207,931		449		0.87	%

Federal funds purchased		—		—		—			226		1		0.69	%
Securities sold under repurchase agreements		7,424		2		0.11	%		8,231		2		0.10	%
FHLB advances		34,722		87		1.00	%		16,000		85		2.13	%
Subordinated notes		2,504		42		6.50	%		—		—		—

Total Interest-Bearing Liabilities	$	306,144	$	701		0.92	%	$	232,388	$	537		0.93	%


Net interest income and net interest margin			$	3,300		3.49	%			$	2,975		3.92	%


Non-interest-bearing deposits	$	61,030		—		0.00	%	$	58,274		—		0.00	%
Total Cost of funds						0.76	%						0.74	%
Net interest rate spread						3.46	%						3.89	%

Notes:

(1)	Income and yield assumes a federal tax rate of 34%.

(2)	Includes loan fees, VISA program and nonaccrual loans.

Interest income for the three months ended June 30, 2015, on a tax-equivalent basis, was $4.0 million, an increase of $489 thousand from the second quarter of 2014, due mainly to increases in loan balances. Interest expense for the three months ended June 30, 2015 was $701 thousand, an increase of $164 thousand from the second quarter of 2014, due to increases in interest-bearing deposits in Richmond, which supported the loan growth. Net interest income for the three months ended June 30, 2015, on a tax-equivalent basis, was $3.3 million, an increase of $325 thousand from the second quarter of 2014.

The annualized net interest margin was 3.49% and 3.92% for the three months ended June 30, 2015 and 2014, respectively. This period to period decline is due to continued reductions in loan yields, to 4.80% for the second quarter of 2015 from 5.09% for the second quarter of 2014, as market rates remain historically low and new loans are made at rates lower than existing loans. The cost of funds increased slightly to 0.76% for the second quarter of 2015 from 0.74% for the second quarter of 2014, a result of new money market products with higher rates.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, decreased to 3.46% for the three months ended June 30, 2015, compared to 3.89% for the three months ended June 30, 2014.

NON-INTEREST INCOME

Non-interest income for the three months ended June 30, 2015 increased by $293 thousand, or 47.0%, compared to the three months ended June 30, 2014. Contributing to this improvement was decreased losses on OREO properties to $41 thousand in 2015 from $249 thousand in 2014 and an increase in secondary market lending income of $72 thousand.

NON-INTEREST EXPENSE

For the three months ended June 30, 2015 and 2014, non-interest expenses totaled $3.6 million and $3.2 million, respectively. The increase in non-interest expense was due primarily to an increase of $243 thousand in salaries and benefits, which was driven by an increase in employees for the new Richmond offices and increased commissions related to loan production. Occupancy expense increased in 2015 by $88 thousand primarily due to the new branches in Richmond which were opened in the fourth quarter of 2014 and the end of the first quarter of 2015. Other expense increases included $47 thousand related to the write down of an asset, $22 thousand related to recruitment fees and $15 thousand related to strategic planning.

FOR THE SIX MONTHS ENDED JUNE 30, 2015 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2014

NET INTEREST INCOME


Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in Thousands)	Six months ended 6/30/2015							Six months ended 6/30/14
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	28,294	$	275		1.94	%	$	20,918	$	179		1.71	%
Tax-exempt investments (1)		16,461		264		3.21	%		19,017		294		3.09	%

Total investments		44,755		539		2.40	%		39,935		473		2.37	%

Gross loans (2)		305,868		7,390		4.83	%		254,625		6,440		5.06	%
Interest-bearing deposits		19,026		21		0.22	%		6,303		8		0.25	%
Federal funds sold		645		—		0.06	%		308		—		0.06	%

Total Interest Earning Assets	$	370,294	$	7,950		4.29	%	$	301,171	$	6,921		4.60	%


INTEREST-BEARING LIABILITIES:
Savings deposits	$	43,669	$	39		0.18	%	$	43,948	$	34		0.16	%
NOW deposits		41,969		31		0.15	%		42,361		31		0.15	%
Time deposits => $100,000		55,844		424		1.53	%		43,893		393		1.81	%
Time deposits < $100,000		56,618		400		1.42	%		50,688		395		1.57	%
Time deposits - Wholesale		7,827		15		0.39	%		210		1		0.52	%
Money market deposit accounts		48,414		177		0.74	%		27,055		53		0.40	%

Total Deposits		254,341		1,086		0.86	%		208,155		907		0.88	%

Federal funds purchased		—		—		—			182		1		0.55	%
Securities sold under repurchase agreements		6,740		4		0.12	%		7,805		4		0.10	%
FHLB advances		34,861		172		0.99	%		15,500		185		2.41	%
Subordinated notes		1,252		42		6.50	%		—		—		—

Total Interest-Bearing Liabilities	$	297,194	$	1,304		0.88	%	$	231,642	$	1,097		0.96	%


Net interest income and net interest margin			$	6,646		3.59	%			$	5,824		3.87	%


Non-interest-bearing deposits	$	61,370		—		0.00	%	$	57,733		—		0.00	%
Total Cost of funds						0.73	%						0.76	%
Net interest rate spread						3.56	%						3.84	%

Notes:

(1)	Income and yield assumes a federal tax rate of 34%.

(2)	Includes loan fees, VISA program and nonaccrual loans.

Interest income for the six months ended June 30, 2015, on a tax-equivalent basis, was $7.9 million, an increase of $1.0 million from the same period of 2014, due primarily to the growth in loan balances. Interest expense for the six months ended June 30, 2015 was $1.3 million, an increase of $207 thousand from the same period of 2014. Net interest income for the six months ended June 30, 2015, on a tax-equivalent basis, was $6.6 million, an increase of $1.0 million from the first half of 2014.

The annualized net interest margin was 3.59% and 3.87% for the six months ended June 30, 2015 and 2014, respectively. This period to period decline is due to continued reductions in loan yields, to 4.83% for the first half of 2015 from 5.06% for the first half of 2014, as market rates remain historically low and new loans are made at lower rates than existing loans. Although the cost of funds is slightly lower for the first half of 2015 compared to the first half of 2014 to 0.73% from 0.76%, the second quarter of 2015 increased compared to both the first quarter of 2015 and the second quarter of 2014.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, decreased to 3.56% for the six months ended June 30, 2015, compared to 3.84% for the six months ended June 30, 2014.

NON-INTEREST INCOME

Non-interest income for the six months ended June 30, 2015 increased by $65 thousand, or 3.7%, compared to the six months ended June 30, 2014. Contributing to this increase were reductions in losses on OREO properties to $80 thousand in 2015 compared to $219 thousand in 2014. Secondary market lending income increased $59 thousand for the six months ended June 30, 2015 compared to the same period in 2014 due to increased mortgage origination volume. In addition, a gain of $138 thousand was recognized on the sale of a branch in the first quarter of 2014.

NON-INTEREST EXPENSE

For the six months ended June 30, 2015 and 2014, non-interest expenses totaled $7.3 million and $6.3 million, respectively. The increase in non-interest expense was due primarily to an increase of $704 thousand in salaries and benefits, as a result of additional personnel for the new Richmond offices and related support functions, plus increased commissions related to loan growth. Occupancy expense increased in 2015 by $165 thousand primarily due to $135 thousand related to the new branches in Richmond. Other expense increases included $47 thousand related to the write down of an asset and $45 thousand related to the new Richmond branches.

AVERAGE INTEREST-EARNINGS ASSETS AND AVERAGE INTEREST-BEARING LIABILITIES

Average interest-earning assets increased 23.0% to $370.3 million for the six months ended June 30, 2015, as compared to $301.2 million for the six months ended June 30, 2014, due to growth of $51.2 million in average loans. Average interest-earning assets as a percent of total average assets were 90.4% for the six months ended June 30, 2015 as compared to 91.2% for the same period in 2014. The loan portfolio, with $305.9 million in average balances as of June 30, 2015, is the largest category of interest-earning assets.

Average interest-bearing liabilities increased 20.7% to $297.2 million for the six months ended June 30, 2015, as compared to $246.1 million for the six months ended June 30, 2014, due primarily to the growth in deposits from the new Richmond branches. The largest category of interest-bearing liabilities is time deposits, with combined average balances of $120.3 million for the six months ended June 30, 2015, up from $94.8 million for the similar period in 2014.

ASSET QUALITY

Asset quality remains good. Loans charged off during the first six months of 2015, net of recoveries, totaled $36 thousand compared to $214 thousand for the first six months of 2014. This represents a decline in the annualized net charge-off ratio to 0.02% for the first six months of 2015 compared to 0.17% for the first six months of 2014, reflecting an improvement in asset quality. The majority of the charge-offs were anticipated and specific reserves had been provided for them in the ALL. Management believes it is maintaining an adequate level of the ALL at 1.09% of total loans at June 30, 2015 and 1.07% at December 31, 2014.

Non-performing assets, which include OREO and non-performing loans, increased by $2.7 million to $7.5 million, or 1.8% of total assets as of June 30, 2015 compared to 1.2% as of December 31, 2014. This increase is primarily related to an increase of $2.5 million in non-accruing loans, a result of two loan relationships moved to non-accruing status, one of which was already identified as impaired.

Non-Performing Assets


(Dollars in thousands)	June 30, 2015			December 31, 2014

Loans past due 90 days or more and still accruing	$	395		$	14
Non-accruing loans		4,447			1,954

Total non-performing loans		4,842			1,968

Other real estate owned		2,624			2,791

Total non-performing assets	$	7,466		$	4,759

Allowance for loan losses	$	3,439		$	3,205

Allowance to non-performing loans		71.0	%		162.9	%
Non-performing assets to total assets		1.8	%		1.2	%

Classified assets, which include loans with risk rating grades of substandard, doubtful and loss, plus OREO, increased by $843 thousand during the first six months of 2015 to $9.8 million, or 23.3% of Tier 1 capital plus the allowance for loan losses. Risk rating grades are assigned conservatively, causing some homogenous loans, such as residential mortgages, to fall into the pool of adversely risk rated loans and thereby evaluated for impairment, even though they may be performing as agreed and therefore not impaired.

As of June 30, 2015, loans valued at $9.8 million were considered impaired, whereas $6.9 million were considered impaired as of December 31, 2014. Between December 31, 2014 and June 30, 2015, five loans were identified as impaired, none were dispensed through foreclosure and charged-off, one was paid off and none were moved into the pool of loans for collective evaluation of impairment. Management has reviewed the impaired credits and the underlying collateral and expects no additional losses above those which are specifically reserved in the ALL.

FINANCIAL CONDITION

Total assets increased to $421.7 million as of June 30, 2015 compared to $390.5 million as of December 31, 2014. Cash and due from banks, which produces no income, was $5.9 million and $6.2 million on June 30, 2015 and December 31, 2014, respectively. Interest-bearing deposits at other banks, which is mainly the Bank’s cash on deposit at the Federal Reserve Bank of Richmond, has increased by $5.8 million since year end 2014 as a result of the cash received from the issuance of an aggregate of $7.0 million of subordinated notes at the end of the second quarter.

During the six months ended June 30, 2015, gross loans increased by $18.5 million or 6.2%, to $316.5 million from $298.1 million at year-end 2014. The largest components of this increase were $16.0 million related to residential first, revolving and junior mortgages, $4.5 million related to commercial mortgages and $800 thousand related to construction, land and land development loans. These increases were partially offset by a $3.0 million decrease related to commercial and industrial loans.

The Bank had $2.6 million and $2.8 million of OREO at June 30, 2015 and December 31, 2014, respectively. As of June 30, 2015, OREO consists of seven residences, seven lots, two former convenience stores, one former restaurant and two commercial business properties. During the first six months of 2015, one property with a book value of $129 thousand from one borrower was added through foreclosure, and nine properties with a total book value of $225 thousand were sold. There were $72 thousand of write-downs of OREO properties during the first six months of 2015, compared to $127 thousand for the same period in 2014. All properties maintained as OREO are valued at the lesser of cost or fair value less estimated costs to sell and are actively marketed.

In March 2014, the Company sold a former branch in Heathsville, Virginia for $311 thousand and recognized a gain of $138 thousand on the sale.

As of June 30, 2015, securities available-for-sale at fair value totaled $47.1 million as compared to $42.6 million on December 31, 2014. This represents a net increase of $4.5 thousand or 10.6% for the six months. As of June 30, 2015, available-for-sale securities represented 11.2% of total assets and 12.2% of earning assets. All securities in the Company’s investment portfolio are classified as available-for-sale and marked to market on a monthly basis. Unrealized gains or losses, net of tax, are booked as an adjustment to shareholders’ equity, and are not realized as an adjustment to earnings until the securities are actually sold or an other than temporary impairment occurs.

During 2013 and 2014, the Company purchased $7.0 million of bank owned life insurance in order to offset the cost of employee benefits. The bank owned life insurance’s carrying value as of June 30, 2015 was $7.4 million.

As of June 30, 2015, total deposits were $333.6 million compared to $307.6 million at year-end 2014. This represents an increase in balances of $26.0 million or 8.5% during the six months. The increase was driven by a $33.8 million increase in money market accounts, offset by decreases of $3.7 million in savings accounts, $2.2 million in noninterest-bearing deposits and $2.0 million in time deposits. The increase in money market is primarily the result of promotional rates for the Richmond market.

To support loan growth since the second quarter of 2014, a net of $5.0 million of new FHLB advances were drawn, plus $3.0 million in a brokered money market account during the third quarter of 2014, and $5.0 million in brokered time deposits during the fourth quarter of 2014.

On May 28, 2015, the Company entered into a Purchase Agreement with twenty-nine accredited investors under which the Company issued an aggregate of $7,000,000 of subordinated notes to the accredited investors. The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the right to redeem the Notes, in whole or in part, without premium or penalty, at any time on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.

As of June 30, 2015, securities sold under repurchase agreements increased by $2.8 million to $8.8 million from $6.0 million at December 31, 2014. This increase was the result of normal seasonality for these customers.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates are major factors for liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At June 30, 2015, cash totaled $5.9 million, federal funds sold totaled $2.2 million, interest-bearing deposits totaled $20.6 million, securities maturing in one year or less totaled $5.3 million and loans maturing in one year or less totaled $26.3 million. This results in a liquidity ratio as of June 30, 2015 of 14.3% as compared to 11.7% as of December 31, 2014. The Company determines this ratio by dividing the sum of cash and cash equivalents, investment securities maturing in one year or less, loans maturing in one year or less and federal funds sold, by total assets. The Bank has a formal liquidity management policy and contingency plan, which includes periodic evaluation of cash flow projections.

In addition, the Company has a line of credit with the FHLB of $78.2 million, with $44.2 million available, plus federal funds lines of credit with correspondent banks totaling $21.5 million.

CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition and quality of the Company’s resources, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allows management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as shareholders’ equity, is comprised mainly of outstanding common stock and retained earnings. Capital can be increased with securities offerings or through earnings.

Several factors impact shareholders’ equity, including net income and regulatory capital requirements. The Company’s capital resources are also impacted by net unrealized gains or losses on securities. The available-for-sale securities portfolio is marked to market monthly and unrealized gains or losses, net of taxes, are recognized as accumulated other comprehensive income (loss) on the balance sheets and statement of changes in shareholders’ equity. Another factor affecting accumulated other comprehensive income (loss) is changes in the market value of the Company’s pension and post-retirement benefit plans. The Company’s shareholders’ equity before accumulated other comprehensive loss was $40.7 million on June 30, 2015 compared to $40.2 million on December 31, 2014. Accumulated other comprehensive loss increased by $175 thousand between December 31, 2014 and June 30, 2015, primarily as a result of increases in unrealized net losses in the investment portfolio. During the six months ended June 30, 2015, the Company repurchased 30,000 shares of its common stock for $168 thousand.

Book value per share, before accumulated other comprehensive loss, on June 30, 2015, compared to December 31, 2014, increased to $8.50 from $8.34. Book value per share, including accumulated other comprehensive loss, increased to $8.27 on June 30, 2015 from $8.14 on December 31, 2014. No cash dividends were paid for the six month period ended June 30, 2015, nor for the comparable period ended June 30, 2014.

The Bank is subject to minimum regulatory capital ratios as defined by the Board of Governors of the Federal Reserve System. As of June 30, 2015, the Bank’s capital ratios continue to be well in excess of regulatory minimums.

In July 2013, the Board of Governors of the Federal Reserve System issued final rules that make technical changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new Common Equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements, which will be phased in over a four-year period. When fully phased in on January 1, 2019, the rules will require the Bank to maintain (i) a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% Common Equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets. The capital conservation buffer requirement will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. As of June 30, 2015, the Bank maintained Common Equity Tier 1 capital of $37.1 million, Tier 1 capital of $37.1 million, risk weighted assets of $287.6 million, and total capital of $40.5 million. As of June 30, 2015, all ratios were in excess of the fully phased-in requirements, with the Common Equity Tier 1 ratio at 12.88% of risk-weighted assets, the Tier 1 capital ratio at 12.88% of risk-weighted assets, the total capital ratio at 14.08% of risk-weighted assets, and the Tier 1 leverage ratio at 9.17% of total assets.

OFF BALANCE SHEET COMMITMENTS

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments may involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Off Balance Sheet Arrangements


	June 30, 2015		December 31, 2014
(Dollars in thousands)
Total loan commitments outstanding	$	44,559	$	36,443
Standby-by letters of credit		431		355
Low income housing tax credit fund		499		—

The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon takedown of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.

There have been no material changes to the off balance sheet items disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014.

CONTRACTUAL OBLIGATIONS

Other than with respect to the issuance of an aggregate of $7.0 million of subordinates notes on May 28, 2015, there have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014. Information on the issuance of the subordinated notes is included in the Company’s Current Report on Form 8-K filed on June 2, 2015.

RECENT ACCOUNTING PRONOUNCEMENTS

Refer to Note 3, Amendments to the Accounting Standards Codification, in the Notes to the Consolidated Financial Statements contained in Item 1 of this report, for information related to the adoption of new amendments to the Accounting Standards Codification.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required.

ITEM 4.

CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions. Based upon their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic Securities and Exchange Commission filings as of June 30, 2015.

CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

There was no change to the Company’s internal control over financial reporting during the six months ended June 30, 2015 that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

ITEM 1A.

RISK FACTORS

Not required.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On December 17, 2014, the Company announced a share repurchase program pursuant to which it is authorized to repurchase up to 240,892 shares of its common stock. The share repurchase program is authorized to last through December 31, 2015. The table below provides information on share repurchases made during the second quarter of 2015.


	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Program		Maximum Number of Shares That May Yet Be Purchased Under the Plans or Program
April 1-30, 2015		—	$	—		—		—
May 1-31, 2015		—		—		—		—
June 1-30, 2015		15,000		5.83		30,000		210,892

Total		15,000	$	5.83		30,000		210,892

ITEM 3.

DEFAULT UPON SENIOR SECURITIES

None to report.

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.

OTHER INFORMATION

None to report.

ITEM 6.

EXHIBITS


4.1		Form of Subordinated Note (incorporated by reference to previously filed Form 8-K filed on June 2, 2015).

10.1		Form of Subordinated Note Purchase Agreement (incorporated by reference to previously filed Form 8-K filed on June 2, 2015).

31.1		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101		The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2015, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets as of June 30, 2015 and December 31, 2014, (ii) Consolidated Statements of Income for the three and six months ended June 30, 2015 and 2014, (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2015 and 2014, (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2015, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2015 and 2014, and (vi) Notes to Consolidated Financial Statements.

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.


	Bay Banks of Virginia, Inc.
	(Registrant)

August 7, 2015		By:	/s/ Randal R. Greene
			Randal R. Greene
			President and Chief Executive Officer
			(Principal Executive Officer)

		By:	/s/ Deborah M. Evans
			Deborah M. Evans
			Treasurer and Chief Financial Officer
			(Principal Financial and Accounting Officer)

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