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EX-21 - EXHIBIT 21 - VALLEY FINANCIAL CORP /VA/ex21.htm
EX-23 - EXHIBIT 23 - VALLEY FINANCIAL CORP /VA/ex23.htm
EX-24 - EXHIBIT 24 - VALLEY FINANCIAL CORP /VA/ex24.htm
EX-32.1 - EXHIBIT 32.1 - VALLEY FINANCIAL CORP /VA/ex321.htm
EX-31.2 - EXHIBIT 31,2 - VALLEY FINANCIAL CORP /VA/ex312.htm
EX-99.1 - EXHIBIT 99.1 - VALLEY FINANCIAL CORP /VA/ex991.htm
EX-99.2 - EXHIBIT 99.2 - VALLEY FINANCIAL CORP /VA/ex992.htm
EX-31.1 - EXHIBIT 31.1 - VALLEY FINANCIAL CORP /VA/ex311.htm
EX-10.19 - EXHIBIT 10.19 - VALLEY FINANCIAL CORP /VA/ex1019.htm
hat

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
 
(Mark One)
 
[ X ]           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2010
 
OR
 
[    ]           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from _______ to ________
 
Commission File Number:  000-28342v



VALLEY FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
   
VIRGINIA
54-1702380
(State or Other Jurisdiction of Incorporation Or Organization)
(I.R.S. Employer Identification Number)
   
36 Church Avenue, S.W.
Roanoke, Virginia
24011
(Zip Code)
(Address of principal executive offices)
 


Registrant’s telephone number, including area code (540) 342-2265
 
Securities registered under Section 12(b) of the Exchange Act of 1934:
 
`
 
Title of Each Class
 
Name of Each Exchange on
Which Registered
Common Stock, No par value
Nasdaq Capital Market
   
Securities registered under Section 12(g) of the Exchange Act of 1934:  None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No S

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No S

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

 
 

 


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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  S

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

 
Large Accelerated filer o
 
Accelerated filer o
       
 
Non-Accelerated filer o
 
Smaller reporting company S
 
(Do not check if a smaller reporting company)
 

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

The aggregate market value of Valley Financial Corporation Common Stock held by non-affiliates of Valley Financial Corporation as of June 30, 2010 was $11,673,702.

The number of shares of Valley Financial Corporation Common Stock outstanding as of March 4, 2011 was 4,697,256.

 
Documents of Which Portions
 
Parts of Form 10-K into Which Portion of
 
 
Are Incorporated by Reference
 
Documents Are Incorporated
 
         
         
 
Proxy Statement for Valley Financial
 
Certain Items in Part III as indicated
 
 
Corporation’s 2011 Annual
     
 
Meeting of Shareholders
     





 
 

 


Table of Contents

VALLEY FINANCIAL CORPORATION
FORM 10-K
December 31, 2010
 
INDEX
 
             
PART I.
  
 
  
 
   
Item 1.
  
Business
  
5
   
Item 1A.
 
Risk Factors
 
15
   
Item 1B.
 
Unresolved Staff Comments
 
21
   
Item 2.
  
Properties
  
21
   
Item 3.
  
Legal Proceedings
  
21
   
Item 4.
  
(Removed and Reserved)
  
21
             
PART II.
  
 
  
 
   
Item 5.
  
Market for Registrant’s Common Equity and Related Stockholder Matters and Issue Purchases of Equity Securities
  
22
   
Item 6.
 
Selected Financial Data
 
23
   
Item 7.
  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  
24
   
Item 7A.
 
Quantitative and qualitative Disclosure About Market Risk
    45
   
Item 8.
  
Financial Statements and Supplementary Data
  
46
   
Item 9.
  
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
  
86
   
Item 9A.
  
Controls and Procedures
  
86
   
Item 9B.
 
Other Information
 
87
             
PART III.
  
 
  
 
   
Item 10.
  
Directors, Executive Officers and Corporate Governance
  
87
   
Item 11.
  
Executive Compensation
  
87
   
Item 12.
  
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
  
87
   
Item 13.
  
Certain Relationships and Related Transactions, and Director Independence
  
87
   
Item 14.
  
Principal Accountant Fees and Services
  
87
             
PART IV.
       
   
Item 15
 
Exhibits, Financial Statement Schedules
 
88
   
SIGNATURES
  
89
   




 
3

 


Forward-Looking and Cautionary Statements

The Private Securities Litigation Reform Act of 1995 (the “1995 Act”) provides a safe harbor for forward-looking statements made by or on our behalf.  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of our management and on information available at the time these statements and disclosures were prepared.
 
This report includes and incorporates by reference forward-looking statements within the meaning of the 1995 Act. These statements are included throughout this report, and in the documents incorporated by reference in this report, and relate to, among other things, projections of revenues, earnings, earnings per share, cash flows, capital expenditures, or other financial items, expectations regarding acquisitions, discussions of estimated future revenue enhancements, potential dispositions, and changes in interest rates. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins, profitability, liquidity, and capital resources. The words “believe”, “anticipate”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “will”, and similar terms and phrases identify forward-looking statements in this report and in the documents incorporated by reference in this report.
 
Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside of our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct.
 
Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a number of factors. Factors that may cause actual results to differ materially from those expected include the following:
 
 
 
General economic conditions may deteriorate and negatively impact the ability of borrowers to repay loans and depositors to maintain balances;
 
 
 
General decline in the residential real estate construction and finance market;
 
 
 
Decline in market value of real estate in the Company’s markets;
 
 
 
Changes in interest rates could reduce net interest income and/or the borrower’s ability to repay loans;
 
 
 
Competitive pressures among financial institutions may reduce yields and profitability;
 
 
 
Legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses that the Company is engaged in;
 
 
 
New products developed or new methods of delivering products could result in a reduction in business and income for the Company;
 
 
 
The Company’s ability to continue to improve operating efficiencies;
 
 
 
Natural events and acts of God such as earthquakes, fires and floods;
 
 
 
Loss or retirement of key executives; and
 
 
 
Adverse changes may occur in the securities market.


These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein.  We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.

 
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PART I.

Item 1.  Business

Valley Financial Corporation (the “Company”) was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of Valley Bank (the “Bank”).   The Company posts all reports required to be filed under the Securities Exchange Act of 1934 on its web site at www.myvalleybank.com.

History

The Bank operates under a state charter issued by the Commonwealth of Virginia, and engages in the business of commercial banking. Its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) and it is a member of the Federal Reserve System. Our primary purpose is to own and manage the Bank.

The Bank opened for business on May 15, 1995 at its main office in the City of Roanoke, opened its second office on September 11, 1995 in the County of Roanoke, its third office on January 15, 1997 in the City of Roanoke, its fourth office in the City of Salem on April 5, 1999, its fifth office in the City of Roanoke on May 7, 2001, its sixth office in County of Roanoke on May 20, 2002, its seventh office in the City of Roanoke on December 8, 2003, and its eighth office in the City of Roanoke on May 9, 2005.  Additionally, the Bank opened its wealth management subsidiary, Valley Wealth Management Services, Inc., in the City of Roanoke on June 23, 2005.
 
Effective June 26, 2003, Valley Financial (VA) Statutory Trust I was established as a wholly-owned subsidiary of the Company for the purpose of issuing trust preferred securities. Effective October 16, 2002, the Bank established VB Investments, LLC as a wholly-owned subsidiary of the Bank to be a limited partner in various tax credit partnerships. The establishment of the subsidiary gives the Bank the right to utilize certain federal and state tax credits. Effective September 26, 2005, Valley Financial (VA) Statutory Trust II was established as a wholly-owned subsidiary of the Company for the purpose of issuing additional trust preferred securities.  Effective December 15, 2006, Valley Financial (VA) Statutory Trust III was established as a wholly owned subsidiary of the Company for the purpose of issuing additional trust preferred securities.  These entities raised capital (in the case of the statutory trusts) or investments (in the case of the LLC) for the Company and the Bank.  VB Land, LLC was established in September 2008 as a wholly-owned subsidiary of the Bank to provide credit intermediary services for the Bank.  In June 2010, the Bank established Ivy View, LLC, a wholly-owned subsidiary, to manage one large commercial real estate project that the Bank anticipated acquiring through foreclosure.

Banking Services

We conduct a general commercial banking business while emphasizing the needs of small-to-medium sized businesses, professional concerns, and individuals.

Deposit Services
We offer a full range of deposit services that are typically available in most banks and savings and loan associations, including checking accounts, NOW accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit. The transaction accounts and time certificates are tailored to the Bank’s principal market area at rates competitive to those offered in the area. In addition, we offer certain retirement account services, such as individual retirement accounts. All deposit accounts are insured by the FDIC up to the maximum amount allowed by law. We solicit accounts from individuals, businesses, associations and organizations and governmental authorities.

The Bank also participates in the Certificate of Deposit Account Registry Service (“CDARS”).  CDARS gives us the ability to provide our deposit customers access to FDIC insurance in amounts exceeding the existing FDIC limit.  This permits our institution to better attract and retain large deposits from businesses, nonprofit organizations, individuals and other customers that require an assurance of safety.  Finally, the Bank offers a remote deposit transaction delivery system (“RDC”) which allows the Bank to receive digital information from deposit documents captured at remote locations.  These locations may be our branches, ATMs, domestic and foreign correspondents, or locations owned or controlled by

 
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commercial or retail customers of the Bank. In substance, RDC is similar to traditional deposit delivery systems; however, it enables customers of financial institutions to deposit items electronically from remote locations. RDC can decrease processing costs, support new and existing banking products, and improve customers' access to their deposits; however, it introduces additional risks to those typically inherent in traditional deposit delivery systems.

Lending Activities
We offer a full range of lending services including commercial loans, residential real estate loans, construction and development loans, and consumer loans.

Credit Policies
The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of its borrowers.  Within each category, such risk is increased or decreased, depending on prevailing economic conditions.  In an effort to manage the risk, our loan policy gives loan amount approval limits to individual bankers based on their position and level of experience, and to our loan committees based on the size of the lending relationship.  The risk associated with real estate and construction loans, commercial loans and consumer loans varies, based on market employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness.  The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

We have written policies and procedures to help manage credit risk.  We utilize an outside third party loan review process that includes regular portfolio reviews to establish loss exposure and to ascertain compliance within our loan policy.

A Senior Loan Committee and a Directors’ Loan Committee are used to approve loans.  The Senior Loan Committee is comprised of our Chief Executive Officer, Chief Lending Officer, Chief Credit Officer, Senior Real Estate Finance Officer, Senior Business Banking Manager and Senior Business Banking Officer.  The Directors’ Loan Committee is comprised of eight Directors, of which seven are independent Directors.  Both Committees approve new, renewed, and modified loans that exceed individual officer loan authorities.  The Directors’ Loan Committee also reviews any changes to the Bank’s lending policies, which are then approved by the Board of Directors.

Commercial Lending
We make both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements) and purchase of equipment and machinery.  Loan requests are granted based upon several factors including credit history, past and present relationships with the Bank, marketability of collateral and the cash flow of the borrowers.  Unsecured commercial loans must be supported by a satisfactory balance sheet, income statement and cash flow statement of the borrowing entity.  Collateralized business loans may be secured by a security interest in marketable equipment, accounts receivable, business equipment and/or general intangibles of the business.  In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate.  The risks associated with commercial loans are related to the strength of the individual business, the value of loan collateral, and the general health of the economy.

Residential Real Estate Lending
Residential real estate loans are secured by deeds of trust on 1-4 family residential properties.  The Bank also serves as a broker for residential real estate loans placed in the secondary market.  There are occasions when a borrower or the real estate does not qualify under secondary market criteria, but the loan request represents a reasonable credit risk.  Also, an otherwise qualified borrower may choose not to have their mortgage loan sold.  On these occasions, if the loan meets the Bank’s internal underwriting criteria, the loan will be closed and placed in the Bank’s portfolio.  Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Valley Bank has expanded its mortgage program by becoming an FHA and VA approved lender. In addition, the Bank continues to add additional external wholesale partners to ensure competitive mortgage programs and interest rate pricing.


 
6

 


Construction and Development Lending
The Bank makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals.  Additionally, the Bank makes loans for the purpose of financing the acquisition and development of commercial and residential projects.  These loans are subject to additional underwriting standards as compared to our commercial and residential real estate loans, due to the following inherent risks associated with construction and development loans. Construction loans and acquisition and development loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time total less than the principal amount of the loan.  Construction loans and acquisition and development loans also bear the risk that the general contractor, who may or may not be the Bank’s loan customer, is unable to finish the construction project as planned because of financial pressures unrelated to the project.  Loans to customers that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures.

Consumer Lending
The Bank routinely makes consumer loans, both secured and unsecured, for financing automobiles, home improvements, education, and personal investments.  The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision.  Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property.  Negative changes in a customer’s financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk.  In addition, deterioration in collateral value can add risk to consumer loans.

Other Lending Activities
We will occasionally buy or sell all or a portion of a loan.  We will consider selling a loan or a participation in a loan, if:  (i) the full amount of the loan will exceed our legal lending limit to a single borrower; (ii) the full amount of the loan, when combined with a borrower’s previously outstanding loans, will exceed our legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with us; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by Bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location or in one particular type of loan.  We will consider purchasing a loan, or a participation in a loan, from another financial institution (including from another subsidiary of the Company) if the loan meets all applicable credit quality standards and (i) the Bank’s loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase.

Additionally, we offer leasing services for our small business, private banking and business banking customers and prospects to access equipment, technology or other capital assets that they need to improve productivity and to facilitate growth without taking on debt or investing significant working capital.  Leasing facilities do generally incorporate above-average risk as they generally require minimal initial equity investments on the part of the lessee and may include residual value risks at the time of lease maturity.

We offer several forms of specialized asset-based lending to our commercial business customers, which include:

·  
Accounts Receivable Financing – enables small businesses to unlock the cash typically frozen in accounts receivable which provides cash flow to support operations.  The Bank utilizes an automated software program to manage and monitor collateral values on a consistent and routine basis.
·  
Automobile Floor Plan Financing – enables auto-related businesses to carry sufficient levels of inventories to support sales demand.

Asset-based loans require substantial risk management and monitoring processes which should help mitigate collateral exposures; however, these types of financing have inherently higher risk due to the ever changing status of the underlying collateral.

Our lending activities are subject to a variety of lending limits imposed by state and federal laws and regulations. In general, the Bank is subject to a loans-to-one borrower limit of an amount equal to 15% of the total of the Bank’s unimpaired capital, surplus, and allowance for loan loss. We may not make any extensions of credit to any director,

 
7

 

executive officer, or principal shareholder of the Bank or the Company, or to any related interest of such person, unless the extension of credit is approved by the Board of Directors of the Bank and the credit is made on terms not more favorable to such person than would be available to an unaffiliated party.

Other Services

Other Bank services include safe deposit boxes, certain cash management services including overnight repurchase agreements, merchant purchase and management programs, traveler’s checks, direct deposit of payroll and social security checks and automatic drafts for various accounts. We operate seven proprietary ATM’s and are associated with the Star, Cirrus and InterCept shared networks of automated teller machines that may be used by bank customers throughout Virginia and other regions. We also offer VISA and MasterCard credit card services as well as a debit-check card. Our lockbox service provides a simple and efficient way to collect accounts receivable payments locally for businesses and non-profit organizations.

Financial Services

Valley Wealth Management Services, Inc, (“VWM”) a wholly-owned subsidiary of the Bank, completed its fifth year of offering non-deposit investment and insurance products to the public.  VWM changed broker dealer services to Investment Centers of America (“ICA”) on January 14, 2011.  This conversion will enable to VWM to broaden its focus on financial planning by incorporating advanced tools and technologies available through ICA.    

We have no immediate plans to obtain or exercise trust powers. We may in the future offer a full-service trust department, but cannot do so without the prior approval of our primary regulators, the Federal Reserve Bank of Richmond and the Virginia State Corporation Commission.

Location and Service Area

Our primary service area is the Roanoke Metropolitan Statistical Area (the “Roanoke MSA”), which is the regional center for southwest Virginia, and is located approximately 165 miles west of Richmond, Virginia, 178 miles northwest of Charlotte, North Carolina, 178 miles east of Charleston, West Virginia and 222 miles southwest of Washington, D.C.

The population in the Roanoke MSA was estimated at 300,856 in 2008 per the Weldon Cooper Center for Public Services, University of Virginia. The Roanoke MSA’s growth typically is slower than that in the Commonwealth overall and in other key Virginia markets in particular. The Virginia Employment Commission reported that the Roanoke MSA had a seasonally unadjusted unemployment rate of 6.8% in December 2010, compared with 9.1% nationally and 6.4% for Virginia.

The business community in the Roanoke MSA is well diversified by industry group. The principal components of the economy are retail trade, services, transportation, manufacturing, finance, insurance, and real estate. The Roanoke MSA’s position as a regional center creates a strong medical, legal and business professional community. Carilion Health System, Advance Auto Parts, Lewis-Gale Hospital, and the Veterans Administration Hospital are among Roanoke’s largest employers. Other large employers include Norfolk Southern Corporation, General Electric Co., Wachovia (a Wells Fargo Company), The Kroger Company – Mid Atlantic, and ITT Industries Night Vision.

Competition

The banking and financial service business in Virginia and in our primary market area specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services.  We compete for loans and deposits with other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other nonbank financial service providers.  In order to compete, we rely upon a service-based business philosophy, personal relationships with customers, specialized services tailored to meet customers’ needs and the convenience of office locations.  In addition, we are generally competitive with other financial institutions in our market area with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts.

 
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Our market area is a highly concentrated, highly branched banking market. Currently, the Bank, Bank of Botetourt, Bank of Fincastle, and Hometown Bank are the only locally owned and operated commercial banks. Most competitors are subsidiaries of large holding companies headquartered in Georgia, Tennessee, Northern Virginia, and California, all of whom have substantially greater resources and lending limits than we do and offer certain services, such as extensive and established branch networks and other services that we cannot provide.  Additionally, these larger institutions operating in the Roanoke MSA have access to borrowed funds at a lower cost than we do.  Numerous credit unions operate additional offices in the Roanoke MSA. Further, various other financial companies, ranging from local to national firms, provide financial services to residents of the Bank’s market area.

We believe that the Bank will continue to be able to compete effectively in this market, and that the community reacts favorably to our community bank focus and emphasis on service to small businesses, individuals and professional entities.

Employees

As of December 31, 2010, the Company had 124 full-time employees and 6 part-time employees, including executive officers, loan and other banking officers, branch personnel, operations personnel and other support personnel.  None of the Company’s employees is represented by a union or covered under a collective bargaining agreement.  Management of the Company considers its employee relations to be excellent.

Supervision and Regulation

The Company and the Bank are subject to state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking, financial institutions, including the Company, are disadvantaged relative to other competitors who are not as highly regulated, and our costs of doing business are much higher.

Regulatory Agreement

On September 30, 2010, the Company and the Bank entered into a written agreement (“Written Agreement”) with the FRB of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank agreed to develop and submit to the Reserve Bank for approval written plans to, among other matters, strengthen credit risk management policies, revise its contingency funding plan, and improve the Bank’s earnings and overall condition.  

The Company has submitted all plans required pursuant to the terms of the agreement and provides updates to these plans on a regular basis.  Additionally, both the Company and the Bank have agreed to maintain sufficient capital and to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not make any other form of payment representing a reduction in Bank’s capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or to purchase or redeem any shares of its stock without prior regulatory approval.

The Company and the Bank have appointed a committee to monitor compliance with the Written Agreement.  The directors of the Company and the Bank have recognized and unanimously agree with the common goal of financial soundness represented by the Written Agreement and have confirmed the intent of the directors and executive management to diligently seek to comply with all requirements of the Written Agreement.

The Company
 
Bank Holding Company Act.  In order to acquire the shares of Valley Bank and thereby become a bank holding company within the meaning of the Bank Holding Company Act, we were required to obtain approval from, and register as a bank holding company, with the Federal Reserve Board (the “Board”), and are subject to ongoing regulation, supervision and examination by the Board.  As a condition to its approval, the Board required that we agree that we would obtain approval of the Federal Reserve Bank of Richmond prior to incurring any indebtedness.  We are required to file

 
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with the Board periodic and annual reports and other information concerning our business operations and those of our subsidiaries.  In addition, the Bank Holding Company Act requires a bank holding company to obtain Board approval before it acquires, directly or indirectly, ownership or control of any voting shares of a second or subsequent bank if, after such acquisition, it would own or control more than 5% of such shares, unless it already owns or controls a majority of such voting shares.  Board approval must also be obtained before a bank holding company acquires all or substantially all of the assets of another bank or merges or consolidates with another bank holding company.  Any acquisition by a bank holding company of more than 5% of the voting shares, or of all or substantially all of the assets, of a bank located in another state may not be approved by the Board unless such acquisition is specifically authorized by the laws of that second state.

A bank holding company is prohibited under the Bank Holding Company Act, with limited exceptions, from acquiring or obtaining direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank, or from engaging in any activities other than those of banking or of managing or controlling banks or furnishing services to or performing services for its subsidiaries.  An exception to these prohibitions permits a bank holding company to engage in, or acquire an interest in a company which engages in, activities which the Board, after due notice and opportunity for hearing by regulation or order, has determined is so closely related to banking or to managing or controlling banks as to be proper incident thereto.  A number of such activities have been determined by the Board to be permissible, including servicing loans, performing certain data processing services, and acting as a fiduciary, investment or financial advisor.

A bank holding company may not, without providing notice to the Board, purchase or redeem its own stock if the gross consideration to be paid, when added to the net consideration paid by the Company for all purchases or redemptions by the Company of its equity securities within the preceding 12 months, will equal 10% or more of the Company’s consolidated net worth, unless it meets the requirements of a well capitalized and managed organization.

Set forth is a summary of statutes and regulations affecting companies like Valley Bank.  Federal and state laws and regulations provide regulatory oversight for virtually all aspects of the Company’s operations.  This summary is qualified in its entirety by reference to these statutes and regulations and is not intended to be an exhaustive description of the statutes or regulations which are applicable to the business of the Company and/or the Bank.  Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company and/or the Bank.


The Bank

General.  Our subsidiary, Valley Bank, is a state bank and member of the Federal Reserve System.  The Federal Reserve and the Virginia Bureau of Financial Institutions regulate and monitor all significant aspects of our operations.  The Federal Reserve requires quarterly reports on our financial condition, and we receive periodic examinations from both federal and state regulators.  The cost of complying with these regulations and reporting requirements can be significant.  In addition, some of these regulations, such as the ability to pay dividends, impact investors directly.

For member banks like Valley Bank, the Federal Reserve has the authority to prevent the continuance or development of unsound and unsafe banking practices and to approve conversions, mergers and consolidation.  Obtaining regulatory approval of these transactions can be expensive, time consuming, and ultimately may not be successful.  We are required to have prior regulatory approval to open any additional banking offices.  This approval takes into account a number of factors, including, among others, adequate Bank capital to support additional expansion and a finding that public interest will be served by such expansion.  While we plan to seek regulatory approval to establish additional banking offices, there can be no assurance when, or if, we will be permitted to so expand.

As a member of the Federal Reserve, the Company and its subsidiary, Valley Bank, are also required to comply with rules that restrict preferential loans by the Company to “insiders”.  We are required to keep information on loans to principal shareholders and executive officers, and prohibit certain director and officer interlocks between financial institutions.  Our loan operations, particularly for consumer and residential real estate loans, are also subject to numerous legal requirements as are our deposit activities.  In addition to regulatory compliance costs, these laws may create the risk of liability to us for noncompliance.

 
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Dividends. The amount of cash dividends we are permitted to pay is limited by federal and state law, regulation and policy and will depend upon our earnings and capital position.  Virginia law imposes restrictions on the ability of all banks chartered under Virginia law to pay dividends.  Under Virginia law, no dividend may be declared or paid that would impair a bank’s paid-in capital, and payments must be paid from retained earnings.  Virginia Banking regulators and the Federal Reserve have the general authority to limit dividends we pay, if such payments are deemed to constitute an unsafe and unsound practice.

Under current supervisory practice, prior approval of the Federal Reserve is required if cash dividends declared in any given year exceed the total of its net profits for such year, plus its retained net profits for the preceding two years.  In addition, we may not pay a dividend in an amount greater than our undivided profits on hand after deducting current losses and bad debts.  For this purpose, bad debts are generally defined to include the principal amount of all loans which are in arrears with respect to interest by six months or more, unless such loans are fully secured and in the process of collection.  Federal law further provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements.

In addition, we are subject to restrictions on our ability to pay common stock dividends as a result of our participation in the Capital Purchase Program and our Written Agreement with the Federal Reserve Bank of Richmond.  See the “Dividends” section under Item 5 for more information.

Dodd-Frank Wall Street Reform and Consumer Protection Act.  On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which implements significant changes in the financial regulatory landscape and will impact all financial institutions, including Valley Financial Corporation and Valley Bank.  The Dodd-Frank Act is likely to increase our regulatory compliance burden.  However, it is too early for us to fully assess the full impact of the Dodd-Frank Act on our business, financial condition or results of operations in part because many of the Dodd-Frank Act’s provisions require subsequent regulatory rulemaking.

Among the Dodd-Frank Act’s significant regulatory changes, it creates a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection (the “Bureau”), that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance, which may increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers.  Moreover, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and state attorney generals may enforce consumer protection rules issued by the Bureau.  The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier 1 capital.  These restrictions may limit our future capital strategies.  The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate and other hedging transactions.

Although certain provisions of the Dodd-Frank Act, such as direct supervision by the Bureau, will not apply to banking organizations with less than $10 billion of assets, such as the Company and Valley Bank, the changes resulting from the legislation could impact our business.  These changes will require us to invest significant management attention and resources to evaluate and make necessary changes.

FDIC Insurance.  The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits. Amendments to the Federal Deposit Insurance Act also revise the assessment base against which an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund (“DIF”) will be calculated. The amount of the assessment is a function of the institution’s risk category, of which there are four, and assessment base.  An institution’s risk category is determined according to its supervisory ratings and capital levels and is used to determine the institution’s assessment rate.  Under the amendments pursuant to the Dodd-Frank Act, the assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period. Additionally, the Dodd-Frank Act makes changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. In December 2010, the FDIC increased the reserve ratio to 2.0 percent. The Dodd-Frank Act also provides that, effective July 1, 2011, depository institutions may pay interest on demand deposits.

 
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Bank Capital Guidelines.  Federal bank regulatory authorities have adopted risk-based and leverage capital guidelines applicable to banking organizations that they supervise.  Under the risk-based capital requirements, the Company and the Bank are each generally required to maintain a minimum ratio of total risk-based capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8% for capital adequacy purposes.  At least half of the total risk-based capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles and ineligible deferred tax assets.  The remainder may consist of “Tier 2 Capital,” which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance.  In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations.  Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 4%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  In sum, the capital measures used by the federal banking regulators are:

·  
the Total Capital ratio, which includes Tier 1 Capital and Tier 2 Capital;
·  
the Tier 1 Capital ratio; and
·  
the leverage ratio.

Under these regulations, a bank will be:

·  
“well capitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1 Capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;
·  
“adequately capitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1 Capital ratio of 4% or greater, and a leverage ratio of 4% or greater – or 3% in certain circumstances – and is not well capitalized;
·  
“undercapitalized” if it has a Total Capital ratio of less than 8%, a Tier 1 Capital ratio of less than 4% - or 3% in certain circumstances;
·  
“significantly undercapitalized” if it has a Total Capital ratio of less than 6%, a Tier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%; or
·  
“critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets.

The risk-based capital standards of the Federal Reserve explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy.  The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FDIC.  These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers.  The Company and the Bank presently maintain sufficient capital to remain in compliance with these capital requirements.

The Dodd-Frank Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which may result in more stringent capital requirements.  Under the Collins Amendment to the Dodd-Frank Act, federal regulators have been directed to establish minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis.  These minimum requirements can’t be less than the generally applicable leverage and risk-based capital requirements established for insured depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of July 21, 2010.  These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions.  The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets.  Trust preferred securities issued prior to

 
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that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013.  The Collins Amendment did not exclude preferred stock issued to the U.S. Treasury through the Capital purchase Program from Tier 1 capital treatment.  Accordingly, the Company’s trust preferred securities and preferred stock issued to the U.S. Treasury through the Capital Purchase Program will continue to qualify as Tier 1 capital.

Affiliate Transactions and Branching.  The Federal Reserve Act restricts the amount and prescribes conditions with respect to loans, investments, asset purchases and other transactions between the Company and the Bank, including placing collateral requirements and requiring that those transactions are on terms and under conditions substantially the same as those prevailing at the time for comparable transactions with non-affiliates.  Subject to receipt of required regulatory approvals, we may branch without geographic restriction in Virginia, and we may acquire branches or banks or merge across state lines in most cases.
 
Community Reinvestment Act. The federal Community Reinvestment Act (“CRA”) requires that the federal banking regulators evaluate the record of financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions.  These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility.  We received a “Satisfactory” CRA rating in the Company’s latest CRA examination.

Other Regulations.  We are subject to a variety of other regulations.  State and federal laws restrict the interest and charges which the Bank may impose for certain loans, potentially affecting our income. The Truth in Lending Act and the Home Mortgage Disclosure Act impose information requirements on the Company in making loans.  The Equal Credit Opportunity Act prohibits discrimination in lending on the basis of race, creed, or other prohibited factors.  The Fair Credit Reporting Act and the Fair and Accurate Credit Transactions Act govern the use and release of information to credit reporting agencies.  The Truth in Savings Act requires disclosure of yields and costs of deposits and deposit accounts.  Other acts govern confidentiality of consumer financial records, automatic deposits and withdrawals, check settlement, endorsement and presentment, and disclosure of cash transactions exceeding $10,000 to the Internal Revenue Service.  These and other similar laws result in significant costs to financial institutions and create the potential for liability to customers and regulatory authorities. Recently regulatory authorities have imposed significant penalties for inadequate compliance.

The Gramm-Leach-Bliley Act.   Effective March 11, 2001, the Gramm-Leach Bliley Act (the “GLB Act”) allows a bank holding company or other company to certify its status as a financial holding company, thereby allowing such company to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities.  The GLB Act enumerates certain activities deemed financial in nature such as underwriting insurance or acting as an insurance principal, agent or broker; underwriting; dealing in or making markets in securities; and engaging in merchant banking under certain restrictions.  It also authorizes the Federal Reserve to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.
 
The Company meets all of the requirements to become a financial holding company, but currently has not made an election with the Federal Reserve to become a financial holding company.

US Patriot Act of 2001.  In October 2001, the USA Patriot Act of 2001 (“Patriot Act”) was enacted in response to the September 11, 2001 terrorist attacks in New York, Pennsylvania and Northern Virginia.  The Patriot Act is intended to strengthen U.S. law enforcement and the intelligence communities’ abilities to work cohesively to combat terrorism.  The continuing impact on financial institutions of the Patriot Act and related regulations and policies is significant and wide ranging.  The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities to identify persons who may be involved in terrorism or money laundering.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (“SOX”) was signed into law on July 30, 2002.  The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate

 
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disclosures pursuant to the securities laws.  SOX is the most far-reaching U.S. securities legislation enacted since the 1930’s.  SOX generally applies to all companies that, like the Company , file or are required to file periodic reports under the Securities Exchange Act of 1934.  The required implementation of SOX for companies with less than $75 Million in market capitalization was 2007.  The Dodd-Frank Act makes permanent an exemption from the external audit attestations requirement of SOX for companies, like the Company, with less than $75 million in market capitalization.  SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the Securities and Exchange Commission, or SEC, and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of specified issues by the SEC.  SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

SOX address, among other matters:  audit committees; certification of financial statements by the chief executive officer and the chief financial officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan black-out periods; disclosure of off-balance sheet transactions; a prohibition on personal loans to directors and officers (subject to certain exceptions for public companies that are financial institutions, like us); disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; “real time” filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws.

United States Treasury Department Oversight.  In October 2008, the United States Treasury Department, the Federal Reserve Board, and the Federal Deposit Insurance Corporation jointly announced the Capital Purchase Program pursuant to the Emergency Economic Stabilization Act of 2008 (“EESA”)  to address instability in the financial markets.  We applied for additional capital in the form of preferred stock with associated common stock warrants, and were approved for $16.0 million in additional capital.  On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (“ARRA”) that modified many previously established provisions of the EESA.  On June 15, 2009, the Treasury issued regulations implementing the executive compensation and corporate governance standards applicable to Capital Purchase Program participants.  These regulations and their implementation may change in the future.  In addition, we are prohibited from increasing our common stock dividend or repurchasing our common stock without Treasury approval.  Until we repay the investment by the United States Treasury Department under the Capital Purchase Program, we will be subject to these regulations.

We received this capital on December 12, 2008.  We also elected to participate in the Temporary Liquidity Guarantee Program to provide unlimited FDIC insurance coverage for non-interest bearing transaction accounts until the expiration of this program on December 31, 2010.  This program is no-longer in effect, as the FDIC has adopted final rules whereby it will provide unlimited deposit insurance for non-interest bearing transaction accounts through December 31, 2012.  This temporary unlimited coverage is in addition to the FDIC’s coverage of $250,000 available to depositors under the FDIC’s general deposit insurance rules.

Governmental Monetary Policies.  Our earnings and growth is affected not only by general economic conditions, but also by the monetary and fiscal policies of various governmental regulatory authorities, particularly the board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “Federal Reserve”).  The Federal Reserve Board’s Open Market Committee implements national monetary policy in United States government securities, control of the discount rate and establishment of reserve requirements against both member and nonmember financial institutions’ deposits.  These actions have a significant effect on the overall growth and distribution of loans, investments, and deposits, as well as the rates earned on loans, or paid on deposits.

Our management is unable to predict the effect of possible changes in monetary policies upon our future operating results.

Access to Filings.  We make available all periodic and current reports, free of charge, on our website as soon as reasonably practicable after such material is electronically filed with, or furnished to the Securities and Exchange Commission (SEC).  The Company and the Bank maintain a website at www.myvalleybank.com.  After accessing the website, the filings are available upon selecting the Shareholder Information menu items.  The contents of the website are not incorporated into this report or into the Company’s other filings with the SEC.

 
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Item 1A.  Risk Factors.

We are subject to various risks, including the risks described below.  The trading price of our common stock could decline due to any of these risks, and investors may lose some or all of any investment.  You should carefully read the risks described below before you decide to buy any of our common stock.  Our business, prospects, financial condition, and results of operations could be harmed by any one of these risks or additional risks not presently known or that we currently deem immaterial.

 
Changes in interest rates may impact our net interest margin and profitability.

Our profitability depends in substantial part on our net interest margin, which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds.  Our net interest margin depends on many factors that are partly or completely outside of our control, including competition, monetary and fiscal policies, and economic conditions generally.  Prior to June of 2004, the Federal Reserve cut short-term interest rates 12 times beginning January 2001.  Since June 2004, the Federal Reserve has increased short-term interest rates 17 times.  Between September 2007 and December 2008, the Federal Reserve lowered rates 10 times.  We believe the Federal Reserve will eventually have no choice but to increase short-term interest rates which will negatively impact our net interest margin due to our large portfolio of floating rate loans that are at the floor interest rate embedded in such loans.

Our profitability depends significantly on economic conditions in our market area.

Our success depends to a large degree on the general economic conditions in Roanoke, Virginia.  A prolonged economic recession in our market area could cause any of the following consequences, each of which could adversely affect our business:

·  
Demand for our products and services could decline;
·  
Loan delinquencies may increase; and
·  
Problem assets and foreclosures may increase

Additionally, the adverse consequences to us in the event of a continued economic recession in our market could be compounded by the fact that the majority of our commercial and real estate loans are secured by real estate located in our market area.  A further decline in real estate values in our market would mean that the collateral for many of our loans would provide less security.  As a result, we would be more likely to suffer losses on defaulted loans because our ability to fully recover on defaulted loans by selling the real estate collateral securing the loans would be diminished.  In addition, many of our loans are dependent on the successful completion of real estate projects and the demand for the sale of homes, both of which could be adversely impacted by a continued decline in the real estate markets.

Future economic conditions in our market will depend on factors outside of our control such as political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government, military and fiscal policies and inflation.  Adverse changes in economic conditions in our market would likely impair our ability to collect loans and could otherwise have a negative effect on our financial condition.

Difficult market conditions have adversely affected our industry.

Dramatic declines in the housing market over the past three years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values by financial institutions. These write-downs, initially of asset-backed securities but spreading to other securities and loans, have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in

 
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payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.

The soundness of other financial institutions could adversely affect us.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. There is no assurance that any such losses would not materially and adversely affect our results of operations.

We have entered into a written agreement with the Federal Reserve Bank of Richmond, which will require us to dedicate resources to comply with the agreement.

We entered into a written agreement with the Federal Reserve Bank of Richmond on September 30, 2010. Among other things, the written agreement requires us to develop and submit for written plans to improve our credit risk management, revise our contingency funding plan and improve our earnings and overall condition. We have also agreed to submit capital plans to maintain sufficient capital and to refrain from declaring or paying dividends without prior regulatory approval.  While subject to the written agreement, we expect that our management and board of directors will be required to focus time and attention on taking actions to comply with its terms.

Recently enacted legislation, legislation enacted in the future, or any proposed federal programs subject us to increased regulation and may adversely affect us.

On October 14, 2008, the U.S. Treasury announced the Capital Purchase Program (the “CPP”) under the EESA pursuant to which it would purchase senior preferred stock in participating financial institutions. We are participating in the CPP. Because we participate in the CPP, we are subject to increased regulation, and we face additional regulations or changes to regulations to which we are subject as a result of our participation. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities. For example, participation in the CPP limits (without the consent of the U.S. Treasury) our ability to increase our dividend or to repurchase our common stock for so long as any securities issued under such program remain outstanding. In addition, the EESA, contains, among other things, significant restrictions on the payment of executive compensation, which may have an adverse effect on the retention or recruitment of key members of senior management. Also, the cumulative dividend payable under the preferred stock that we issued to the U.S. Treasury pursuant to the CPP increases from 5% to 9% after 5 years and we may not deduct interest paid on our preferred stock for income tax purposes.

Additionally, the FDIC has increased premiums on insured accounts because market developments, including the increase of failures in the banking industry, have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which implements significant changes in the financial regulatory landscape and will impDodd-Frank Act all financial institutions, including Valley Financial Corporation and Valley Bank.  The Dodd-Frank Act is likely to increase our regulatory compliance burden.  However, it is too early for us to fully assess the full impDodd-Frank Act of the Dodd-Frank Act on our business, financial condition or results of operations in part because many of the Dodd-Frank Act’s provisions require subsequent regulatory rulemaking.  Among the Dodd-Frank Act’s significant regulatory changes, it creates a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection (the “Bureau”), that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance, which may increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers.  Moreover, the Dodd-Frank Act permits states to adopt stricter

 
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consumer protection laws and state attorney generals may enforce consumer protection rules issued by the Bureau.  The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier 1 capital.  These restrictions may limit our future capital strategies.  The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate and other hedging transactions.  Although certain provisions of the Dodd-Frank Act, such as direct supervision by the Bureau, will not apply to banking organizations with less than $10 billion of assets, such as Valley Financial Corporation and Valley Bank, the changes resulting from the legislation could impact our business.  These changes will require us to invest significant management attention and resources to evaluate and make necessary changes.

We are not able to predict when or whether regulatory or legislative reforms will be enacted or what its contents will be. Accordingly, we cannot predict the impact of any legislation on our businesses or operations.

If our allowance for loan losses becomes inadequate, our results of operations and capital may be adversely affected.

We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio.  Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our clients relative to their financial obligations with us.  The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rate; that may be beyond our control, and these losses may exceed our current estimates.  Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future.  Excessive loan losses could have a material impact on our financial performance and adversely impact capital levels.

Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different from those of our management.  Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results and capital.

If we experience greater loan losses than anticipated, it will have an adverse effect on our net income and our ability to fund growth.

While the risk of nonpayment of loans is inherent in banking, if we experience greater nonpayment levels than we anticipate, our earnings and overall financial condition, as well as the value of our common stock, could be adversely affected.  We cannot assure you that our monitoring, procedures, and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses.  Loan losses can cause insolvency and failure of a financial institution and, in such an event, our shareholders could lose their entire investment.  In addition, future provisions for loan losses could materially and adversely affect our profitability.  Any loan losses will reduce the loan loss allowance.  A reduction in the loan loss allowance may be restored by an increase in our provision for loan losses.  This would reduce our earnings, which could have an adverse effect on our stock price.

Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans.  Many of our loans are secured by real estate (both residential and commercial) in our market area.  A major change in the real estate market, such as deterioration in the value of this collateral, or in the local or national economy, could adversely affect our clients’ ability to pay these loans, which in turn could impact us.  Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully.  We cannot fully eliminate credit risk, and as a result, credit losses may occur in the future.

 
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We may incur losses if we are unable to successfully manage interest rate risk.

Our profitability will depend in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities.  We may pay above-market rates to attract deposits as we have done in some of our marketing promotions in the past to fund loan growth.  Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, the volume of loan originations and the value we can recognize on the sale of mortgage and home equity loans in the secondary market.  We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it.  Based on our asset/liability position at December 31, 2010, a rise in interest rates would negatively impact our net interest income in the short term.  Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary, and fiscal policies, and economic conditions generally.

Our profitability depends on our ability to manage our balance sheet to minimize the effects of interest rate fluctuation on our net interest margin.

Our results of operations depend on the stability of our net interest margin, which is the difference in the yield we earn on our earning assets and our cost of funds, both of which are influenced by interest rate fluctuations.  Interest rates, because they are influenced by, among other things, expectations about future events, including the level of economic activity, federal monetary and fiscal policy and geo-political stability, are not predictable or controllable.  In addition, the interest rates we can earn on our loan and investment portfolios and the interest rates we pay on our deposits are heavily influenced by competitive factors.  Community banks are often at a competitive disadvantage in managing their cost of funds compared to the large regional, super-regional, or national banks that have access to the national and international capital markets.  These factors influence our ability to maintain a stable net interest margin.

Our long-term goal is to maintain a balanced position in terms of the volume of assets and liabilities that mature or re-price during any period so that we may reasonably predict our net interest margin; however, interest rate fluctuations, loan prepayments, loan production and deposit flows are constantly changing and influence our ability to maintain this neutral position.  Generally speaking, our earnings will be more sensitive to fluctuations in interest rates, the greater the variance in the volume of assets and liabilities that mature or re-price in any period.  The extent and duration of the sensitivity will depend on the cumulative variance over time, the velocity and direction of interest rates, and whether the Company is more asset sensitive or liability sensitive.  Accordingly, we may not be successful in maintaining this position and, as a result, our net interest margin may suffer, which will negatively impact our earnings.

Our future success will depend on our ability to compete effectively in the highly competitive financial services industry.

The banking business is highly competitive, and we face substantial competition in all phases of our operations from a variety of different competitors.  Our future growth and success will depend on our ability to compete effectively in this highly competitive financial services environment.  Some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on bank holding companies and federally insured state-chartered banks, national banks and federal savings institutions.  As a result, these non-bank competitors have certain advantages over us in accessing funding and in providing various services.  Some of these competitors are subject to similar regulation, but have the advantages of larger established customer bases, higher lending limits, extensive branch networks, numerous ATMs, greater advertising-marketing budgets and other factors.

Valley Bank encounters strong competition from a variety of bank and non-bank financial service providers.  These competitors include commercial banks, savings banks, credit unions, consumer finance companies, money market mutual funds, mortgage banks, leasing, and finance companies.  In addition, the delivery of financial services has changed significantly with the telephone, ATM, personal computer and the Internet being used to access information and perform banking transactions.

Competition in our target market area for loans to businesses, professionals, and consumers is very strong.  Most of our competitors have substantially greater resources and lending limits than we do and offer certain services, such as extensive and established branch networks and trust services that we cannot provide.  Moreover, larger institutions operating in the Roanoke market have access to borrowed funds at lower cost than we will have available.  Several community banks are headquartered in our trade area.  Several regional and super-regional banks, as well as a number of credit unions, also have banking offices in our market area.  Competition among institutions for checking and savings deposits in the area is intense.

 
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We do not plan to pay cash dividends on common stock in the immediate, foreseeable future.

In accordance with the Written Agreement, the Company is not able to make any distributions on its Preferred Stock, any interest payments on its Trust Preferred Securities, or declare any common dividends without prior approval from the Federal Reserve.  In addition, the preferred stock issued to the United States Treasury under the CPP on December 12, 2008 (the “Series A Preferred Stock’) is senior to the Company’s common stock. Dividends must be paid to the Series A Preferred Stockholder before they can be paid to the common stock holder. The Company has the right to defer distributions on its Series A Preferred Stock for any period of time, during which time no dividends may be paid on its common stock. Our ability to declare and pay cash dividends will be dependent upon, among other things, restrictions imposed by the reserve and capital requirements of Virginia and federal banking regulations, our income and financial condition, tax considerations and general business conditions.

The Series A Preferred Stock reduces both net income available to our common shareholders and earnings per share.

On December 12, 2008 we closed on our agreement with the U.S. Treasury to participate in the CPP.  As a part of that program, we issued 16,019 shares of Series A Preferred Stock to the U.S. Treasury.  During the period the shares of our Series A Preferred Stock are outstanding, no dividends may be paid on our common stock unless all preferred dividends have been paid in full.  Additionally, while the Treasury owns shares of the Series A Preferred Stock, we are not permitted to increase the level of cash dividends on our common stock without the U.S. Treasury’s consent.  The dividends declared on shares of our Series A Preferred Stock will reduce the net income available to common shareholders and our earnings per common share.  Additionally, warrants to purchase our common stock issued to the Treasury, in conjunction with the issuance of the Series A Preferred Stock, may result in dilution to our earnings per share.  The shares of our Series A Preferred Stock will also receive preferential treatment in the event of our liquidation or dissolution.  See Note 17 of the Consolidated Financial Statements.

Holders of the Series A Preferred Stock may, under certain circumstances, have the right to elect two directors to our board of directors.

As of December 31, 2010, we have deferred payment of dividends on the Series A Preferred Stock for an aggregate of three quarterly dividend periods.  In the event that we fail to pay dividends on the Series A Preferred Stock for an aggregate of six quarterly dividend periods or more (whether or not consecutive), the authorized number of directors then constituting our board of directors will be increased by two.  Holders of the Series A Preferred Stock, together with the holders of any outstanding parity stock with like voting rights, referred to as voting parity stock, voting as a single class, will be entitled to elect the two additional members of our board of directors, referred to as the preferred stock directors, at the next annual meeting (or at a special meeting called for the purpose of electing the preferred stock directors prior to the next annual meeting) and at each subsequent annual meeting until all accrued and unpaid dividends for all past dividend periods have been paid in full.

We are subject to executive compensation restrictions because of our participation in the Treasury’s Capital Purchase Program.

We are subject to TARP rules and standards governing executive compensation, which generally apply to our Chief Executive Officer, Chief Financial Officer, and the three next most highly compensated senior executive officers, as well as a number of other employees.  The standards include (i) a requirement to recover any bonus payment to senior executive officers or certain other employees if payment was based on materially inaccurate financial statements or performance metric criteria; (ii) a prohibition on making any golden parachute payments to senior executive officers and certain other employees; (iii) a prohibition on paying or accruing any bonus payment to certain employees, except as otherwise permitted by the rules; (iv) a prohibition on maintaining any plan for senior executive officers that encourage such officers to take unnecessary and excessive risks that threaten the Company’s value; (v) a prohibition on maintaining any employee compensation plan that encourages the manipulation of reported earnings to enhance the compensation of any employee; and (vi) a prohibition on providing tax gross-ups to senior executive officers and other employees.  These restrictions and standards could limit our ability to recruit and retain executives.

 
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The securities purchase agreement between the Company and Treasury permits Treasury to impose additional restrictions on us retroactively.

The securities purchase agreement we entered into with Treasury permits Treasury to unilaterally amend the terms of the securities purchase agreement to comply with any changes in federal statutes after the date of its execution.  The American Recovery and Reinvestment Act (“ARRA”) imposed additional executive compensation limits on all current and future TARP recipients, including us, until we have repaid Treasury.  These additional restrictions may impede our ability to attract and retain qualified executive officers.  ARRA also permits TARP recipients to repay the Treasury without penalty or requirement that additional capital be raised, subject to Treasury’s consultation with our primary federal regulator while the terms of the securities purchase agreement required that, for a period of three years, the Series A Preferred Stock could generally only be repaid if we raised additional capital to repay the securities and such capital qualified as Tier 1 capital.  Additional unilateral changes in the securities purchase agreement could have a negative impact on our financial condition and results of operations.

Our legal lending limit may limit our growth.

We are limited in the amount we can lend to a single borrower by the amount of our capital.  Generally, under current law, we may lend up to 15% of our unimpaired capital and surplus to any one borrower.  As of December 31, 2010, we were permitted, by law, to lend approximately $11.4 million to any one borrower.  However, we have set a “house lending limit” of approximately $7.9 million.  This amount is significantly less than many of our competitors and may discourage potential borrowers who have credit needs in excess of our legal lending limit from doing business with us.  Our legal lending limit also impacts the efficiency of our lending operation because it tends to lower our average loan size, which means we have to generate a higher number of transactions to achieve the same portfolio volume.  We can accommodate larger loans by selling participations in those loans to other financial institutions, but this strategy is not always efficient or always available.  We may not be able to attract or maintain clients seeking larger loans or may not be able to sell participations in such loans on terms we consider favorable.

Our operations depend upon third party vendors that perform services for us.

We outsource many of our operating and banking functions, including our data processing function, our item processing and the interchange and transmission services for our ATM network.  As such, our success and our ability to expand our operations depend on the services provided by these third parties.  Disputes with these third parties can adversely affect our operations.  We may not be able to engage appropriate vendors to adequately service our needs, and the vendors that we engage may not be able to perform successfully.

We depend on the services of our key personnel, and a loss of any of those personnel may disrupt our operations and result in reduced revenues.

Our success depends upon the continued service of our senior management team and upon our ability to attract and retain qualified financial services personnel.  Competition for qualified employees is intense.  In our experience, it can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy.  If we lose the services of our key personnel, or are unable to attract additional qualified personnel, our business, financial condition, results of operations and cash flows could be materially adversely affected.

Our ability to operate profitably may be dependent on our ability to implement various technologies into our operations.

The market for financial services, including banking services and consumer finance services is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, internet-based banking and tele-banking.  Our ability to compete successfully in our market may depend on the extent to which we are able to exploit such technological changes.  If we are not able to afford such technologies, properly or timely anticipate or implement such technologies, or properly train our staff to use such technologies, our business, financial condition or operating results could be adversely affected.

 
20

 


If we need additional capital in the future, we may not be able to obtain it on terms that are favorable.  This could negatively affect our performance and the value of our common stock.

We may need to raise additional capital in the future to support our growth and to maintain our capital levels.  Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time.  We may not be able to obtain additional capital in the amounts or on terms satisfactory to us.  Our growth may be constrained if we are unable to raise additional capital as needed.

We may in the future issue additional stock, any or all of which will dilute your percentage ownership and, possibly, the value of your shares.

Our board of directors has the authority to issue all or part of any authorized but unissued common shares without prior shareholder approval and without allowing the shareholders the right to purchase their pro rata portion of such shares.  This includes shares authorized to be issued under our equity incentive plans.  The issuance of any new common shares will dilute your percentage ownership, and could dilute the value of your shares.

There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them.

Our common stock is currently listed on the NASDAQ Capital Market under the symbol “VYFC.”  The volume of trading activity in our stock is relatively limited.  Even if a more active market develops, there can be no assurance that such market will continue, or that you will be able to sell your shares at or above your purchase price.

Item 1B.  Unresolved Staff Comments.

Not applicable.

Item 2.  Properties.

Our main office is located in a seven-story office building at 36 Church Avenue, S.W., in downtown Roanoke, Virginia 24011, in which we lease six floors.  The lease on all floors terminates on December 31, 2014 with options to renew for two additional five-year terms at the end of the December 31, 2014 extension period.  The Company has entered into a land lease for its South Roanoke office.  The land lease has an initial lease term of twenty-five years with the option to renew for two additional twenty-five year periods.  The Company has entered into a lease for its Grandin Village office.  The lease has an initial term of five years with the option to renew for four additional five year periods.  We own our Starkey Road, Salem, Hershberger, Vinton, and Lewis Gale offices.

In the opinion of management of the Company, its properties are adequate for its current operations and adequately covered by insurance.

Item 3.  Legal Proceedings.

The Bank was named a defendant in litigation filed by Ukrop’s Super Markets, Inc. (“Ukrop’s”) against the Bank in relation to a lease agreement with IMD Investment Group, LLC (“IMD”).  The litigation was filed in the Circuit Court for the City of Richmond, Virginia on or about July 22, 2010.  The suit alleges that pursuant to an August 31, 2009 Subordination, Attormment and Non-Disturbance Agreement (the “SNDA”) between Ukrop’s and the Bank, when the Bank foreclosed on the Deed of Trust, it automatically succeeded to the position of IMD under the lease between IMD and Ukrop’s and became responsible for any alleged breaches of that lease by IMD.  Ukrop’s is requesting monetary damages in an amount of approximately $8.7 million as a result of IMD’s alleged breach of contract.  At this time, the Bank disputes Ukrop's allegations and believes that they are without merit.  The Bank intends to vigorously defend itself.

 
Item 4.  (Removed and Reserved).

 
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PART II.

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
Market information. The Company is authorized to issue up to 10,000,000 shares of Common Stock, no par value, of which 4,697,256 shares were issued and outstanding and held of record by approximately 842 holders on the beneficial side and 499 shareholders on the registered side at March 4, 2011.
 
The Common Stock is quoted under the symbol VYFC on the NASDAQ Capital Market.   According to information obtained by Company management and believed to be reliable, the quarterly high and low sales prices per share for the Common Stock during each quarter of the last two fiscal years and the dividends declared during these periods were as follows:

   
2010
   
2009
 
Quarter
Ended
 
High
   
Low
   
Dividends Declared
   
High
   
Low
   
Dividends Declared
 
                                     
March 31
  $ 4.88     $ 3.15     $ -     $ 5.65     $ 3.75     $ -  
June 30
  $ 5.92     $ 3.78     $ -     $ 5.50     $ 3.61     $ 0.04  
September 30
  $ 4.58     $ 3.05     $ -     $ 4.31     $ 2.30     $ -  
December 31
  $ 4.00     $ 2.90     $ -     $ 3.53     $ 2.71     $ -  

Dividends.  In accordance with the written agreement, the Company is not able to make any distributions on its Series A Preferred Stock, any interest payments on its Trust Preferred Securities, or declare any common dividends without prior approval from the Federal Reserve.  The Series A Preferred Stock issuance completed to United States Treasury under the Capital Purchase Plan on December 12, 2008 is senior to the Company’s common stock. Dividends must be paid to the Series A Preferred Stockholder before they can be paid to the common stock holders. The Company has the right to defer distributions on its Series A Preferred Stock for any period of time, during which time no dividends may be paid on its common stock. The dividends declared on the Preferred Stock will reduce the net income to common shareholders and the Company’s earnings per common share.

The securities purchase agreement between the Company and Treasury provides that prior to the earlier of (i) December 12, 2011 and (ii) the date on which all of the shares of the Preferred Stock have been redeemed by the Company or transferred by Treasury to third parties, the Company may not, without the consent of Treasury, (a) increase the cash dividend on its common stock or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of its common stock or preferred stock other than the Preferred Stock or trust preferred securities. In addition, the Company is unable to pay any dividends on its common stock unless it is current in its dividend payments on the Series A Preferred Stock.



 
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Item 6.  Selected Financial Data
 
Selected Financial Data
 
(in 000’s)
 
                               
   
2010
   
2009
   
2008
   
2007
   
2006
 
For the Year
                             
Net interest income
  $ 21,063     $ 19,824     $ 17,199     $ 15,600     $ 15,680  
Noninterest income
    2,793       3,222       2,411       2,326       2,212  
Revenue, net of interest expense
    23,856       23,046       19,610       17,926       17,892  
Noninterest expense
    17,918       16,816       14,034       12,699       11,338  
Provision for loan losses
    1,127       15,179       3,323       1,250       2,796  
Tax provision (benefit)
    1,318       (3,263 )     577       1,049       876  
                                         
Net income (loss)
  $ 3,493     $ (5,686 )   $ 1,676     $ 2,928     $ 2,882  
                                         
Preferred dividends and accretion of       warrants
     959        947        53        -        -  
Net income (loss) to common shareholders
  $ 2,534     $ (6,633 )   $ 1,623     $ 2,928     $ 2,882  
                                         
Per Common Share
                                       
Basic net income (loss)
  $ 0.54     $ (1.42 )   $ 0.35     $ 0.69     $ 0.70  
Diluted net income (loss)
  $ 0.54     $ (1.42 )   $ 0.35     $ 0.68     $ 0.68  
Cash dividends declared
  $ 0.00     $ 0.04     $ 0.14     $ 0.14     $ 0.14  
                                         
At Year-End
                                       
Assets
  $ 767,588     $ 713,725     $ 674,479     $ 600,967     $ 591,936  
Securities
    159,189       88,648       92,851       81,085       73,617  
Loans, gross
    544,294       571,021       553,046       487,164       471,052  
Reserve for loan losses
    (11,003 )     (14,630 )     (7,592 )     (4,883 )     (5,658 )
Deposits
    627,412       552,928       466,335       432,453       441,489  
Short-term borrowings
    5,000       20,000       17,000       13,000       25,000  
Securities under agreement to repurchase
     17,296        21,304        35,693        33,294        21,635  
Long-term debt
    43,000       48,000       63,000       55,000       48,000  
Trust preferred securities
    16,496       16,496       16,496       16,496       16,496  
Total shareholders’ equity
    53,928       51,539       58,505       40,716       33,401  
                                         
Ratios
                                       
Return on average assets
    0.46 %     (0.81 %)     0.27 %     0.50 %     0.54 %
Return on average equity
    6.49 %     (10.03 %)     3.87 %     8.03 %     8.67 %
Dividend payout ratio
    0.00 %     (2.82 %)     40.00 %     20.59 %     20.51 %
Average equity to average assets
    7.20 %     8.17 %     6.86 %     6.16 %     6.11 %


Operating Revenue

The following table sets forth, for the two fiscal years ended December 31, 2010 and 2009, the percentage of total operating revenue contributed by each class of similar services which contributed 15 percent or more of total consolidated revenues of the Company during such periods.

 
Period
 
Class of Service
% of Total Revenues
December 31, 2010
Interest and fees on loans
81.41%
December 31, 2009
Interest and fees on loans
80.99%


 
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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis of the financial condition and results of operations of the Company as of and for the years ended December 31, 2010 and 2009. The purpose of this discussion is to focus on important factors affecting our financial condition and results of operations.  The discussion should be read in conjunction with the audited consolidated financial statements and related notes to assist in the evaluation of our 2010 performance.

Executive Overview
Valley Financial Corporation, a Virginia corporation, is a financial holding company based in Roanoke, Virginia.  Its principal subsidiary, Valley Bank, is also headquartered in Roanoke, Virginia.  The Company’s core businesses include commercial banking, retail and small business banking, consumer lending, mortgage banking, and wealth management services.  The Company has eight full-service financial centers serving the Roanoke Valley at December 31, 2010.

The Company provides convenient financial services through multiple channels in its primary banking market.  The Company has developed products and services designed to meet the needs of all consumers.  The Company focuses on attracting and retaining customers through providing customer service that “Exceeds Expectations”.  This strategy includes partnering with our clients while providing excellent service through branches that are open six days a week, automated teller machine (“ATM”) networks and telephone and internet banking.

The Company’s lending strategy is to originate high credit quality, primarily secured, loans.  The Company’s largest core lending business is its commercial real estate loan operation, which offers fixed and variable-rate loans and lines of credit secured by real estate properties.  These loans are generally made on local properties or to local customers within our market.

As 2010 came to an end, we were quite pleased with the significant progress we made in dealing with the unprecedented real estate downturn and resulting economic malaise brought on by the severe recession over the past two and one-half years. In May of 2010, we celebrated our fifteen year anniversary and while the memories of 2009 were still fresh in our minds, we did see a light at the end of this tunnel developing. Due to the extraordinary efforts and commitment of our directors, management and all employees, we produced Pre-TARP “Record Earnings” that exceeded our budgeted goal.

2010 also witnessed our ascension to the #4 market share position (according to the FDIC Summary of Deposits Report, June 30, 2010) in deposits for the Greater Roanoke Metropolitan Statistical Area. We surpassed Bank of America and now trail just Wachovia, SunTrust and BB&T in terms of market share. More importantly, however, is the fact that this deposit growth continues to be fueled by core, transaction-based accounts. Our innovative and exciting suite of products such as MyLifestyle Checking and Savings and our Prime Money Market have lead the way which has greatly reduced the need to chase higher cost certificates of deposit. As of the end of 2010, Prime Money Market deposits totaled $252 Million, up $116 Million, or 86% over year-end 2009, and MyLifestyle Savings, which we introduced in February of 2010, had grown to over $41 Million by year-end 2010. We also achieved significant growth in our commercial cash management areas and we attribute all of this phenomenal deposit growth to great products, delivered by our experienced and talented bankers with an exceptional level of service offered to our customers. We do anticipate that this significant growth in core deposits will have a very positive effect on our overall cost of funds going forward.

Improving credit quality remains the primary focus of senior management and we are pleased to report that during 2010 we successfully resolved several problem loan situations that resulted in a reduction in the level of reserves required. The Company’s ratio of non-performing assets as a percentage of total assets decreased 38 basis points to 3.98% as of December 31, 2010, as compared to 4.36% as of December 31, 2009.  Loan loss provisions decreased substantially in comparison to the prior year period, from $15.2 million in 2009 to $1.1 million in 2010. At December 31, 2010, the ratio of allowance for loan losses as a percentage of total loans was 2.02% compared to 2.56% as of December 31, 2009. We remain, however, cautiously optimistic that asset quality will continue to improve and that our potential to achieve improved profitability will continue to be enhanced.

While loan growth did slightly tick upward during the fourth quarter, we have yet to see a resounding flow of high quality loan demand.  As a result, we believe loan growth will remain relatively stagnant in 2011. Our plan for 2011 incorporates growing our capital base at a pace exceeding the rate of asset growth in order to  position the Company to begin

 
24

 

repayment of the  preferred stock associated with the U.S. Treasury Departments’ Capital Purchase Program from retained earnings in increments of 25% of the amount outstanding, or approximately $4 million in 2012.

Financial Summary
For the year ended December 31, 2010, the Company reported net income of $3.5 million compared to a net loss of $5.7 million for the same period last year, an increase of $9.2 million.  After the dividend on preferred stock and accretion of discounts on warrants, net income available to common shareholders year-to-date was $2.5 million, or $0.54 per diluted common share, as compared to a net loss to common shareholders of $6.6 million, or ($1.42) per diluted common share, for the same period last year.   The Company’s earnings for the year produced an annualized return on average total assets of 0.46% and an annualized return on average shareholder’s equity of 6.49%.  The book value of the Company’s common stock increased to $8.45 per share as of December 31, 2010, up 9.0% over the $7.75 per share book value as of a year earlier.

At December 31, 2010, Valley Financial’s total assets were $767.6 million, total deposits were $627.4 million, total loans stood at $544.3 million and total shareholders' equity was $53.9 million. Compared with December 31, 2009, the Company experienced increases of $53.9 million or 7.5% in total assets and $74.5 million or 13.5% in total deposits, while total loans decreased $26.7 million or 4.7% over the twelve-month period. The Company’s risk based capital levels remain well above regulatory standards for well-capitalized banks.  Tier 1 risk-based and total risk-based capital ratios were 12.11% and 13.37%, respectively, at December 31, 2010 compared to 11.88% and 13.10% reported at December 31, 2009.

As we look forward to the continued growth and success of our company, we must continue to focus on the four key constituencies we have identified as the keys to achieving our goals and objectives, those being:

·  
Our Shareholders
·  
Our Employees
·  
Our Customers
·  
Our Community

We remain committed to attracting and retaining employees who possess an unparalleled desire to achieve, who thrive in a banking environment that provides new challenges and opportunities, and who seek to take this institution to new heights. Our ability to continue to build strong and enduring relationships with our customers coupled with an ability to provide a “unique customer experience” will be, in our opinion, the differentiating factors. If we continue to be successful in these two key areas, we feel confident we can also deliver superior returns for our shareholders.

Non-GAAP Financial Measures

The Company measures the net interest margin as an indicator of profitability. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax-equivalent net interest income is considered in the calculation of this ratio. Tax-equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for 2010 and 2009 is 34%. The reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.

In thousands
 
2010
   
2009
 
Net interest income, non tax-equivalent
  $ 21,063     $ 19,824  
                 
Less: tax-exempt interest income
    (563 )     (511 )
Add: tax-equivalent of tax-exempt interest income
    853       774  
                 
Net interest income, tax-equivalent
  $ 21,353     $ 20,087  

 
25

 
Critical Accounting Estimates

General

The Company’s financial statements are prepared in accordance with Accounting Principles Generally Accepted in the United States “USGAAP” and with general practices within the banking industry.  In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, deferred tax assets, and foreclosed assets have been critical to the determination of our financial position and results of operations.

Management considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s financial statements.

Allowance for Loan Losses
The Company considers the allowance for loan and lease losses of $11.0 million appropriate to cover losses incurred in the loan and lease portfolio as of December 31, 2010.  However, no assurance can be given that the Company will not in any particular period, sustain loan and lease losses that are sizable in relation to the amount reserved, or that subsequent evaluations of the loan and lease portfolio, in light of factors then prevailing, including economic conditions, the Company’s ongoing credit review process or regulatory requirements, will not require significant changes in the allowance for loan and lease losses.  Among other factors, a continued economic slowdown and/or a decline in commercial or residential real estate values in the Company’s market may have an adverse impact on the current adequacy of the allowance for loan and lease losses by increasing credit risk and the risk of potential loss.

The total allowance for loan and lease losses is generally available to absorb losses from any segment of the portfolio.  The allocation of the Company’s allowance for loan and lease losses disclosed in the asset quality table is subject to change based on the changes in criteria used to evaluate the allowance and is not necessarily indicative of the trend or future losses in any particular portfolio.

The discussion and analysis included in this section contains detailed information regarding the Company’s allowance for loan and lease losses, net charge-offs, non-performing assets, past due loans and leases and potential problem loans and leases.  Included in this data are numerous portfolio ratios that must be carefully reviewed in relation to the nature of the underlying loan and lease portfolios before appropriate conclusions can be reached regarding the Company or for purposes of making comparisons to other banks.  Most of the Company’s non-performing assets and past due loans are secured by real estate.  Given the nature of these assets and the related mortgage foreclosure and property sale, it can take 12 months or longer for a loan to migrate from initial delinquency to final disposition.  This resolution process generally takes much longer for loans secured by real estate than for unsecured loans or loans secured by other property primarily due to state real estate foreclosure laws.

Deferred Taxes
The Company uses the asset and liability method of accounting for income taxes.  Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance may be established.  Management considers the determination of this valuation allowance to be a critical accounting policy due to the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income.  These judgments and estimates are reviewed on a continual basis as regulatory and business factors change.  A valuation allowance for deferred tax assets may be required if the amounts of taxes recoverable through loss carry backs decline, or if we project lower levels of future taxable income.  If such a valuation allowance is deemed necessary in the future, it would be established through a charge to income tax expense that would adversely affect our operating results.

Foreclosed Assets
Foreclosed assets represent properties acquired through foreclosure or physical possession.  Write-downs to fair value at the time of transfer to foreclosed assets are charged to allowance for loan losses.  Subsequent to foreclosure, we periodically evaluate the value of foreclosed assets held for sale and record an impairment charge for any subsequent

 
26

 

declines in fair value less selling costs.  Subsequent declines in value are charged to operations.  Fair value is based on our assessment of information available to us at the end of a reporting period and depends upon a number of factors, including our historical loss experience, economic conditions, and issues specific to individual properties.  Our evaluation of these factors involves subjective estimates and judgments that may change.

Results of Operations

Net Income

2010 Compared to 2009
For the year ended December 31, 2010, the Company reported net income of $3.5 million compared to a net loss of $5.7 million for the same period last year, an increase of $9.2 million.  After the dividend on preferred stock and accretion of discounts on warrants, net income available to common shareholders year-to-date was $2.5 million, or $0.54 per diluted common share, as compared to a net loss to common shareholders of $6.6 million, or ($1.42) per diluted common share, for the same period last year.   The Company’s earnings for the year produced an annualized return on average total assets of 0.46% and an annualized return on average shareholder’s equity of 6.49%.  The book value of the Company’s common stock increased to $8.45 per share as of December 31, 2010, up 9.0% over the $7.75 per share book value as of a year earlier. Loan loss provisions decreased substantially in comparison to the prior year period, from $15.2 million in 2009 to $1.1 million in 2010.   We believe our total reserve is adequate and appropriate to cover our potential loss exposure on impaired loans (based upon a full collateral analysis of each impaired relationship identified) and to cover any other probable losses on our remaining portfolio.

Net income for the three-month period ending December 31, 2010 was $342,000 compared to net loss of $2.7 million for the same period last year.  After deducting the dividends and discount accretion on preferred stock, net income available to common shareholders for the three-month period ended December 31, 2010 amounted to $101,000 compared to net loss to common shareholders of $3.0 million for the same period last year. Diluted earnings per share for the three-month period ended December 31, 2010 were $0.02 compared to ($0.63) for the fourth quarter of 2009.  Valley Financial’s earnings for the fourth quarter 2010 produced an annualized return on average total assets of 0.17% and an annualized return on average shareholders’ equity of 2.43%.  The fourth quarter 2010 results were impacted primarily by new specific reserves on impaired loans and expenses on foreclosed assets.

The following table shows our key performance ratios for the years ended December 31, 2010 and 2009:

Key Performance Ratios
 
   
2010
   
2009
 
Return on average assets
    0.46 %     (0.81 %)
Return on average equity (1)
    6.49 %     (10.03 %)
Net interest margin (2)
    2.97 %     2.99 %
Cost of funds
    1.72 %     2.26 %
Yield on earning assets
    4.64 %     5.14 %
Basic net earnings per share
  $ 0.54     $ (1.42 )
Diluted net earnings per share
  $ 0.54     $ (1.42 )

All percentage calculations are on an annualized basis.

1.  
The calculation of return on average equity (“ROE”) excludes the effect of any unrealized gains or losses on investment securities available-for-sale.
2.  
Calculated on a fully taxable equivalent basis (“FTE”).

2009 Compared to 2008
We recorded net loss of $5.7 million for the year ended December 31, 2009, a decrease of $7.4 million over the $1.7 million net income reported for the same period in 2008.  After deducting the dividends and discount accretion on preferred stock, net loss to common shareholders for the year ending December 31, 2009 amounted to $6.6 million.  The decline in earnings was largely attributable to the recessionary environment and its impact on asset quality.  Loan loss

 
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provisions of $15.2 million were recorded in 2009, an increase of $11.8 million over the $3.3 million in loan loss provisions for the same 12 month period in 2008.  Net loss for the three months ended December 31, 2009 was $2.7 million, a decrease of $2.2 million over the net loss of $0.5 million reported for the fourth quarter of 2008.

Net Interest Income
The primary source of the Company’s banking revenue is net interest income, which represents the difference between interest income on earning assets and interest expense on liabilities used to fund those assets.  Earning assets include loans, securities, and federal funds sold.  Interest bearing liabilities include deposits and borrowings.  To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 34% federal corporate income tax rate.

Net interest income is affected by changes in interest rates, volume of interest bearing assets and liabilities, and the composition of those assets and liabilities.  The “interest rate spread” and “net interest margin” are two common statistics related to changes in net interest income.  The interest rate spread represents the difference between the yields earned on interest earning assets and the rates paid for interest bearing liabilities.  The net interest margin is defined as the percentage of net interest income to average earning assets.  Earning assets obtained through noninterest bearing sources of funds such as regular demand deposits and shareholders’ equity result in a net interest margin that is higher than the interest rate spread.

2010 Compared to 2009
Net interest income for the year ended December 31, 2010 was $21.1 million, a $1.2 million, or 6.3%, increase when compared to the $19.8 million reported for the same period in 2009.   However, our net interest margin declined by 2 basis points to 2.97% for the year ended December 31, 2010 as compared to 2.99% for the same period last year.  The Federal Reserve Open Market Committee (“FOMC”), which sets the federal funds rate, kept rates at historically low levels throughout 2010 due to the global economic recession over the last 36 months, deflating the yield on our investment portfolio as well as allowing us to decrease the rate on our cost of funds.  While the tax equivalent yield on earning assets decreased 50 basis points during the year, from 5.14% in 2009 to 4.64% in 2010, our yield on average loans held constant at 5.26% in 2009 and 2010.  However, the yield on our investment portfolio decreased 130 basis points from 5.01% in 2009 to 3.71% in 2010.  Additionally, our net interest margin was adversely impacted due to the significant increase in liquid assets maintained in interest bearing accounts which averaged $56.4 million for 2010 as compared to $12.2 million for 2009.  On the liability side, we were successful in reducing our cost of funds (including noninterest bearing deposits) by 54 basis points, from 2.26% in 2009 to 1.72% in 2010.

2009 Compared to 2008
Net interest income for the year ended December 31, 2009 was $19.8 million, a $2.6 million, or 15.3%, increase when compared to the $17.2 million reported for the same period in 2008.   The tax equivalent yield on earning assets decreased 91 basis points during the year, from 6.05% in 2008 to 5.14% in 2009.  The yield on average loans decreased 92 basis points, from 6.18% in 2008 to 5.26% in 2009.  The cost of funds (including noninterest bearing deposits) decreased 100 basis points, from 3.26% in 2008 to 2.26% in 2009.  As a result of the above movements, our net interest margin improved by 9 basis points to 2.99% for the year ended December 31, 2009 as compared to 2.90% for 2008.  Net interest income for the quarter ended December 31, 2009 was $5.2 million, a $0.6 million increase when compared to the $4.6 million reported for the same period in 2008.

The following table presents the major categories of interest-earning assets, interest-bearing liabilities and shareholders’ equity with corresponding average balances, related interest income or expense, and resulting yields and rates for the periods indicated. Where appropriate income categories and yields have been adjusted in the table to their fully taxable equivalent basis.


 
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NET INTEREST INCOME AND AVERAGE BALANCES (1)

   
2010
   
2009
   
2008
 
 
 
In thousands
 
Average
Balance
   
Interest
Income/
Expense
   
Average
Yield/Rate
   
Average
Balance
   
Interest
Income/
Expense
   
Average
Yield/Rate
   
Average
Balance
   
Interest Income/
Expense
   
Average
Yield/Rate
 
                                                       
Assets
                                                     
Interest-earning assets:
                                                     
Loans (2) (5)
  $ 554,396     $ 29,184       5.26 %   $ 577,386     $ 30,349       5.26 %   $ 508,757     $ 31,511       6.18 %
Investment securities
                                                                       
   Taxable
    94,745       3,171       3.35 %     70,861       3,351       4.73 %     77,034       4,163       5.40 %
   Nontaxable (3)
    13,623       853       6.26 %     11,421       774       6.78 %     9,384       573       6.11 %
Money market investments
    56,404       127       0.23 %     12,171       28       0.23 %     3,390       65       1.91 %
                                                                         
Total interest-earning assets
    719,168       33,335       4.64 %     671,839       34,502       5.14 %     598,564       36,312       6.05 %
                                                                         
Other Assets:
                                                                       
Reserve for loan losses
    (12,543 )                     (10,409 )                     (5,056 )                
Cash and due from banks
    6,891                       7,429                       7,355                  
Premises and equipment, net
    7,572                       7,981                       7,291                  
Other assets
    35,092                       22,821                       19,969                  
                                                                         
Total assets
  $ 756,180                     $ 699,661                     $ 628,124                  
                                                                         
Liabilities and Shareholders’ Equity
                                                                 
Interest-bearing liabilities
                                                                       
Savings, NOW and MMA
  $ 304,147     $ 4,712       1.55 %   $ 157,977     $ 2,909       1.84 %   $ 126,341     $ 2,988       2.36 %
Time deposits
    237,344       4,296       1.81 %     308,096       8,010       2.60 %     269,650       11,305       4.18 %
Repurchase agreements
    17,340       44       0.25 %     23,952       59       0.25 %     32,677       630       1.92 %
Federal funds purchased and overnight borrowings from discount window
    47       -       0.00 %     3,496       18       0.54 %     5,065       123       2.42 %
Trust preferred
    16,496       376       2.28 %     16,496       475       2.88 %     16,496       850       5.14 %
Long-term FHLB
    43,534       1,631       3.75 %     60,370       2,467       4.09 %     60,910       2,544       4.17 %
Short-term FHLB
    21,260       923       4.34 %     11,148       477       4.28 %     15,134       478       3.15 %
                                                                         
Total interest-bearing liabilities
    640,168       11,982       1.87 %     581,535       14,415       2.48 %     526,273       18,918       3.54 %
                                                                         
Noninterest-bearing liabilities
                                                                       
Demand deposits
    58,344                       56,273                       52,529                  
Total interest-bearing liabilities and demand deposits
    698,512       11,982       1.72 %     637,808       14,415       2.26 %     578,802       18,918       3.26 %
                                                                         
Other liabilities
    3,864                       5,166                       6,092                  
                                                                         
Total liabilities
    702,376                       642,974                       584,894                  
                                                                         
Shareholders’ Equity, exclusive of unrealized gains/losses on AFS securities
    53,804                       56,687                       43,230                  
                                                                         
Total liabilities and shareholders’ equity
  $ 756,180                     $ 699,661                     $ 628,124                  
                                                                         
Net interest income
          $ 21,353                     $ 20,087                     $ 17,394          
                                                                         
Net interest margin (4)
                    2.97 %                     2.99 %                     2.90 %

Legends for the table are as follows:

(1)  
Averages are daily averages.
(2)  
Loan interest income includes loan fees of $0.4 million, $0.8 million and $1.0 million for the years ended 2010, 2009 and 2008, respectively.
(3)  
Nontaxable interest income is adjusted to its fully taxable equivalent basis using a federal tax rate of 34 percent.
(4)  
The net interest margin is calculated by dividing net interest income (tax equivalent basis) by average total earning assets.
(5)  
Non-accrual loans are included in the above yield calculation.



 
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As discussed above, the Company’s net interest income is affected by the change in the amount and mix of interest-earning assets and interest-bearing liabilities (referred to as “volume change”) as well as by changes in yields earned on interest-earning assets and rates paid on deposits and borrowed funds (referred to as “rate change”). The following table presents, for the periods indicated, a summary of changes in interest income and interest expense for the major categories of interest-earning assets and interest-bearing liabilities and the amounts of change attributable to variations in volumes and rates. Changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and rate, respectively.  Where appropriate income categories and yields have been adjusted in the table to their fully taxable equivalent basis.

RATE/VOLUME ANALYSIS
  
In thousands
 
2010 compared to 2009
   
2009 compared to 2008
 
   
Volume
   
Rate
   
Net
   
Volume
   
Rate
   
Net
 
Interest earned on interest-earning assets:
                                   
Loans
  $ (1,210 )   $ 45     $ (1,165 )   $ 9,524     $ (10,686 )   $ (1,162 )
Investment securities:
                                               
Taxable
    (1,354 )     1,174       (180 )     (317 )     (495 )     (812 )
Nontaxable
    131       (52 )     79       133       68       201  
Money market investments
    100       (1 )     99       (56 )     19       (37 )
                                                 
Total interest earned on interest-earning assets
    (2,333 )     1,166       (1,167 )     9,284       (11,094 )     (1,810 )
                                                 
Interest paid on interest-bearing liabilities:
                                               
Savings, NOW, and money markets
    2,176       (373 )     1,803       (682 )     603       (79 )
Time deposits
    (1,599 )     (2,115 )     (3,714 )     1,980       (5,275 )     (3,295 )
Trust Preferred Securities
    -       (99 )     (99 )     -       (375 )     (375 )
Repurchase agreements
    (17 )     2       (15 )     (134 )     (437 )     (571 )
Federal funds and overnight borrowings
    (10 )     (8 )     (18 )     (31 )     (74 )     (105 )
Long-term FHLB advances
    (644 )     (192 )     (836 )     (22 )     (55 )     (77 )
Short-term FHLB advances
    439       7       446       3       (4 )     (1 )
                                                 
Total interest paid on interest-bearing liabilities
     345       2,778 )     (2,433 )      1,114       (5,617 )     (4,503 )
                                                 
Change in net interest income
  $ (2,678 )   $ 3,944     $ 1,266     $ 8,170     $ (5,477 )   $ 2,693  

Market Risk Management
Financial institutions can be exposed to several market risks that may impact the value or future earnings capacity of an organization.  These risks involve interest rate risk, foreign currency exchange risk, commodity price risk and equity market price risk.  The Company’s primary market risk is interest rate risk.  Interest rate risk is inherent because as a financial institution, the Company derives a significant amount of its operating revenue from “purchasing” funds (customer deposits and borrowings) at various terms and rates.  These funds are then invested into earning assets (loans, leases, investments, etc.) at various terms and rates.  This risk is further discussed below.

Equity market risk is not a significant risk to the Company as equity investments on a cost basis comprise less than 1% of corporate assets.  The Company does not have any exposure to foreign currency exchange risk or commodity price risk.

Interest rate risk is the exposure to fluctuations in the Company’s future earnings (earnings at risk) and value (economic value at risk) resulting from changes in interest rates.  This exposure results from differences between the amounts of interest earning assets and interest bearing liabilities that reprice within a specified time period as a result of scheduled maturities and repayment and contractual interest rate changes.

The primary objective of the Company’s asset/liability management process is to maximize current and future net interest income within acceptable levels of interest rate risk while satisfying liquidity and capital requirements.  Management recognizes that a certain amount of interest rate risk is inherent and appropriate, yet is not essential to the Company’s

 
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profitability.  Thus the goal of interest rate risk management is to maintain a balance between risk and reward such that net interest income is maximized while risk is maintained at a tolerable level.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations.  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 and more likely to prepay in a falling 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 attemps 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.

Management endeavors to control the exposures to changes in interest rates by understanding, reviewing and making decisions based on its risk position.  The corporate asset/liability management committee is responsible for these decisions.  The committee operates under management policies defining guidelines and limits on the level of acceptable risk.  These policies are approved by the Boards of Directors of the Company and its banking subsidiary.  The Company primarily uses the securities portfolios and FHLB advances to manage its interest rate risk position.  Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives.  At present, the Company does not use off-balance sheet instruments.

The Company uses simulation analysis to assess earnings at risk and Economic Value of Equity analysis to assess value at risk.  These methods allow management to regularly monitor both the direction and magnitude of the Company’s interest rate risk exposure.  These modeling techniques involve assumptions and estimates that inherently cannot be measured with complete precision.  Key assumptions in the analyses include maturity and repricing characteristics of both assets and liabilities, prepayments on amortizing assets, other embedded options, non-maturity deposit sensitivity and loan and deposit pricing.  These assumptions are inherently uncertain due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors.  However, the analyses are useful in quantifying risk and provide a relative gauge of the Company’s interest rate risk position over time.

Earnings at Risk
Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income.  The analysis involved changing the interest rates used in determining net interest income over the next twelve months.  The resulting percentage change in net interest income in various rate scenarios is an indication of the Company’s shorter-term interest rate risk.  Various assumptions are applied to the measurement date balance sheet over the simulation time period to account for management’s projection of balance sheet movement over the simulation period, including assumptions related to maturing and repayment dollars.  Additional assumptions are applied to modify volumes and pricing under the various rate scenarios.  These include prepayment assumptions on mortgage assets, the sensitivity of non-maturity deposit rates, and other factors deemed significant.

The base net interest income simulation performed at December 31, 2010, assumes interest rates are unchanged for the next twelve months.  The simulation then assumes that rates are shocked up and down by 400 bps in 100bps increments.  The simulation analysis results are presented in the table below.  These results, as of December 31, 2010, indicate that the Company would expect net interest income to decrease over the next twelve months by 2% assuming an immediate upward shift in market interest rates of 200 basis points and to increase by 9% if rates shifted downward in the same manner.  The Company was liability sensitive at December 31, 2010 as simulation results indicate that net interest income would increase in a down rate environment and decrease in an upward rate environment.  The Company’s risk position is within the guidelines set by policy.

 
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Change in Net Interest Income
 
 
Change in Yield Curve:
 
Percentage
   
Amount
 (in thousands)
 
+200 basis points
    (2 %)   $ (526 )
+100 basis points
    (3 %)     (703 )
Level – Base Case
    -       -  
-100 basis points
    5 %     1,099  
-200 basis points
    9 %     2,107  

Economic Value of Equity
The Economic Value of Equity (EVE) analysis provides information on the risk inherent in the balance sheet that might not be taken into account in the simulation analysis due to the shorter time horizon used in that analysis.  The EVE of the balance sheet is defined as the discounted present value of expected asset cash flows minus the discounted present value of expected liability cash flows.  The economic value simulation uses instantaneous rate shocks to determine the expected cash flows in various rate scenarios.  The resulting percentage change in EVE is an indication of the longer term repricing risk and options embedded in the balance sheet.   The EVE analysis results are presented in the table below.  These results as of December 31, 2010 indicate that EVE would decrease 12% assuming an immediate upward shift in market interest rates of 200 basis points and increase 8% if rates shifted downward in the same manner.  The Company’s risk position is within the guidelines set by policy.

   
Change in EVE
 
 
Change in Yield Curve:
 
Percentage
   
Amount
 (in thousands)
 
+200 basis points
    (12 %)   $ (8,429 )
+100 basis points
    (6 %)     (3,923 )
Level – Base Case
    -       -  
-100 basis points
    6 %     3,986  
-200 basis points
    8 %     5,329  

Derivative Financial Instruments
For asset/liability management purposes, we may use interest rate swap agreements to hedge interest rate risk exposure to declining rates.  Such derivatives are used as part of the asset/liability management process and are linked to specific assets, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. At December 31, 2010 and 2009 the Company did not have any derivative agreements related to interest rate hedging in place.

Noninterest Income
The following table presents the components of noninterest income and the variance or percentage change:

   
2010 vs. 2009
 
In thousands
 
2010
   
2009
   
%
 
Service charges on deposits
  $ 1,341     $ 1,189       12.8  
Income from bank owned life insurance
    545       540       0.9  
Mortgage banking-related fees
    252       102       147.1  
Brokerage fee income
    343       186       84.4  
Realized gains/(losses) on sale of securities
    -       1,019       (100.0 )
Other operating income
    312       186       67.7  
Total noninterest income
  $ 2,793     $ 3,222       (13.3 )

The decrease when comparing 2010 to 2009 is attributable to the $1.0 million in gains on the sale of available for sale (“AFS”) securities realized in 2009 as compared to $0 realized in 2010.  Absent these gains, non-interest income increased $590 thousand or 26.8% as compared to 2009.  As evident from the table above, non-interest income increased

 
32

 

in all other categories from year to year; however the most notable increases were in mortgage banking-related fees and brokerage fee income due to a greater emphasis on growing our noninterest income.

Noninterest income for the year ended December 31, 2009 increased by $836 thousand or 35.0% in 2009 as compared to the year ended December 31, 2008.  The increase when comparing 2009 to 2008 was mainly attributable to gains realized on the sale of securities totaling $1.0 million.  Excluding this gain, our core noninterest income totaled $2.2 million as compared to $2.4 million for 2008, a decrease of $198,000 or 8.3%.  This decline was largely attributable to a reduction in income earned from brokerage fees.
 
 
Noninterest Expense
The following table presents the components of noninterest expense and the variance or percentage change:

   
2010 vs. 2009
 
In thousands
 
2010
   
2009
   
%
 
Compensation
  $ 8,442     $ 7,627       10.7  
Occupancy and equipment
    1,581       1,603       (1.4 )
Data processing
    1,085       1,029       5.4  
Advertising and marketing
    371       296       25.3  
Insurance
    1,593       1,355       17.6  
Audit fees
    205       218       (6.0 )
Legal fees
    384       586       (34.5 )
State franchise taxes
    494       425       16.2  
Deposit expense
    461       425       8.5  
Loan expense
    278       357       (22.1 )
Computer software
    386       427       (9.6 )
Consulting fees
    422       334       26.3  
Foreclosed asset  expenses, net
    973       904       7.6  
Other expense
    1,243       1,230       1.1  
Total noninterest expense
  $ 17,918     $ 16,816       6.6  

The increase when comparing 2010 to 2009 was mainly attributable to the following factors:
·  
Compensation expenses increased year over year due to a number of factors including annual merit increases for all employees, a reduction of salary deferrals related to loan originations, growth in our Mortgage Banking division, and profit sharing awards earned by all employees for exceptional performance measured against budget;
·  
Advertising and marketing expenses increased year over year due to the roll-out of our new savings product which was met with great success in the market place.  We raised over $40 million in new core deposits with this product during 2010;
·  
Insurance fees increased year over year due primarily to the increased FDIC assessment as a result of our phenomenal deposit growth;
·  
Legal fees decreased year over year due to the litigation costs incurred in 2009.  We anticipate legal costs for 2011 to increase due to the current litigation between the Company and Ukrops (see “Legal Proceedings”);
·  
State franchise tax expense is calculated based on the Bank’s capital position at the end of the preceding fiscal year.  Despite the loss recorded for 2009, the Bank’s capital position increased significantly during 2009 due to the investment of a portion of the TARP proceeds from the Company to the Bank;
·  
Deposit expenses continued to grow due to the growth in our CDARS certificates of deposits and the program fees associated with those deposits;
·  
Loan expenses decreased year over year due to a decline in the number of loan originations; and
·  
Consulting fees increased primarily as a result of increasing the scope of our external loan review program.

Noninterest expense for the year ended December 31, 2009 increased by a total of $2.8 million or 20.0% over the same period in 2008, from $14.0 million to $16.8 million.   Over one-third of the increase ($948 thousand) was due to increases in FDIC assessment rates during 2009 and a special assessment applied to all insured institutions as of June 30, 2009.

 
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Increases in legal fees of $400 thousand were due to expenses associated with a higher volume of customer work out agreements, foreclosures, and settlements, as well as a significant increase in litigation costs.  Foreclosed asset expenses increased in 2009 as we foreclosed on and carried on our balance sheet numerous real estate properties during the year.  These expenses include fees incurred to foreclose on the asset and expenses incurred to keep the property in a favorable condition.   Additionally, we incurred losses on the sale of foreclosed assets of $692 thousand.  Finally, deposit expenses increased primarily due to program fees related to wholesale and brokered deposits, CDARS certificates of deposits and our MyLifestyle deposit suite of products.

Noninterest expenses are expected to continue to increase as a direct result of business growth, the continuation of the depressed local economy, the complexity of banking operations and the implementation of the Dodd-Frank Act.

Income Taxes
For the year ended December 31, 2010, the Company recorded $1.3 million of expense resulting in an effective tax rate of 27.4% compared to an income tax benefit of $3.3 million or (36.5%) in 2009.   The pretax loss in 2009 is the contributing factor to the variance.   The tax preference items such as tax exempt interest income and income from BOLI are comparable for 2010 and 2009.  However, these preference items have the effect of increasing a tax benefit during a loss year which increases the benefit in relation to pretax earnings, thus, increasing the effective rate.  These same comparable preference items have the effect of reducing income tax expense during a year in which income is recognized which reduces income taxes expense in relation to pretax earnings, thus reducing the effective rate.

Asset Quality

Summary of Allowance for Loan Losses
We establish the allowance for loan losses through charges to earnings through a provision for loan losses.  Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely.  Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be appropriate to absorb probable losses on existing loans that may become uncollectible. Some of the factors we consider in determining the appropriate level of the allowance for loan losses are as follows:

·  
an evaluation of the current loan portfolio;
·  
identified loan problems;
·  
loan volume outstanding;
·  
past loss experience;
·  
present and expected industry and economic conditions and, in particular, how such conditions relate to our market area;
·  
problem loan trends over a 3-year historical time period; and
·  
loan growth trends over a 3-year historical time period

The general component of the reserve covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.  An unallocated component is maintained to cover uncertainties that could affect our estimate of probable losses. It also reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The allowance for loan losses is evaluated on a regular basis by management.  On a quarterly basis, we perform a detailed analysis of the allowance for loan losses to verify the adequacy and appropriateness of the allowance in meeting probable losses in the loan portfolio.

We use generally accepted accounting standards related to receivables and contingencies when segregating our portfolio into loans classified as impaired and non-impaired loan pools and in analyzing our current portfolio to determine the appropriate level of the allowance for loan losses.  Included in our potentially impaired loan category are our current “watch list” credits plus any additional credits which have been past due three or more times within the past 12-month period.  We individually review these potentially impaired loans based on generally accepted accounting standards related to receivables and make a determination if the loan in fact is impaired.  We consider a loan impaired when we determine that is probable that we will be unable to collect all interest and principal payments as scheduled in the loan agreement.  We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due.  If it is found to be impaired, an allowance is established when the collateral value, discounted cash flows, or observable market price of the impaired loan is lower than the carrying value of that loan. We recognize any

 
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impairment by creating a valuation allowance with a corresponding charge to the provision for loan losses or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to bad-debt expense.  The valuation allowance becomes our “specific reserve” for the specific loan.

We take the balance of our portfolio and add back to it any loans that were included in the potentially impaired loan category but that were found not to be impaired.  We then segregate the remaining portfolio into specific categories based on type of loan and review the groups of loans to estimate loss under generally accepted accounting standards based on contingencies.  We apply a specific loss factor to each category based upon our historical loss experience for each category of loans over the current two years ending December 31, 2010.  The loss factor is multiplied by the outstanding balance in the loan category to estimate potential loss for our allowance for loan losses.  We then evaluate certain environmental and qualitative factors that are relevant to our portfolio and make a risk assessment of low, medium, or high for each factor.  An additional loss factor is assigned to the portfolio according to the risk assessment.  This evaluation is inherently subjective, because it requires estimates that may be significantly revised as more information becomes available.

Bank regulators also periodically review the loan portfolio and other assets to assess their quality, and we employ independent, third party loan reviewers as well.  This evaluation is inherently subjective because it requires estimates that may be significantly revised as more information becomes available.

Loans are assigned to our “watch list” based upon our internal risk rating system.  There are three levels of accountability in the risk rating process.  The primary responsibility for risk identification lies with the account officer.  It is the account officer’s responsibility for the initial and ongoing risk rating of all notes and commitments in his or her portfolio.  On a monthly basis, each account officer signs a Credit Risk Rating Certification attesting to the accuracy of the credit risk ratings for the loans in his or her loan portfolio.  The Chief Credit Officer is responsible for periodically reviewing the risk rating process employed by the lending officers.  The Chief Credit Officer is responsible for the accuracy and timeliness of account officer risk ratings and has the authority to override account officer risk ratings and initiate rating changes, if warranted.  Finally, the Bank has a loan review program to provide an independent validation of portfolio quality.  This independent review is intended to assess adherence to underwriting guidelines, proper credit analysis and documentation.  In addition, the loan review process is required to test the integrity, accuracy and timeliness of account officer risk ratings and to test the effectiveness of the credit administration’s controls over the risk identification process.   Risk Management reports its findings to the Board of Directors. 

We regularly review asset quality and re-evaluate the allowance for loan losses.  However, no assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in the future.  Our current market environment, with a nationwide recession, makes this risk even higher.  Additionally, regulatory examiners may require us to recognize additions or reductions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations.  On a quarterly basis, the Directors’ Loan Committee will review all loans on our watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review.   Additionally, the Directors’ Loan Committee and the Audit Committee meet jointly at the end of each quarter to review in detail management’s assessment of the adequacy of the allowance for loan losses.  We believe that the allocated reserves are adequate for the impaired loans in our portfolio based upon a detailed review of the quality and pledged collateral of each individual loan considered impaired at each of the above-referenced periods.

The allowance for loan losses was $11.0 million and $14.6 million as of December 31, 2010 and 2009, respectively.  The ratio of the allowance for loan losses to total loans outstanding was approximately 2.02% at December 31, 2010, which compares to approximately 2.56% of total loans at December 31, 2009 (see Note 5 to the Consolidated Financial Statements).  These estimates are primarily based on our historical loss experience, portfolio concentrations, evaluation of individual loans and economic conditions.  A total of $1.3 million in specific reserves was included in the balance of the allowance for loan losses as of December 31, 2010 for impaired loans, which compares to a total of $4.3 million as of December 31, 2009.   We believe the allowance for loan losses is adequate to provide for expected losses in the loan portfolio, but there are no assurances that it will be.


The following table represents the Company’s activity in its allowance for loan losses:

 
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ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES

In thousands
 
2010
   
2009
   
2008
   
2007
   
2006
 
Balance at January 1
  $ 14,630     $ 7,592     $ 4,883     $ 5,658     $ 4,124  
Recoveries:
                                       
Commercial
    24       42       58       -       2  
Commercial real estate
    48       -       -       -       -  
Residential real estate
    97       1       -       -       -  
Real estate construction
    3       -       -       -       -  
Loans to individuals
    11       3       -       15       -  
Total Recoveries
    183       46       58       15       2  
Charged off loans:
                                       
Commercial
    922       2,612       165       505       1,253  
Commercial real estate
    353       790       252       1,489       -  
Residential real estate
    1,089       1,363       43       -       -  
Real estate construction
    2,525       3,337       189       15       -  
Loans to individuals
    48       85       23       31       11  
Total Loans Charged-Off
    4,937       8,187       672       2,040       1,264  
Net charge-offs
    4,754       8,141       614       2,025       1,262  
Provision for Loan Losses
    1,127       15,179       3,323       1,250       2,796