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EX-31.A - EXHIBIT (31)(A) - PEOPLES BANCORP OF NORTH CAROLINA INCex31_a.htm
EX-32 - EXHIBIT (32) - PEOPLES BANCORP OF NORTH CAROLINA INCex32.htm
EX-31.B - EXHIBIT (31)(B) - PEOPLES BANCORP OF NORTH CAROLINA INCex31_b.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
     
 
FORM 10-Q
 
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended:   March 31, 2011
 
OR
 
[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina
(State or other jurisdiction of incorporation or organization)
 
000-27205
56-2132396
(Commission File No.)
(IRS Employer Identification No.)
 
518 West C Street, Newton, North Carolina
28658
(Address of principal executive offices)
(Zip Code)
 
(828) 464-5620
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes
  X    No
 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 
 
Yes
    No
X
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large Accelerate Filer
   
Accelerated Filer
   
Non-Accelerated Filer
   
 
Smaller Reporting Company
X
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2 of the Exchange Act).
 
Yes
    No 
X
 
 
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
5,542,703 shares of common stock, outstanding at April 30, 2011.
 
 
 
 

 
 
 
  INDEX
       
PART I.
FINANCIAL INFORMATION
PAGE(S)
       
Item 1.
 
Financial Statements
 
       
   
Consolidated Balance Sheets at March 31, 2011 (Unaudited) and
 
   
December 31, 2010 (Audited)
3
       
   
Consolidated Statements of Earnings for the three months ended March
 
   
31, 2011 and 2010 (Unaudited)
4
       
   
Consolidated Statements of Comprehensive Income for the three months
 
   
ended March 31, 2011 and 2010 (Unaudited)
5
       
   
Consolidated Statements of Cash Flows for the three months ended March
 
   
31, 2011 and 2010 (Unaudited)
6-7
       
   
Notes to Consolidated Financial Statements (Unaudited)
8-20
       
Item 2.
 
Management's Discussion  and Analysis of Financial Condition
 
   
and Results of Operations
21-32
       
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
33
       
Item 4T.
 
Controls and Procedures
34
       
PART II.
OTHER INFORMATION
 
       
Item 1.
 
Legal Proceedings
35
Item 1A.
 
Risk Factors
35
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
35
Item 3.
 
Defaults upon Senior Securities
35
Item 5.
 
Other Information
35
Item 6.
 
Exhibits
35-38
Signatures
   
39
Certifications
   
40-42
 
 
Statements made in this Form 10-Q, other than those concerning historical information, should be considered forward-looking statements pursuant to the safe harbor provisions of the Securities Exchange Act of 1934 and the Private Securities Litigation Act of 1995.  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management and on the information available to management at the time that this Form 10-Q was prepared.  These statements can be identified by the use of words like “expect,”  “anticipate,” “estimate,” and “believe,” variations of these words and other similar expressions.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environments and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in other filings with the Securities and Exchange Commission, including but not limited to those described in Peoples Bancorp of North Carolina, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2010.



 
2

 
 
 
PART I. FINANCIAL INFORMATION  
     
Item 1. Financial Statements  
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
         
Consolidated Balance Sheets
         
(Dollars in thousands)
         
 
March 31,
 
December 31,
 
Assets
2011
 
2010
 
 
(Unaudited)
  (Audited)  
         
Cash and due from banks, including reserve requirements
$ 44,918   22,521  
Interest bearing deposits
  1,335   1,456  
Cash and cash equivalents
  46,253   23,977  
           
Certificates of deposit
  735   735  
           
Investment securities available for sale
  271,570   272,449  
Other investments
  5,976   5,761  
Total securities
  277,546   278,210  
           
Mortgage loans held for sale
  2,415   3,814  
           
Loans
  711,166   726,160  
Less allowance for loan losses
  (15,410 ) (15,493 )
Net loans
  695,756   710,667  
           
Premises and equipment, net
  17,155   17,334  
Cash surrender value of life insurance
  7,599   7,539  
Accrued interest receivable and other assets
  24,587   25,376  
Total assets
$ 1,072,046   1,067,652  
           
  Liabilities and Shareholders' Equity
         
           
Deposits:
         
Non-interest bearing demand
$ 120,550   114,792  
NOW, MMDA & savings
  349,077   332,511  
Time, $100,000 or more
  224,485   241,366  
Other time
  144,868   150,043  
Total deposits
  838,980   838,712  
           
Demand notes payable to U.S. Treasury
  843   1,600  
Securities sold under agreement to repurchase
  38,446   34,094  
FHLB borrowings
  70,000   70,000  
Junior subordinated debentures
  20,619   20,619  
Accrued interest payable and other liabilities
  5,957   5,769  
Total liabilities
  974,845   970,794  
           
Shareholders' equity:
         
           
Series A preferred stock, $1,000 stated value; authorized
         
5,000,000 shares; issued and outstanding
         
25,054 shares in 2010 and 2009
  24,652   24,617  
Common stock, no par value; authorized
         
20,000,000 shares; issued and outstanding
         
5,542,703 shares in 2011 and 5,541,413 shares in 2010
  48,289   48,281  
Retained earnings
  24,475   23,573  
Accumulated other comprehensive (loss) income
  (215 ) 387  
Total shareholders' equity
  97,201   96,858  
           
Total liabilities and shareholders' equity
$ 1,072,046   1,067,652  
           
See accompanying notes to consolidated financial statements.
         
 
 
 
3

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
       
Consolidated Statements of Earnings
       
Three months ended March 31, 2011 and 2010
       
(Dollars in thousands, except per share amounts)
       
 
2011
 
2010
 
(Unaudited)
 
(Unaudited)
Interest income:
     
Interest and fees on loans
$ 9,614   10,091
Interest on investment securities:
       
U.S. Government sponsored enterprises
  1,082   1,405
States and political subdivisions
  805   402
Other
  57   32
Total interest income
  11,558   11,930
         
Interest expense:
       
NOW, MMDA & savings deposits
  717   866
Time deposits
  1,404   1,876
FHLB borrowings
  744   889
Junior subordinated debentures
  100   97
Other
  79   97
Total interest expense
  3,044   3,825
         
Net interest income
  8,514   8,105
         
Provision for loans losses
  2,950   2,382
         
Net interest income after provision for loan losses
  5,564   5,723
         
Non-interest income:
       
Service charges
  1,255   1,319
Other service charges and fees
  582   602
Gain sale of securities
  1,075   22
Mortgage banking income
  187   156
Insurance and brokerage commissions
  108   98
Miscellaneous
  395   413
Total non-interest income
  3,602   2,610
         
Non-interest expense:
       
Salaries and employee benefits
  3,667   3,520
Occupancy
  1,365   1,351
Other
  2,368   2,318
Total non-interest expense
  7,400   7,189
         
Earnings before income taxes
  1,766   1,144
         
Income taxes
  405   269
         
Net earnings
  1,361   875
         
Dividends and accretion on preferred stock
  348   348
         
Net earnings available to common shareholders
$ 1,013   527
         
Basic net earnings per common share
$ 0.18   0.10
Diluted net earnings per common share
$ 0.18   0.09
Cash dividends declared per common share
$ 0.02   0.02
         
See accompanying notes to consolidated financial statements.
       
 
 
 
4

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
           
Consolidated Statements of Comprehensive Income
           
Three months ended March 31, 2011 and 2011
           
(Dollars in thousands)
           
 
2011
   
2010
 
 
(Unaudited)
   
(Unaudited)
 
           
Net earnings
$ 1,361     875  
             
Other comprehensive (loss) income:
           
Unrealized holding gains on securities
           
available for sale
  473     924  
Reclassification adjustment for gains on
           
 securities available for sale included in net earnings
  (1,075 )   (22 )
Unrealized holding losses on derivative
           
financial instruments qualifying as cash flow
           
hedges
  (384 )   (148 )
             
Total other comprehensive (loss) income,
           
before income taxes
  (986 )   754  
             
Income tax (benefit) expense related to other
           
comprehensive income:
           
             
Unrealized holding gains on securities
           
available for sale
  185     360  
Reclassification adjustment for gains on
           
 securities available for sale included in net earnings
  (419 )   (9 )
Unrealized holding losses on derivative
           
financial instruments qualifying as cash flow
           
hedges
  (150 )   (58 )
             
Total income tax (benefit) expense related to
           
other comprehensive income
  (384 )   293  
             
Total other comprehensive (loss) income,
           
net of tax
  (602 )   461  
             
Total comprehensive income
$ 759     1,336  
             
See accompanying notes to consolidated financial statements.
           
 
 
 
5

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
           
Consolidated Statements of Cash Flows
           
Three months ended March 31, 2011 and 2010
           
(Dollars in thousands)
           
 
2011
   
2010
 
  (unaudited)     (unaudited)  
Cash flows from operating activities:
         
Net earnings
$ 1,361     875  
Adjustments to reconcile net earnings to
           
net cash provided by operating activities:
           
Depreciation, amortization and accretion
  1,537     992  
Provision for loan losses
  2,950     2,382  
Gain on sale of investment securities
  (1,075 )   (22 )
(Gain)/loss on sale of other real estate and repossessions
  97     (133 )
Write-down of other real estate and repossessions
  250     336  
Restricted stock expense
  7     8  
Change in:
           
Mortgage loans held for sale
  1,399     841  
Cash surrender value of life insurance
  (60 )   (64 )
Other assets
  474     (299 )
Other liabilities
  181     932  
             
Net cash provided by operating activities
  7,121     5,848  
             
Cash flows from investing activities:
           
Net change in certificates of deposit
  -       1,209  
Purchases of investment securities available for sale
  (39,988 )   (34,963 )
Proceeds from calls, maturities and paydowns of investment securities
           
available for sale
  9,881     11,870  
Proceeds from sale of investment securities avialiable for sale
  30,440        
Purchases of other investments
  (215 )   -    
Net change in loans
  9,457     8,471  
Purchases of premises and equipment
  (340 )   (86 )
Proceeds from sale of other real estate and repossessions
  2,472     1,471  
             
Net cash provided (used) by investing activities
  11,707     (12,028 )
             
Cash flows from financing activities:
           
Net change in deposits
  268     28,530  
Net change in demand notes payable to U.S. Treasury
  (757 )   181  
Net change in securities sold under agreement to repurchase
  4,352     1,595  
Proceeds from FHLB borrowings
  5,000     -    
Repayments of FHLB borrowings
  (5,000 )   (5,000 )
Restricted stock Payout
  9     -    
Cash dividends paid on Series A preferred stock
  (313 )   (313 )
Cash dividends paid on common stock
  (111 )   (111 )
             
Net cash provided by financing activities
  3,448     24,882  
             
Net change in cash and cash equivalent
  22,276     18,702  
             
Cash and cash equivalents at beginning of period
  23,977     31,340  
             
Cash and cash equivalents at end of period
$ 46,253     50,042  
 
 
 
6

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
         
Consolidated Statements of Cash Flows, continued
         
Three months ended March 31, 2011 and 2010
         
(Dollars in thousands)
         
         
 
2011
 
2010
 
  (unaudited)   (unaudited)  
         
Supplemental disclosures of cash flow information:
       
Cash paid during the year for:
       
Interest
$ 3,076   3,842  
           
Noncash investing and financing activities:
         
Change in unrealized gain on investment securities
         
 available for sale, net
$ 368   (551 )
Change in unrealized gain on derivative financial
         
 instruments, net
$ 234   90  
Transfer of loans to other real estate and repossessions
$ 2,991   2,076  
Financed portion of sale of other real estate
$ 487   932  
Accretion of Series A preferred stock
$ 35   35  
           
           
See accompanying notes to consolidated financial statements.
         
           
 
 
 
7

 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1)
    Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly-owned subsidiaries, Peoples Bank (the “Bank”) and Community Bank Real Estate Solutions, LLC, along with the Bank’s wholly-owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.

The consolidated financial statements in this report are unaudited.  In the opinion of management, all adjustments (none of which were other than normal accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included.  Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”).  Actual results could differ from those estimates.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of the specific accounting guidance.  A description of the Company’s significant accounting policies can be found in Note 1 of the notes to consolidated financial statements in the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Recently Issued Accounting Pronouncements
In April 2011, the Financial Accounting Standard Accounting Board (“FASB”) issued Accounting Standards Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (“ASU No. 2011-02”). ASU No. 2011-02 provides additional guidance for determining what constitutes a troubled debt restructuring.  The ASU is effective for interim and annual periods ending after June 15, 2011.  The adoption of this guidance is not expected to have a material impact on the Company’s results of operations or financial position; however, additional disclosures will be required for ASU No. 2011-02.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's results of operations, financial position or disclosures.

(2)
    Investment Securities

Investment securities available for sale at March 31, 2011 and December 31, 2010 are as follows:
 
(Dollars in thousands)
       
 
March 31, 2011
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized Losses
 
Estimated Fair Value
               
Mortgage-backed securities
$ 131,679   840   560   131,959
U.S. Government
               
sponsored enterprises
  49,119   138   703   48,554
State and political subdivisions
  89,134   929   1,509   88,554
Trust preferred securities
  1,250   -     -     1,250
Equity securities
  1,003   338   88   1,253
                 
Total
$ 272,185   2,245   2,860   271,570
 
 
 
8

 
 
 
(Dollars in thousands)          
 
December 31, 2010
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized Losses
 
Estimated Fair Value
               
Mortgage-backed securities
$ 137,811   2,119   569   139,361
U.S. Government
               
sponsored enterprises
  42,933   393   686   42,640
State and political subdivisions
  89,486   793   2,450   87,829
Trust preferred securities
  1,250   -     -     1,250
Equity securities
  982   387   -     1,369
                 
Total
$ 272,462   3,692   3,705   272,449
 
The current fair value and associated unrealized losses on investments in securities with unrealized losses at March 31, 2011 and December 31, 2010 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.

(Dollars in thousands)
                     
 
March 31, 2011
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized Losses
                       
Mortgage-backed securities
$ 55,276   560   -   -   55,276   560
U.S. Government
                       
sponsored enterprises
  30,067   703   -   -   30,067   703
State and political subdivisions
  45,699   1,509   -   -   45,699   1,509
Equity securities
  320   88   -   -   320   88
                         
Total
$ 131,362   2,860   -   -   131,362   2,860
                         
 
December 31, 2010
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized Losses
                         
Mortgage-backed securities
$ 59,471   569   -   -   59,471   569
U.S. Government
                       
sponsored enterprises
  24,123   686   -   -   24,123   686
State and political subdivisions
  56,374   2,450   -   -   56,374   2,450
                         
Total
$ 139,968   3,705   -   -   139,968   3,705
 
At March 31, 2011, unrealized losses in the investment securities portfolio relating to debt securities totaled $2.9 million.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the March 31, 2011 tables above, 68 out of 156 securities issued by state and political subdivisions contained unrealized losses and 48 out of 116 securities issued by U.S. government sponsored enterprises, including mortgage-backed securities, contained unrealized losses.  These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.  The unrealized loss on one equity security was $88,000 as of March 31, 2011.  This unrealized loss is considered temporary based upon its strong capital position and growth potential.
 
 
 
9

 

The amortized cost and estimated fair value of investment securities available for sale at March 31, 2011, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
(Dollars in thousands)
     
 
Amortized
Cost
 
Estimated Fair Value
Due within one year
$ 3,957   3,979
Due from one to five years
  50,006   49,901
Due from five to ten years
  67,417   66,525
Due after ten years
  18,123   17,953
Mortgage-backed securities
  131,679   131,959
Equity securities
  1,003   1,253
Total
$ 272,185   271,570
 
Proceeds from sales of securities available for sale during the three months ended March 31, 2011 were $30.4 million and resulted in a gross gain of $1.1 million.  During first quarter 2010, the Company recognized a $22,000 gain on a security called at a premium.

Securities with a fair value of approximately $99.6 million and $75.5 million at March 31, 2011 and December 31, 2010, respectively, were pledged to secure public deposits and for other purposes as required by law.

(3)
    Loans

Major classifications of loans at March 31, 2011 and December 31, 2010 are summarized as follows:
 
(Dollars in thousands)
     
       
 
March 31, 2011
 
December 31, 2010
       
Real Estate Loans
     
Construction and land development
$ 114,983   124,048
Single-family residential
  281,045   287,307
Commercial
  212,680   213,487
Multifamily and farmland
  6,361   6,455
Total real estate loans
  615,069   631,298
         
Commercial loans (not secured by real estate)
  58,517   60,994
Consumer loans (not secured by real estate)
  10,709   11,500
All other loans (not secured by real estate)
  26,871   22,368
         
Total loans
  711,166   726,160
         
Less allowance for loan losses
  15,410   15,493
         
Total net loans
$ 695,756   710,667
 
The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties of North Carolina.  Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
 
10

 
 
The following tables present an age analysis of past due loans, by loan type, as of March 31, 2011 and December 31, 2010:
 
March 31, 2011                    
(Dollars in thousands)
               
 
Loans 30-89
Days Past
Due
 
Loans 90 or More Days
Past Due
 
Total
Past Due
Loans
 
Total
Current
 Loans
 
Total
Loans
 
Accruing
 Loans 90 or More Days
Past Due
Real Estate Loans
                     
     Construction and land development
$ 1,612   6,871   8,483   106,500   114,983   -  
     Single-family residential
  18,927   4,106   23,033   258,012   281,045   185
     Commercial
  2,875   530   3,405   209,275   212,680   -  
     Multifamily and farmland
  -     -      -     6,361   6,361   -  
          Total real estate loans
  23,414   11,507   34,921   580,148   615,069   185
                         
Commercial loans (not secured by real estate)
  651   75   726   57,791   58,517   -  
Consumer loans (not secured by real estate)
  46   9   55   10,654   10,709   -  
All other loans (not secured by real estate)
  -     -     -     26,871   26,871   -  
     Total loans
$ 24,111   11,591   35,702   675,464   711,166   185
 
 
December 31, 2010
                     
(Dollars in thousands)
                     
 
Loans 30-89 Days Past
Due
 
Loans 90 or More Days Past Due
 
Total
Past Due Loans
 
Total
Current Loans
 
Total
Loans
 
Accruing Loans 90 or More Days Past Due
Real Estate Loans
                     
     Construction and land development
$ 2,306   8,870   11,176   112,872   124,048   197
     Single-family residential
  19,377   5,936   25,313   261,994   287,307   -  
     Commercial
  382   1,482   1,864   211,623   213,487   -  
     Multifamily and Farmland
  -     -     -     6,456   6,456   -  
          Total real estate loans
  22,065   16,288   38,353   592,945   631,298   197
                         
Commercial loans (not secured by real estate)
  1,098   720   1,818   59,176   60,994   13
Farm loans (not secured by real estate)
  -     -     -     -     -     -  
Consumer loans (not secured by real estate)
  98   13   111   11,389   11,500   -  
All other loans (not secured by real estate)
  -     -     -     22,368   22,368   -  
     Total loans
$ 23,261   17,021   40,282   685,878   726,160   210
 
The following table presents the Company’s non-accrual loans as of March 31, 2011 and December 31, 2010:

(Dollars in thousands)
     
 
March 31, 2011
 
December 31, 2010
Real Estate Loans
     
     Construction and land development
$ 20,874   22,916
     Single-family residential
  8,404   10,837
     Commercial
  3,121   5,351
     Multifamily and Farmland
  -     -  
          Total real estate loans
  32,399   39,104
         
Commercial loans (not secured by real estate)
  417   816
Consumer loans (not secured by real estate)
  133   142
All other loans (not secured by real estate)
  -     -  
     Total
$ 32,949   40,062
 
At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which is generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.  No interest income is recognized on impaired loans subsequent to their classification as impaired.
 
 
11

 
 
The following tables present the Company’s impaired loans as of March 31, 2011 and December 31, 2010:

March 31, 2011                      
(Dollars in thousands)
                     
 
Unpaid Contractual Principal
Balance
 
Recorded Investment
With No Allowance
 
Recorded Investment
With
Allowance
 
Recorded Investment
in Impaired
Loans
 
Related
Allowance
 
Average
Recorded Impairment
Real Estate Loans
            -        
     Construction and land development
$ 28,972   18,255   2,619   20,874   121   21,895
     Single-family residential
  9,605   8,277   127   8,404   1,258   9,621
     Commercial
  3,699   2,765   356   3,121   149   4,236
     Multifamily and farmland
  -     -     -     -     -     -  
          Total impaired real estate loans
  42,276   29,297   3,102   32,399   1,528   35,751
                         
Commercial loans (not secured by real estate)
  453   153   264   417   89   617
Consumer loans (not secured by real estate)
  146   133   -     133   -     137
All other loans (not secured by real estate)
  -     -     -     -     -     -  
     Total impaired loans
$ 42,875   29,583   3,366   32,949   1,617   36,506
 
 
December 31, 2010
                       
(Dollars in thousands)
                       
   
 Unpaid Contractual Principal
Balance
 Recorded Investment
With No Allowance
 Recorded Investment
With
Allowance
 Recorded
Investment
in Impaired
Loans
 
 
Related Allowance
 
Average Recorded Impairment
Real Estate Loans
$
           
               
       
     Construction and land development
 
         31,346
 
        20,787
 
          2,130
 
        22,916
 
                1,055
 
        18,767
     Single-family residential
 
         12,376
 
          9,847
 
             990
 
        10,837
 
                   168
 
        12,573
     Commercial
 
           6,018
 
          4,991
 
             359
 
          5,351
 
                   148
 
          4,769
     Multifamily and Farmland
 
                 -  
 
                -  
 
                -  
 
                -  
 
                      -  
 
               27
          Total impaired real estate loans
 
         49,740
 
        35,625
 
          3,479
 
        39,104
 
                1,371
 
        36,136
                         
Commercial loans (not secured by real estate)
           1,243
 
             811
 
                 5
 
             816
 
                       5
 
          1,479
Farm loans (non RE)
             
                -  
       
Consumer loans (not secured by real estate)
 
              152
 
             142
 
                -  
 
             142
 
                      -  
 
               79
All other loans (not secured by real estate)
 
                 -  
 
                -  
 
                -  
 
                -  
     
                -  
     Total impaired loans
$
         51,135
 
        36,578
 
          3,484
 
        40,062
 
                1,376
 
        37,694
                         
 
Changes in the allowance for loan losses for the three months ended March 31, 2011 were as follows:
 
Three months ended March 31, 2011
               
(Dollars in thousands)
               
                                 
 
Real Estate Loans
                 
 
Construction and Land Development
 
Single Family Residential
 
Commercial Real Estate
 
Multifamily & Farmland
 
Commercial
 
Consumer
 
Unallocated
 
Total
 
Allowance for loan losses:
                               
Beginning balance
$ 5,774   6,097   1,409   17   1,174   430   592   15,493  
Charge-offs
  (1,999 ) (663 ) (487 ) -   (41 ) (155 ) -   (3,345 )
Recoveries
  199   24   2   -   34   53   -   312  
Provision
  1,416   387   717   -   9   17   404   2,950  
Ending balance
$ 5,390   5,845   1,641   17   1,176   345   996   15,410  
                                   
Ending balance: Individually
                                 
evaluated for impairment
$ 121   1,258   149   -   89   -   -   1,617  
Ending balance: Collectively
                                 
evaluated for impairment
  5,269   4,587   1,492   17   1,087   345   996   13,793  
Ending balance
$ 5,390   5,845   1,641   17   1,176   345   996   15,410  
 
 
The Company utilizes an internal risk grading matrix to assign a risk grade to each of its loans.  Loans are graded on a scale of 1 to 9.  A description of the general characteristics of the nine risk grades is as follows:

·  
Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists.  CD or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.

 
 
12

 
 

·  
Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company’s range of acceptability.  The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.
·  
Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company’s range of acceptability but higher than normal. This may be a new organization or an existing  organization in a transitional phase (e.g. expansion, acquisition, market change).
·  
Risk Grade 4 – Management Attention: These loans have very high risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends are evident.  These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.
·  
Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company’s position at some future date.  This frequently results from deviating from prudent lending practices, for instance over-advancing on collateral.
·  
Risk Grade 6 – Substandard: A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any).  There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
·  
Risk Grade 7 – Low Substandard: These loans have the general characteristics of a Grade 6 Substandard loan, with heightened potential concerns.  The exact amount of loss is not yet known because neither the liquidation value of the collateral nor the borrower’s predicted repayment ability is known with confidence.
·  
Risk Grade 8 – Doubtful: Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable.  Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.
·  
Risk Grade 9 – Loss: Loans classified Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future.  Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.
 
The following table presents weighted average risk grades and balances of the total loan portfolio, along with balances of classified loans, by loan type as of March 31, 2011.  Classified loans include loans in risk grades 6, 7, 8 and 9.
March 31, 2011            
(Dollars in thousands)
           
 
Weighted Average
Risk Grade of Loans Outstanding
 
Loans
Outstanding
 
Classified
Loans
 
Real Estate Loans
           
     Construction and land development
4.14   $ 114,983   26,355  
     Single-family residential
2.97     281,045   13,561  
     Commercial
3.31     212,680   10,626  
     Multifamily and farmland
2.84     6,361   218  
          Total real estate loans
      615,069   50,760  
               
Commercial loans (not secured by real estate)
3.04     58,517   1,051  
Consumer loans (not secured by real estate)
2.47     10,709   145  
All other loans (not secured by real estate)
2.76     26,871   -    
     Total loans
    $ 711,166   51,956 (1)
               
(1) Includes $36.5 million TDR loans
             
 
 
 
13

 
 
 
December 31, 2010
           
(Dollars in thousands)
           
 
Weighted Average
Risk Grade of Loans Outstanding
 
Loans
Outstanding
 
Classified
Loans
Real Estate Loans
           
     Construction and land development
4.19   $ 124,048   29,890  
     Single-family residential
2.97     287,307   15,859  
     Commercial
3.33     213,487   12,965  
     Multifamily and Farmland
2.83     6,456   223  
          Total real estate loans
      631,298   58,936  
               
Commercial loans (not secured by real estate)
3.09     60,994   1,710  
Farm loans (non RE)
      -        
Consumer loans (not secured by real estate)
2.48     11,500   151  
All other loans (not secured by real estate)
2.77     22,368   -    
     Total loans
    $ 726,160   60,797  (1)
               
(1) Includes $39.2 million TDR loans
             
 
At March 31, 2011, troubled debt restructured (“TDR”) loans amounted to $52.0 million, including $12.2 million in performing TDR loans.  The terms of these loans have been renegotiated to provide a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  At December 31, 2010, TDR loans amounted to $56.7 million, including $10.0 million in performing TDR loans.

The following table presents an analysis of TDR loans by loan type as of March 31, 2011.

(Dollars in thousands)
           
   
Number of Contracts
 
Pre-Modification Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
 Investment
Real Estate Loans
           
     Construction and land development
  41   $ 26,045   21,079
     Single-family residential
  229     26,359   24,854
     Commercial
  16     7,521   3,941
     Multifamily and farmland
  1     322   218
          Total real estate TDR loans
  287     60,247   50,092
               
Commercial loans (not secured by real estate)
  23     5,702   1,786
Consumer loans (not secured by real estate)
  10     142   133
All other loans (not secured by real estate)
  -       -     -  
     Total TDR loans
  320   $ 66,091   52,011
 
(4)
    Net Earnings Per Common Share
 
Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share.  The average market price during the year is used to compute equivalent shares.

The reconciliation of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the three months ended March 31, 2011 and 2010 is as follows:
 
 
14

 
 
For the three months ended March 31, 2011
         
 
Net Earnings Available to Common Shareholders (Dollars in thousands)
 
Common Shares
 
Per Share Amount
           
Basic earnings per common share
$ 1,013   5,541,542   $ 0.18
Effect of dilutive securities:
             
Stock options
  -     1,552      
Diluted earnings per common share
$ 1,013   5,543,094   $ 0.18
 
 
For the three months ended March 31, 2010
         
 
Net Earnings Available to Common Shareholders (Dollars in thousands)
 
Common Shares
 
Per Share Amount
           
Basic earnings per common share
$ 527   5,539,056   $ 0.10
Effect of dilutive securities:
             
Stock options
  -     4,705      
Diluted earnings per common share
$ 527   5,543,761   $ 0.09
 
(5)
    Stock-Based Compensation
 
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “1999 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  The 1999 Plan expired on May 13, 2009.

Under the 1999 Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant.  The options granted in 1999 vested over a five-year period.  Options granted subsequent to 1999 vested over a three-year period.  All options expire ten years after issuance.  The Company did not grant any options during the three months ended March 31, 2011 and 2010.

The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock at a grant date fair value of $12.80 per share during the third quarter of 2008 and 2,000 shares of restricted stock at a fair value of $11.37 per share during the fourth quarter of 2008. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date).  The amount of expense recorded each period reflects the changes in the Company’s stock price during the period.  As of March 31, 2011, there was $3,000 of total unrecognized compensation cost related to restricted stock grants, which is expected to be recognized during 2011.

The Company also has an Omnibus Stock Ownership and Long Term Incentive Plan that was approved by shareholders’ on May 7, 2009 (the “2009 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  A total of 360,000 shares are currently reserved for possible issuance under the 2009 Plan.   All rights must be granted or awarded within ten years from the May 7, 2009 effective date of the 2009 Plan.  The Company has not granted any rights under the 2009 Plan.
 
 
 
15

 
 

(6)
Fair Value

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.

Cash and Cash Equivalents
For cash, due from banks and interest bearing deposits, the carrying amount is a reasonable estimate of fair value.

Certificates of Deposit
The carrying amount of certificates of deposit is a reasonable estimate of fair value.

Investment Securities Available for Sale
Fair values for investment securities are based on quoted market prices.

Other Investments
For other investments, the carrying value is a reasonable estimate of fair value.

Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at lower of aggregate cost or market value.  The cost of mortgage loans held for sale approximates the market value.

Loans
The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.

Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Derivative Instruments
For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.

Deposits and Demand Notes Payable
The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to the U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Securities Sold Under Agreements to Repurchase
For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.

Federal Home Loan Bank (“FHLB”) Borrowings
The fair value of FHLB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.

Junior Subordinated Debentures
Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit
Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.
 
 
16

 

Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability.   The tables below presents the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of March 31, 2011 and December 31, 2010.

(Dollars in thousands)
             
 
Fair Value Measurements March 31, 2011
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
Investment securities available for sale
$ 271,570   1,253   269,067   1,250
Mortgage loans held for sale
$ 2,415   -   2,415   -
Market value of derivatives (in other assets)
$ 264   -   264   -
 
 
(Dollars in thousands)
             
 
Fair Value Measurements December 31, 2010
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
Investment securities available for sale
$ 272,449   1,369   269,830   1,250
Mortgage loans held for sale
$ 3,814   -   3,814   -
Market value of derivatives (in other assets)
$ 648   -   648   -
 
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the three months ended March 31, 2011:

(Dollars in thousands)
 
 
Investment Securities Available for Sale
 
Level 3 Valuation
Balance, beginning of period
$ 1,250
Change in book value
  -
Change in gain/(loss) realized and unrealized
  -
Purchases/(sales)
  -
Transfers in and/or out of Level 3
  -
Balance, end of period
$ 1,250
     
Change in unrealized gain/(loss) for assets still held in Level 3
$ -

 
 
17

 

The Company’s March 31, 2011 and December 31, 2010 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:

(Dollars in thousands)
                 
 
Fair Value Measurements
March 31, 2011
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
 
Total Gains/(Losses) for
the Three Months Ended
March 31, 2011
Impaired loans
$ 32,949   -   21,578   11,371   (3,246)
Other real estate
$ 6,358   -   6,358   -   (347)
                     
(Dollars in thousands)
                   
 
Fair Value Measurements December 31, 2010
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
 
Total Gains/(Losses) for the Year Ended December 31,
2010
Impaired loans
$ 40,062   -   26,798   13,264   (10,591)
Other Real Estate
$ 6,673   -   6,673   -   (340)
 
The carrying amount and estimated fair value of the Company’s financial instruments at March 31, 2011 and December 31, 2010 are as follows:
 
(Dollars in thousands)
             
 
March 31, 2011
 
December 31, 2010
 
Carrying Amount
 
Estimated
Fair Value
 
Carrying
Amount
 
Estimated
Fair Value
Assets:
             
Cash and cash equivalents
$ 46,253   46,253   23,977   23,977
Certificates of deposit
  735   735   735   735
Investment securities available for sale
  271,570   271,570   272,449   272,449
Other investments
  5,976   5,976   5,761   5,761
Mortgage loans held for sale
  2,415   2,415   3,814   3,814
Loans, net
  695,756   692,216   710,667   710,880
Cash surrender value of life insurance
  7,599   7,599   7,539   7,539
Derivative instruments
  264   264   648   648
                 
Liabilities:
               
Deposits and demand notes payable
$ 839,823   839,343   840,312   839,379
Securities sold under agreements
               
to repurchase
  38,446   38,446   34,094   34,094
FHLB borrowings
  70,000   80,189   70,000   79,950
Junior subordinated debentures
  20,619   20,619   20,619   20,619
 
 (7)
Derivative Instruments and Hedging Activities

Accounting Policy for Derivative Instruments and Hedging Activities
The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

 
 
18

 
 
The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
 
Risk Management Objective of Using Derivatives
The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  As of March 31, 2011, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.

Fair Values of Derivative Instruments on the Balance Sheet
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of March 31, 2011 and December 31, 2010.

(Dollars in thousands)
             
 
Asset Derivatives
 
As of March 31, 2011
 
As of December 31, 2010
 
Balance Sheet
Location
 
Fair Value
 
Balance Sheet
Location
 
Fair Value
Interest rate derivative contracts
Other assets
  $ 264  
Other assets
  $ 648

Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floors designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.  As of March 31, 2011, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  Such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets during 2011 and 2010.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company’s derivatives did not have any hedge ineffectiveness recognized in earnings during the three months ended March 31, 2011 and 2010.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next twelve months, the Company estimates that $264,000 will be reclassified as an increase to interest income.
 
 
19

 
 
Effect of Derivative Instruments on the Income Statement
The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended March 31, 2011 and 2010.

(Dollars in thousands)
       
          Location of Gain   Amount of Gain
  Amount of Gain   (Loss) Reclassified   (Loss) Reclassified
  (Loss) Recognized in   from Accumulated   from Accumulated
  OCI on Derivatives   OCI into Income   OCI into Income
 
Three months ended
March 31,
     
Three months ended
March 31,
 
2011
 
2010
     
2011
 
2010
Interest rate derivative contracts
 $      (10)
 
 $      227
 
Interest income
 
 $      374
 
 $      374  
 
Subsequent Events
The Company has reviewed and evaluated subsequent events and transactions for material subsequent events through the date the financial statements are issued.  Management has concluded that there were no material subsequent events.
 
 
 
 
20

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

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-30  through A-63 of the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc (“the Company”). The Company is the parent company of Peoples Bank (the “Bank”) and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview
Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Economic conditions in 2011 continue to have a negative impact on our financial condition and results of operations.  Unfavorable trends, such as increased unemployment, falling real estate prices, increased loan default and increased bankruptcy rates, have created the difficult business conditions that are affecting the general economy and therefore our operating results.  The unemployment rates in our primary market area continue to be higher than state and national averages.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. This new legislation makes extensive changes to the laws regulating financial products and services as well as firms and companies offering financial products and services. The Dodd-Frank Act also alters certain corporate governance matters affecting public companies. The legislation requires substantial rulemaking and mandates numerous additional studies, the results of which could impact future legislative and regulatory action. We are in the process of evaluating this new legislation and determining the extent to which it will impact our current and future operations. Among other things that could have an impact on our operations and activities, the Dodd-Frank Act (i) amends the manner for calculating the assessment base for deposit insurance premiums paid to the FDIC; (ii) requires the federal banking agencies to issue new rules to implement new minimum leverage and risk-based capital requirements for insured depository institutions; and (iii) requires the Securities and Exchange Commission to complete studies and develop rules or approve stock exchange rules regarding various investor protection issues, including shareholder access to the proxy process, and various matters pertaining to executive compensation and compensation committee oversight. Additionally, the Dodd-Frank Act establishes the Consumer Financial Protection Bureau (“Bureau”) as a new, independent federal agency, which will have broad rulemaking, supervisory and enforcement authority over financial institutions providing consumer financial products and services. Examples of such products and services include deposit products, residential mortgages, home-equity loans and credit cards. Under the Dodd-Frank Act, states are permitted to adopt more stringent consumer protection laws, and state attorneys general can enforce those laws as well as consumer protection rules issued by the Bureau.
 
 
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While we are unable to determine all ramifications of the Dodd-Frank Act at this time, we expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years.  Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies, the full extent of the impact of such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business.  These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Federal Reserve has maintained the Federal Funds Rate at 0.25% since December 2008.  This historically low rate has had a negative impact on earnings and will continue to have a negative impact on our net interest income in future periods.  The negative impact of low interest rates has been partially offset by earnings realized on interest rate contracts utilized by the Company.  Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”

On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”).  Under  the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the UST’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”).  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield.  As of March 31, 2011, the Company has accreted a total of $302,000 of the discount related to the Series A preferred stock.  The Company has paid dividends of $313,000 on the Series A preferred stock during 2011for the period from November 16, 2010 through February 15, 2011.  Cumulative undeclared dividends at March 31, 2011 were $157,000 for the period from February 16, 2011 through March 31, 2011.

The Series A preferred stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends.  Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital.  However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000.  There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.
 
 
22

 
 
It is the intent of the Company to utilize CPP funds to provide capital to support making loans to qualified borrowers in the our market area.  The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.  We are also working with our current builders and contractors to provide financing for potential buyers who may not be able to qualify for financing in the current mortgage market in order to help these customers sell existing single family homes.  The Company will also use the CPP capital infusion as additional Tier I capital to protect the Bank from potential losses that may be incurred during this current recessionary period.  It is the desire of the Company to repay the CPP funds without raising additional equity capital.  The Company anticipates being able to repay the CPP funds from future earnings and existing capital.  However, the funds will not be repaid until economic conditions improve and the Company achieves higher levels of earnings.

The Company continues to face challenges resulting from the impact of the current economy on the housing and real estate markets.  We continue to monitor and evaluate all significant loans in our portfolio, and will continue to manage our credit risk exposure with the expectation that stabilization of the real estate market will not occur within the next 18 to 24 months.  The CPP funds have enhanced our capital position as the Company infused the Bank with $8.0 million additional regulatory capital. The Company has $16.5 million available that can be infused into the Bank as additional capital if needed to maintain its position as a well capitalized bank.  We anticipate increased loan losses in the short run and have prepared for that expectation. We have experienced staff managing our past due loans and foreclosed properties to minimize our potential losses. As the economy recovers, we are positioned to take advantage of all opportunities that present themselves.  Over the remainder of the year we anticipate net interest margin improvement as repricing of deposits should exceed repricing of loans. The amount and timing of any future Federal Reserve rate adjustment remains uncertain, and may further impact the us if those adjustments are significant.

Summary of Significant Accounting Policies
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectibility of loans is reflected through the Company’s estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectibility.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company’s internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the Notes to the Consolidated Financial Statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards.  These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with GAAP.  For a more complete discussion of policies, see the Notes to the Consolidated Financial Statements.

The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
 
 
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The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  As of March 31, 2011, the Company had one interest rate swap contract with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of March 31, 2011 and December 31, 2010.

DERIVATIVE INSTRUMENTS AS OF MARCH 31, 2011
       
(Dollars in thousands)
         
   Type of Derivative
Notional
Amount
 
Contract
Rate
 
Year-to-date Income
Interest rate swap contact expiring 06/01/11
$ 50,000   6.245%   $ 374
 
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floor designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.  

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in “accumulated other comprehensive income” and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. Such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets during 2011 and 2010.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company’s derivatives did not have any hedge ineffectiveness recognized in earnings during the three months ended March 31, 2011 and 2010.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities.  During the next twelve months, the Company estimates that approximately $264,000 will be reclassified as an increase to interest income.

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended March 31, 2011 and 2010.
 
(Dollars in thousands)
                 
                   
 
 
Amount of Gain
(Loss) Recognized in
OCI on Derivatives
 
Location of Gain
(Loss) Reclassified
from Accumulated
OCI into Income
 
Amount of Gain
(Loss) Reclassified
from Accumulated
OCI into Income
 
Three months ended
March 31,
     
Three months ended
March 31,
 
2011
 
2010
     
2011
 
2010
Interest rate derivative contracts
 $      (10)
 
 $      227
 
Interest income
 
 $      374
 
 $      374   
 
 
 
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GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements.  There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability.   The tables below present the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of March 31, 2011 and December 31, 2010.

(Dollars in thousands)
             
 
Fair Value Measurements
March 31, 2011
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
Investment securities available for sale
$ 271,570   1,253   269,067   1,250
Mortgage loans held for sale
$ 2,415   -   2,415   -
Market value of derivatives (in other assets)
$ 264   -   264   -
                 
(Dollars in thousands)                
    Fair Value             
    Measurements    Level 1    Level 2    Level 3  
    December 31, 2010    Valuation    Valuation    Valuation 
Investment securities available for sale 272,449   1,369   269,830   1,250
Mortgage loans held for sale $  3,814   -   3,814   -
Market value of derivatives (in other assets) $ 648   -   648   -
 
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available.  If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.  Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the three months ended March 31, 2011:

(Dollars in thousands)
 
 
Investment Securities Available for Sale
 
Level 3 Valuation
Balance, beginning of period
$ 1,250
Change in book value
  -
Change in gain/(loss) realized and unrealized
  -
Purchases/(sales)
  -
Transfers in and/or out of Level 3
  -
Balance, end of period
$ 1,250
     
Change in unrealized gain/(loss) for assets still held in Level 3
$ -
 
The Company’s March 31, 2011 and December 31, 2010 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:

(Dollars in thousands)
                 
 
Fair Value Measurements March 31, 2011
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
 
Total Gains/(Losses) for the
Three Months Ended
March 31, 2011
Impaired loans
$ 32,949   -   21,578   11,371   (3,246)
Other real estate
$ 6,358   -   6,358   -   (347)
 
 
 
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Fair Value Measurements December 31, 2010
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
 
Total Gains/(Losses) for the
Year Ended December 31,
2010
Impaired loans
$ 40,062   -   26,798   13,264   (10,591)
Other Real Estate
$ 6,673   -   6,673   -   (340)
 
At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which are generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP.  Actual results could differ from those estimates.
 
Results of Operations
Summary.  Net earnings for the first quarter of 2011 were $1.4 million, or $0.25 basic and diluted net earnings per share before adjustment for preferred stock dividends and accretion as compared to $875,000, or $0.16 basic and diluted net earnings per share for the same period one year ago.  After adjusting for $348,000 in dividends and accretion on preferred stock, net earnings available to common shareholders for the three months ended March 31, 2011 were $1.0 million, or $0.18 basic and diluted net earnings per common share as compared to $527,000, or $0.10 basic net earnings per share and $0.09 diluted net earnings per common share for the same period one year ago.  The increase in first quarter earnings is attributable to increases in net interest income and non-interest income, which were partially offset by increases in the provision for loan losses and non-interest expense, as discussed below.

The annualized return on average assets was 0.52% for the three months ended March 31, 2011 compared to 0.33% for the same period in 2010, and annualized return on average shareholders’ equity was 5.66% for the three months ended March 31, 2011 compared to 3.53% for the same period in 2010.

Net Interest Income.  Net interest income, the major component of the Company’s net earnings, was $8.5 million for the three months ended March 31, 2011 compared to $8.1 million for the same period in 2010.  This increase is primarily attributable to a reduction in interest expense due to a decrease in deposit interest rates.

Interest income decreased $372,000 or 3% for the three months ended March 31, 2011 compared with the same period in 2010.  The decrease was primarily due to a reduction in average loans.  The average yield on earning assets for the quarters ended March 31, 2011 and 2010 was 4.81% and 5.05%, respectively.  During the quarter ended March 31, 2011, average loans decreased $54.6 million to $721.7 million from $776.3 million for the three months ended March 31, 2010.  During the quarter ended March 31, 2011, average investment securities available-for-sale increased $77.0 million to $268.2 million from $191.2 million for the three months ended March 31, 2010 primarily due to the investment of additional funds received from the growth in deposits and a decrease in loans.

Interest expense decreased $781,000 or 20% for the three months ended March 31, 2011 compared with the same period in 2010.  The average rate paid on interest-bearing checking and savings accounts was 0.87% for the three months ended March 31, 2011 as compared to 1.21% for the same period of 2010.  The average rate paid on certificates of deposits was 1.48% for the three months ended March 31, 2011 compared to 1.85% for the same period one year ago.

Provision for Loan Losses. For the three months ended March 31, 2011 a contribution of $3.0 million was made to the provision for loan losses compared to a $2.4 million contribution to the provision for loan losses for the three months ended March 31, 2010.  The increase in the provision for loan losses is primarily attributable to  a $2.0 million increase in net charge-offs during the first quarter of 2011 compared to the first quarter of 2010.

Non-Interest Income.  Total non-interest income was $3.6 million for the first quarter of 2011 as compared to $2.6 million for the same period of 2010.  The increase was primarily due to a $1.1 million increase in the gain on sale of securities in the first quarter of 2011 that reflects the repositioning of our investment portfolio to recognize a portion of the gains in the investment portfolio during the first quarter of 2011.  Service charges decreased 5% to $1.3 million for the three months ended March 31, 2011 when compared to the same period one year ago.  Other service charges and fees decreased 3% to $582,000 for the three-month period ended March 31, 2011 as compared to $602,000 for the same period one year ago.  Mortgage banking income increased to $187,000 during the three months ended March 31, 2011 from $156,000 for the same period in 2010.  Miscellaneous income decreased to $395,000 for the three months ended March 31, 2011 as compared to $413,000 for the same period in 2010.
 
 
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 Non-Interest Expense.  Total non-interest expense was $7.4 million for the first quarter of 2011 as compared to $7.2 million for the first quarter of 2010.  Salary and employee benefits totaled $3.7 million for the three months ended March 31, 2011, as compared to $3.5 million for the same period in 2010.  Occupancy expense totaled $1.4 million for the three months ended March 31, 2011 and 2010.  Other non-interest expense increased 2% to $2.4 million for the three months ended March 31, 2011 as compared to the same period in 2010.

Income Taxes.  The Company reported income taxes of $405,000 and $269,000 for the three months ended March 31, 2011 and 2010, respectively.  This represented effective tax rates of 23% for the three months ended March 31, 2011and 2010.

Analysis of Financial Condition
Investment Securities.  Available for sale securities amounted to $271.6 million at March 31, 2011 compared to $272.4 million at December 31, 2010.  Average investment securities available for sale for the three months ended March 31, 2011 amounted to $268.2 million compared to $219.8 million for the year ended December 31, 2010. This increase reflects the investment of additional funds received from the decrease in loans.
 
Loans.  At March 31, 2011, loans amounted to $711.2 million compared to $726.2 million at December 31, 2010, a decrease of $15.0 million.  This decrease reflects a decline in loan originations combined with continuing payments on existing loans. Loans originated or renewed during the three months ended March 31, 2011, amounting to approximately $18.1 million, were offset by paydowns and payoffs of existing loans.  Average loans represented 71% and 76% of average earning assets for the three months ended March 31, 2011 and the year ended December 31, 2010, respectively.  The Company had $2.4 million and $3.8 million in mortgage loans held for sale as of March 31, 2011 and December 31, 2010, respectively.

Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Real estate mortgage loans include both commercial and residential mortgage loans.  At March 31, 2011, the Company had $122.0 million in residential mortgage loans, $97.5 million in home equity loans and $280.8 million in commercial mortgage loans, which include $219.0 million using commercial property as collateral and $61.8 million using residential property as collateral.   Residential mortgage loans include $66.6 million made to customers in the Company’s traditional banking offices and $55.4 million in mortgage loans originated in the Company’s Latino banking operations.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.

At March 31, 2011, the Company had $115.2 million in acquisition development and construction “(AD&C”) loans.  The following table presents a breakout of these loans.

AD&C Loans
           
             
(Dollars in thousands)
 
Number of Loans
 
Balance Outstanding
 
Non-accrual Balance
Land acquisition and development - commercial purposes
  79   $ 23,500   $ 3,044
Land acquisition and development - residential purposes
  361     78,533     17,118
1 to 4 family residential construction
  40     11,443     644
Commercial construction
  5     1,694     254
Total acquisition, development and construction
  485   $ 115,170   $ 21,060
 
At March 31, 2011, troubled debt restructured (“TDR”) loans amounted to $52.0 million, including $12.2 million in performing TDR loans.  The terms of these loans have been renegotiated to provide a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  At December 31, 2010, TDR loans amounted to $56.7 million, including $10.0 million in performing TDR loans.

Allowance for Loan Losses.  The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  We periodically analyze the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
 
 
 
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·  
our loan loss experience;
·  
the amount of past due and non-performing loans;
·  
specific known risks;
·  
the status and amount of other past due and non-performing assets;
·  
underlying estimated values of collateral securing loans;
·  
current and anticipated economic conditions; and
·  
other factors which management believes affect the allowance for potential credit losses.
 
Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the originating loan officer evaluates the quality of the loan and assigns one of nine risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by our Credit Administration department. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the  Credit Administration department. Any issues regarding the risk assessments are addressed by our senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Credit