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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Quarterly Period Ended March 31, 2011

 

 

BANK OF THE JAMES FINANCIAL GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Virginia		000-50548		20-0500300
(State or other jurisdiction of incorporation or organization)		(Commission file number)		(I.R.S. Employer Identification No.)
828 Main Street, Lynchburg, VA				24504
(Address of principal executive offices)				(Zip Code)

(434) 846-2000

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		¨		Smaller reporting company		x

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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 3,323,743 shares of Common Stock, par value $2.14 per share, were outstanding at May 13, 2011.

 

 

 

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PART I – FINANCIAL INFORMATION							1
		Item 1.		Consolidated Financial Statements			1
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			29
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			42
		Item 4.		Controls and Procedures			42
PART II – OTHER INFORMATION							42
		Item 1.		Legal Proceedings			42
		Item 1A.		Risk Factors			42
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			42
		Item 3.		Defaults Upon Senior Securities			42
		Item 4.		[Removed and Reserved]			42
		Item 5.		Other Information			42
		Item 6.		Exhibits			43
SIGNATURES							44

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PART I – FINANCIAL INFORMATION

 

Item 1.

Consolidated Financial Statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

(dollar amounts in thousands, except per share amounts)

 

		(unaudited) 3/31/2011				(audited) 12/31/2010
Assets
Cash and due from banks		$	10,949			$	11,665
Federal funds sold			12,964				7,094
Total cash and cash equivalents			23,913				18,759
Securities held-to-maturity (fair value of $13,545 in 2011 and $14,601 in 2010)			13,241				14,297
Securities available-for-sale, at fair value			44,047				38,586
Restricted stock, at cost			2,181				2,180
Loans, net of allowance for loan losses of $5,318 in 2011 and $5,467 in 2010			322,966				320,715
Premises and equipment, net			8,869				8,791
Software, net			115				89
Interest receivable			1,623				1,469
Cash value - bank owned life insurance			5,415				5,360
Other real estate owned			3,931				3,440
Income taxes receivable			109				304
Deferred tax asset			1,723				1,899
Other assets			2,770				3,039
Total assets		$	430,903			$	418,928
Liabilities and Stockholders’ Equity
Deposits
Noninterest bearing demand		$	49,482			$	44,272
NOW, money market and savings			249,010				241,176
Time			80,715				82,942
Total deposits		$	379,207			$	368,390
Repurchase agreements			7,651				7,330
FHLB borrowings			10,000				10,000
Capital notes			7,000				7,000
Interest payable			120				121
Other liabilities			654				592
Total liabilities		$	404,632			$	393,433
Stockholders’ equity
Common stock $2.14 par value; authorized 10,000,000 shares; issued and outstanding 3,323,743 as of March 31, 2011 and December 31, 2010			7,113				7,113
Additional paid-in-capital			22,742				22,742
Accumulated other comprehensive (loss)			(350	)			(692	)
Retained earnings			(3,234	)			(3,668	)
Total stockholders’ equity		$	26,271			$	25,495
Total liabilities and stockholders’ equity		$	430,903			$	418,928

 

See accompanying notes to these consolidated financial statements

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Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Income

(dollar amounts in thousands, except per share amounts) (unaudited)

 

		For the Three  Months Ended March 31,
		2011				2010
Interest Income
Loans		$	4,473			$	4,844
Securities
US Government and agency obligations			238				415
Mortgage backed securities			116				2
Municipals			88				52
Dividends			3				1
Other (Corporates)			19				47
Federal Funds sold			5				7
Total interest income			4,942				5,368
Interest Expense
Deposits
NOW, money market savings			612				1,224
Time Deposits			429				617
FHLB borrowings			73				100
Reverse repurchase agreements			16				33
Capital notes 6% due 4/1/2012			105				105
Total interest expense			1,235				2,079
Net interest income			3,707				3,289
Provision for loan losses			579				387
Net interest income after provision for loan losses			3,128				2,902
Other operating income
Mortgage fee income			286				291
Service charges, fees and commissions			283				352
Increase in cash value of life insurance			55				60
Other			17				22
Gain on sale of available-for-sale securities			31				75
Total other operating income			672				800
Other operating expenses
Salaries and employee benefits			1,427				1,649
Occupancy			276				245
Equipment			261				260
Supplies			89				101
Professional, data processing, and other outside expense			473				380
Marketing			79				67
Credit expense			72				66
Loss (gain) on sale and/or writedown of OREO and other OREO expenses			92				(5	)
FDIC insurance expense			229				192
Other			172				203
Total other operating expenses			3,170				3,158
Income before income taxes			630				544
Income tax expense			195				178
Net Income		$	435			$	366
Weighted average shares outstanding – basic			3,323,743				3,289,867
Weighted average shares outstanding– diluted			3,336,860				3,321.363
Income per common share - basic and diluted		$	0.13			$	0.11

 

See accompanying notes to these consolidated financial statements

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Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Three Months Ended March 31, 2011 and 2010

(dollar amounts in thousands, except per share amounts) (unaudited)

 

		March 31,
		2011				2010
Cash flows from operating activities
Net Income		$	435			$	366
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation		$	189			$	204
Net amortization and accretion of premiums and discounts on securities			160				150
(Gain) on sale of available-for-sale securities			(31	)			(75	)
Provision for loan losses			579				387
(Gain) loss on sale of other real estate owned			56				(5	)
(Increase) in cash value of life insurance			(55	)			(60	)
Stock compensation expense			—				2
(Increase) decrease in interest receivable			(154	)			345
(Increase) decrease in other assets			262				93
Decrease in income taxes receivable			195				589
(Decrease) in interest payable			(1	)			(36	)
Increase in other liabilities		$	62			$	369
Net cash provided by operating activities		$	1,697			$	2,329
Cash flows from investing activities
Purchases of securities held-to-maturity		$	(1,000	)		$	—
Proceeds from maturities and calls of securities held-to-maturity			2,000				—
Purchases of securities available-for-sale			(8,324	)			(5,714	)
Proceeds from maturities, calls and paydowns of securities available-for-sale			719				4,194
Proceeds from sale of securities available-for-sale			2,589				18,648
Purchase of Federal Reserve Bank stock			(1	)			(30	)
Proceeds from sale of other real estate owned			329				—
Origination of loans, net of principal collected			(3,700	)			(4,783	)
Purchases of premises and equipment			(293	)			(58	)
Net cash (used in) provided by investing activities		$	(7,681	)		$	12,257
Cash flows from financing activities
Net increase (decrease) in deposits		$	10,817			$	(17,203	)
Net increase (decrease) in repurchase agreements			321				(1,768	)
Net (decrease) in Federal Home Loan Bank advances			—				(10,000	)
Net cash provided by (used in) financing activities		$	11,138			$	(28,971	)
Increase (decrease) in cash and cash equivalents			5,154				(14,385	)
Cash and cash equivalents at beginning of period		$	18,759			$	31,305
Cash and cash equivalents at end of period		$	23,913			$	16,920
Non cash transactions
Transfer of loans to foreclosed assets		$	870			$	115
Fair value adjustment for securities			518				628
Cash transactions
Cash paid for interest		$	1,236			$	2,115
Cash paid for taxes			—				—

 

See accompanying notes to these consolidated financial statements

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Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income

(dollars in thousands) (unaudited)

 

		Total Shares Outstanding				Common Stock				Additional Paid-in Capital				Retained Earnings (Deficit)				Accumulated Other Comprehensive Gain (Loss)				Total
Balance at December 31, 2009			2,990,788			$	6,400			$	20,765			$	(2,938	)		$	(502	)		$	23,725
Net Income			—				—				—				1,820				—				1,820
Changes in unrealized gains on securities available for sale net of deferred taxes of $24			—				—				—				—				47				47
Reclassification adjustment for gains included in net income, net of income tax expense of $121			—				—				—				—				(237	)			(237	)
Comprehensive Income																							1,630
10% Stock dividend			298,942				640				1,910				(2,550	)			—				—
Exercise of stock options			34,013				73				65				—				—				138
Stock compensation expense			—				—				2				—				—				2
Balance at December 31, 2010			3,323,743			$	7,113			$	22,742			$	(3,668	)		$	(692	)		$	25,495
Net Income			—				—				—				434				—				434
Changes in unrealized gains on securities available for sale net of deferred taxes of $187			—				—				—				—				362				362
Reclassification adjustment for gains included in net income, net of income tax expense of $11																			(20	)			(20	)
Comprehensive Income																							777
Balance at March 31, 2011			3,323,743			$	7,113			$	22,742			$	(3,234	)		$	(350	)		$	26,271

 

See accompanying notes to these consolidated financial statements

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Notes to Consolidated Financial Statements

Note 1 – Basis of Presentation

The unaudited consolidated financial statements have been prepared by Bank of the James Financial Group, Inc. (“Financial” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. In management’s opinion the accompanying financial statements, which unless otherwise noted are unaudited, reflect all adjustments, consisting solely of normal recurring accruals, necessary for a fair presentation of the financial information as of and for the three months ended March 31, 2011 and 2010 in conformity with accounting principles generally accepted in the United States of America. Additional information concerning the organization and business of Financial, accounting policies followed, and other related information is contained in Financial’s Annual Report on Form 10-K for the year ended December 31, 2010. These financial statements should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2010 included in Financial’s Annual Report on Form 10-K. Results for the three month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

Financial’s critical accounting policy relates to the evaluation of the allowance for loan losses which is based on management’s opinion of an amount that is adequate to absorb loss in the existing loan portfolio of Bank of the James (the “Bank”), Financial’s wholly-owned subsidiary. The allowance for loan losses is established through a provision for loan loss based on available information including the composition of the loan portfolio, historical loan losses (to the extent available due to limited history), specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan losses could result in material changes in Financial’s financial condition and results of operations. The Bank’s policies with respect to the methodology for determining the allowance for loan losses involve a higher degree of complexity and require management to make subjective judgments that often require assumptions or estimates about uncertain matters. These critical policies and their assumptions are periodically reviewed with the Board of Directors.

Note 2 – Use of Estimates

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

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Note 3 – Earnings Per Share

All earnings per share amounts have been adjusted to reflect the 10% stock dividend paid by Financial in July 2010, the 5% stock dividend paid by Financial in July 2009, as well as all prior stock dividends.

Currently, only the option shares granted to certain officers and other employees of Financial pursuant to the Amended and Restated Stock Option Plan of 1999 Financial (the “1999 Plan”) are considered dilutive. The following is a summary of the earnings per share calculation for the three months ended March 31, 2011 and 2010.

 

		Three months ended March 31,
		2011				2010
Net income		$	435,000			$	366,000
Weighted average number of shares			3,323,743				3,289,867
Options affect of incremental shares			13,117				31,496
Weighted average diluted shares			3,336,860				3,321,363
Basic EPS (weighted avg shares)		$	0.13			$	0.11
Diluted EPS (Including Option Shares)		$	0.13			$	0.11

For the three months March 31, 2011 there were 207,305 option shares that had an exercise price higher than the market price on March 31, 2011. These shares were not included in calculating the diluted earnings per share during this period because their effect was anti-dilutive. For the three months March 31, 2010 there were 211,303 option shares that had an exercise price higher than the market price on March 31, 2010. These shares were not included in calculating the diluted earnings per share during this period because their effect was anti-dilutive.

Note 4 – Stock Based Compensation

Accounting standards require companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.

 

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Note 4 – Stock Based Compensation (continued)

 

Stock option plan activity for the three months ended March 31, 2011 is summarized below:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Life (in years)				Average Intrinsic Value
Options outstanding, January 1, 2011			284,906			$	8.42
Exercised			—
Forfeited			(3,373	)		$	13.88
Options outstanding, March 31, 2011			281,533			$	8.35				3.20			$	50,705
Options exercisable, March 31, 2011			281,533			$	8.35				3.20			$	50,705

Intrinsic value is calculated by subtracting exercise price of option shares from the market price of underlying shares and multiplying that amount by the number of options outstanding. No intrinsic value exists where the exercise price is less than the market price on a given date.

As of March 31, 2011 all compensation expense related to the foregoing stock option plan has been recognized. The Company’s ability to grant additional options shares under the 1999 Plan has expired.

Note 5 – Stock Dividend

On May 18, 2010, the Board of Directors of the Company declared a 10% stock dividend. The stock dividend was paid on July 23, 2010 to shareholders of record as of June 21, 2010. Following the stock dividend, the number of outstanding shares increased by approximately 299,000. The dividend required a reclassification of retained earnings effective May 18, 2010 in the amount of $2,550,000. Of this amount, $640,000 was reclassified as common stock and $1,910,000 was reclassified as additional paid-in-capital. The reclassification did not change total stockholders’ equity. All per share amounts have been retroactively adjusted to reflect this dividend.

Note 6 – Fair Value Measurements

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The recent fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the

 

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Note 6 – Fair Value Measurements (continued)

 

measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

 

•

Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

•

Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

•

Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s securities are considered to be Level 2 securities.

 

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Note 6 – Fair Value Measurements (continued)

 

The following table summarizes the Company’s financial assets that were measured at fair value on a recurring basis during the period (in thousands):

 

						Carrying Value at March 31, 2011
Description		Balance as of March  31, 2011				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US agency obligations		$	14,628			$	—			$	14,628			$	—
Mortgage-backed securities			20,587				—				20,587				—
Municipals			7,812				—				7,812				—
Corporates			1,020				—				1,020				—
Total available-for-sale securities		$	44,047			$	—			$	44,047			$	—
						Carrying Value at December 31, 2010
Description		Balance as of December 31, 2010				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US agency obligations		$	14,341			$	—			$	14,341			$	—
Mortgage-backed securities			17,762				—				17,762				—
Municipals			5,465				—				5,465				—
Corporates			1,018				—				1,018				—
Total available-for-sale securities		$	38,586			$	—			$	38,586			$	—

Loans held for sale

Loans held for sale are required to be measured in a lower of cost or fair value. Under ASC 820, market value is to represent fair value. Management obtains quotes or bids on all or part of these loans directly from the purchasing financial institutions. Premiums received or to be received on the quotes or bids are indicative of the fact that cost is lower than fair value. At March 31, 2011, the Company had no loans held for sale.

Impaired loans

ASC 820 applies to loans measured for impairment using the practical expedients permitted by SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral.

 

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Note 6 – Fair Value Measurements (continued)

 

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over one year old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Statements of Income.

Other Real Estate Owned

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of ASC 820.

Real estate acquired through foreclosure is transferred to other real estate owned (“OREO”). The measurement of loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. The value of OREO collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate is over one year old, then the fair value is considered Level 3. Any fair value adjustments are recorded in the period incurred and expensed against current earnings.

The following table summarizes the Company’s impaired loans and OREO measured at fair value on a nonrecurring basis during the period (in thousands).

 

						Carrying Value at March 31, 2011
Description		Balance as of March 31, 2011				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans		$	10,043			$	—			$	4,349			$	5,694
Other real estate owned		$	3,931			$	—			$	3,931			$	—

 

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Note 6 – Fair Value Measurements (continued)

 

						Carrying Value at December 31, 2010
Description		Balance as of December 31, 2010				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans		$	11,188			$	—			$	3,205			$	7,983
Other real estate owned		$	3,440			$	—			$	3,440			$	—

Financial Instruments

Cash, cash equivalents and Federal Funds sold

The carrying amounts of cash and short-term instruments approximate fair values.

Securities

Fair values of securities, excluding Federal Reserve Bank stock, Federal Home Loan Bank stock, and Community Bankers’ Bank stock are based on quoted market prices.

Loans

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain fixed rate loans are based on quoted market prices of similar loans adjusted for differences in loan characteristics. Fair values for other loans such as commercial real estate and commercial and industrial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values of nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Bank Owned Life Insurance (BOLI)

The carrying amount approximates fair value.

Deposits

Fair values disclosed for demand deposits (e.g., interest and noninterest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed rate certificates of deposit are estimated using discounted cash flow analyses that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

FHLB borrowings

The fair value of FHLB borrowings is estimated using discounted cash flow analysis based on the rates currently offered for borrowings of similar remaining maturities and collateral requirements.

Short-term borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate fair value.

 

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Note 6 – Fair Value Measurements (continued)

 

Capital notes

Fair values of capital notes are based on market prices for debt securities having similar maturity and interest rate characteristics.

Accrued interest

The carrying amounts of accrued interest approximate fair value.

Off-balance sheet credit-related instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. Fair value of off-balance sheet credit-related instruments were deemed to be immaterial at March 31, 2011 and December 31, 2010 and therefore are not included in the table below.

The estimated fair values, and related carrying or notional amounts, of Financial’s financial instruments are as follows (in thousands):

 

		March 31, 2011								December 31, 2010
		Carrying Amounts				Approximate Fair Values				Carrying Amounts				Approximate Fair Values
Financial assets
Cash and due from banks		$	10,949			$	10,949			$	11,665			$	11,665
Federal funds sold			12,964				12,964				7,094				7,094
Securities
Available-for-sale			44,047				44,047				38,586				38,586
Held-to-maturity			13,241				13,545				14,297				14,601
Loans, net			322,966				325,388				320,715				323,120
Interest receivable			1,623				1,623				1,469				1,469
BOLI			5,415				5,415				5,360				5,360
Financial liabilities
Deposits		$	379,207			$	380,989			$	368,390			$	370,123
FHLB borrowings			10,000				10,518				10,000				10,518
Repurchase agreements			7,651				7,651				7,330				7,330
Capital notes			7,000				6,981				7,000				6,981
Interest payable			120				120				121				121

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 Bank’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Bank’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. 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-balance-sheet and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities

 

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Note 6 – Fair Value Measurements (continued)

 

that are not considered financial instruments. Significant assets that are not considered financial assets include deferred income taxes and bank premises and equipment; a significant liability that is not considered a financial liability is accrued post-retirement benefits. 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.

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

Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Bank’s overall interest rate risk.

Note 7 – Capital Notes

Financial has issued capital notes in the amount $7,000,000 (the “Notes”). The Notes bear interest at the rate of 6% per year with interest payable quarterly in arrears. The first quarterly interest payment on the Notes was paid on July 1, 2009. No principal payments are due until the Notes mature on April 1, 2012. On the maturity date the principal and all accrued but unpaid interest on the Notes will be due and payable

Note 8 – Investments

The following tables summarize the Bank’s holdings for both securities held-to-maturity and securities available-for-sale as of March 31, 2011 and December 31, 2010 (amounts in thousands):

 

		Amortized Costs				March 31, 2011 Gross Unrealized								Fair Value
						Gains				(Losses)
Held-to-Maturity
US agency obligations		$	13,241			$	304			$	—			$	13,545
Available-for-Sale
US agency obligations		$	14,727			$	183			$	(282	)		$	14,628
Mortgage-backed securities			20,839				4				(256	)			20,587
Municipals			7,979				75				(242	)			7,812
Other			1,033				—				(13	)			1,020
		$	44,578			$	262			$	(793	)		$	44,047

 

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Note 8 – Investments (continued)

 

		Amortized Costs				December 31, 2010 Gross Unrealized								Fair Value
						Gains				(Losses)
Held-to-Maturity
US agency obligations		$	14,297			$	304			$	—			$	14,601
Available-for-Sale
US agency obligations		$	14,758			$	24			$	(441	)		$	14,341
Mortgage-backed securities			18,057				1				(296	)			17,762
Municipals			5,787				15				(337	)			5,465
Other			1,033				—				(15	)			1,018
		$	39,635			$	40			$	(1,089	)		$	38,586

The following tables show the gross unrealized losses and fair value of the Bank’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010 (amounts in thousands):

 

		Less than 12 months								More than 12 months								Total
March 31, 2011		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
Description of securities
U.S. agency obligations		$	8,873			$	282			$	—			$	—			$	8,873			$	282
Mortgage-backed securities			—				—				18,590				256				18,590				256
Municipals			3,015				233				614				9				3,629				242
Corporates			—				—				1,033				13				1033				13
Total		$	11,888			$	515			$	20,237			$	278			$	32,125			$	793
		Less than 12 months								More than 12 months								Total
December 31, 2010		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
Description of securities
U.S. agency obligations		$	11,808			$	441			$	—			$	—			$	11,808			$	441
Mortgage-backed securities			16,740				296				—				—				16,740				296
Municipals			3,178				303				590				34				3,768				337
Corporates			—				—				1,018				15				1,018				15
Total		$	31,726			$	1,040			$	1,608			$	49			$	33,334			$	1,089

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and may do so more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) the intent of Financial, if any, to sell the security; (4) whether Financial more likely than not will be required to sell the security before recovering its cost; and (5) whether Financial does not expect to recover the security’s entire amortized cost basis (even if Financial does not intend to sell the security).

 

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Note 8 – Investments (continued)

 

At March 31, 2011, the Company did not consider the unrealized losses as other-than-temporary losses due to the nature of the securities involved. As of March 31, 2011, the Bank owned 24 securities that were being evaluated for other than temporary impairment. 17 of these securities were S&P rated AAA, 6 were S&P rated AA, and 1 was S&P rated A. As of March 31, 2011,16 of these securities were obligations of government sponsored entities, 7 were municipal bank-qualified issues, and 1 was issued by a publicly traded United States corporation. The securities issued by publicly traded corporations are classified as “Corporates” in the tables set forth above.

Based on the analysis performed by management as mandated by the Bank’s investment policy, management believes the default risk to be minimal. Because the Bank expects to recover the entire amortized cost basis, no declines currently are deemed to be other-than-temporary.

Note 9 – Loans and allowance for loan losses

Management has an established methodology used to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Bank has segmented certain loans in the portfolio by product type. Within these segments, the Bank has sub-segmented its portfolio by classes within the segments, based on the associated risks within these classes. The classifications set forth below do not correspond directly to the classifications set forth in the call report (Form FFIEC 041). Management has determined that the classifications set forth below are more appropriate for use in identifying and managing risk in the loan portfolio.

 

Loan Segments:				Loan Classes:
		Commercial				Commercial and industrial loans
		Commercial real estate				Commercial mortgages – owner occupied
						Commercial mortgages – non-owner occupied
						Commercial construction
		Consumer				Consumer unsecured
						Consumer secured
		Residential				Residential mortgages
						Residential consumer construction

 

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Note 9 – Loans and allowance for loan losses (continued)

 

A summary of loans, net is as follows (dollars in thousands):

 

		As of:
		March 31, 2011				December 31, 2010
Commercial		$	65,735			$	62,786
Commercial real estate			148,376				143,428
Consumer			67,879				68,289
Residential			46,294				51,679
Total loans			328,284				326,182
Less allowance for loan losses			5,318				5,467
Net loans		$	322,966			$	320,715

The Bank’s internal risk rating system is in place to grade commercial and commercial real estate loans. Category ratings are reviewed periodically by lenders and the credit review area of the Bank based on the borrower’s individual situation. Additionally, internal and external monitoring and review of credits are conducted on an annual basis.

Below is a summary and definition of the Bank’s risk rating categories:

 

RATING 1		Excellent
RATING 2		Above Average
RATING 3		Satisfactory
RATING 4		Acceptable / Low Satisfactory
RATING 5		Monitor
RATING 6		Special Mention
RATING 7		Substandard
RATING 8		Doubtful
RATING 9		Loss

We segregate loans into the above categories the criteria for special mention, substandard, doubtful and loss from non-classified, or pass rated, loans. We review the characteristics of each rating at least annually, generally during the first quarter. The characteristics of these ratings are as follows:

 

•

“Pass.” These are loans having risk ratings of 1 through 4. Pass loans are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loan, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that this type of payment history will continue. When necessary, acceptable personal guarantors support the loan.

 

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Note 9 – Loans and allowance for loan losses (continued)

 

•

“Monitor.” These are loans having a risk rating of 5. Monitor loans have currently acceptable risk but may have the potential for a specific defined weakness in the borrower’s operations and the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history may currently or in the future be characterized by late payments. The Bank’s risk exposure is mitigated by collateral supporting the loan. The collateral is considered to be well-margined, well maintained, accessible and readily marketable.

 

•

“Special Mention.” These are loans having a risk rating of 6. Special Mention loans have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. These loans do warrant more than routine monitoring due to a weakness caused by adverse events.

 

•

“Substandard.” These are loans having a risk rating of 7. Substandard loans are considered to have specific and well-defined weaknesses that jeopardize the viability of the Bank’s credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provides evidence that it is probable that the Bank will be unable to collect all amounts due.

 

•

“Doubtful.” These are loans having a risk rating of 8. Doubtful rated loans have all the weaknesses inherent in a loan that is classified substandard but with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high.

 

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Note 9 – Loans and allowance for loan losses (continued)

 

Financing Receivables on Non-Accrual Status

(dollars in thousands)

 

		As of
		March 31, 2011				December 31, 2010
Commercial		$	509			$	756
Commercial Real Estate:
Commercial Mortgages-Owner Occupied			574				1,157
Commercial Mortgages-Non-Owner Occupied			2,709				2,504
Commercial Construction			207				923
Consumer
Consumer Unsecured			—				83
Consumer Secured			1,559				1,153
Residential:
Residential Mortgages			1,362				1,725
Residential Consumer Construction			65				65
Totals		$	6,985			$	8,366

We also classify other real estate owned (OREO) as a nonperforming asset. OREO, which is accounted for in the “other assets” section of the Consolidated Balance Sheets, represents real property owned by the Bank either through purchase at foreclosure or received from the borrower through a deed in lieu of foreclosure. OREO increased to $3,931,000 on March 31, 2011 from $3,440,000 on December 31, 2010. The following table represents the changes in OREO balance during the three months ended March 31, 2011.

OREO Changes

(Dollars in Thousands)

 

		Three months ended March 31, 2011
Balance at the beginning of the year (gross)		$	3,440
Transfers from loans			870
Transfer from premises and equipment			—
Capitalized costs			6
Charge-Offs			—
Sales proceeds			(329	)
Gain (loss) on disposition			(56	)
Balance at the end of the period (gross)		$	3,931
Less valuation allowance			—
Balance at the end of the period (net)		$	3,931

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Impaired Loans (dollars in thousands) For the Three Months Ended March 31, 2011
2011		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
With No Related Allowance Recorded:
Commercial		$	9,209			$	9,252			$	—			$	11,904			$	126
Commercial Real Estate
Commercial Mortgages-Owner Occupied			3,150				3,179				—				2,927				52
Commercial Mortgage Non-Owner Occupied			6,209				6,771				—				6,082				62
Commercial Construction			1,424				1,424				—				1,144				19
Consumer
Consumer Unsecured			—				—				—				—				—
Consumer Secured			978				1,289				—				672				—
Residential
Residential Mortgages			343				566				—				373				(5	)
Residential Consumer Construction			65				69				—				65				—
With An Allowance Recorded:
Commercial		$	1,256			$	1,292			$	268			$	1,314			$	15
Commercial Real Estate
Commercial Mortgages-Owner Occupied			4,363				4,382				777				4,739				57
Commercial Mortgage Non-Owner Occupied			1,555				1,580				165				1,340				4
Commercial Construction			2,575				2,826				408				2,892				16
Consumer
Consumer Unsecured			—				—				—				286				—
Consumer Secured			427				429				165				442				3
Residential
Residential Mortgages			1,922				2,076				272				1,847				32
Residential Consumer Construction			—				—				—				—				—
Totals:
Commercial		$	10,465			$	10,544			$	268			$	13,218			$	141
Commercial Real Estate
Commercial Mortgages-Owner Occupied			7,513				7,561				777				7,666				109
Commercial Mortgage Non-Owner Occupied			7,764				8,351				165				7,422				66
Commercial Construction			3,999				4,250				408				4,036				35
Consumer
Consumer Unsecured			—				—				—				286				—
Consumer Secured			1,405				1,718				165				1,114				3
Residential
Residential Mortgages			2,265				2,642				272				2,220				27
Residential Consumer Construction			65				69				—				65				—
		$	33,476			$	35,135			$	2,055			$	36,027			$	381

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Impaired Loans (dollars in thousands)
		For the Year Ended December 31, 2010
2010		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
With No Related Allowance Recorded:
Commercial		$	14,598			$	14,787			$	—			$	14,794			$	687
Commercial Real Estate
Commercial Mortgages-Owner Occupied			2,703				2,729				—				2,740				177
Commercial Mortgage Non-Owner Occupied			5,955				6,569				—				6,035				171
Commercial Construction			864				864				—				876				45
Consumer
Consumer Unsecured			—				—				—				—				—
Consumer Secured			366				660				—				371				13
Residential
Residential Mortgages			403				613				—				406				8
Residential Consumer Construction			65				68				—				66				1
With An Allowance Recorded:
Commercial		$	1,371			$	1,371			$	195			$	1,388			$	82
Commercial Real Estate
Commercial Mortgages-Owner Occupied			5,114				5,144				1,218				5,184				177
Commercial Mortgage Non-Owner Occupied			1,125				1,132				53				1,141				21
Commercial Construction			3,208				3,355				437				3,252				103
Consumer
Consumer Unsecured			572				589				75				578				15
Consumer Secured			456				456				195				461				25
Residential
Residential Mortgages			1,772				1,923				257				1,794				124
Residential Consumer Construction			—				—				—				—				—
Totals:
Commercial		$	15,969			$	16,158			$	195			$	16,182			$	769
Commercial Real Estate
Commercial Mortgages-Owner Occupied			7,817				7,873				1,218				7,924				354
Commercial Mortgage Non-Owner Occupied			7,080				7,701				53				7,176				192
Commercial Construction			4,072				4,219				437				4,128				148
Consumer
Consumer Unsecured			572				589				75				578				15
Consumer Secured			822				1,116				195				832				38
Residential
Residential Mortgages			2,175				2,536				257				2,200				132
Residential Consumer Construction			65				68				—				66				1
		$	38,572			$	40,260			$	2,430			$	39,086			$	1,649

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Allowance for Credit Losses and Recorded Investment in Financing Receivables (dollars in thousands)
		For the Three Months Ended March 31, 2011
2011		Commercial				Commercial Real Estate				Consumer				Residential				Total
Allowance for Credit Losses:
Beginning Balance		$	473			$	2,897			$	1,207			$	890			$	5,467
Charge-offs			(164	)			(313	)			(136	)			(126	)			(739	)
Recoveries			3				—				7				1				11
Provision			458				(75	)			98				98				579
Ending Balance			770				2,509				1,176				863				5,318
Ending Balance: Individually evaluated for impairment		$	268			$	1,350			$	165			$	272			$	2,055
Ending Balance: Collectively evaluated for impairment			502				1,159				1,011				591				3,263
Totals:		$	770			$	2,509			$	1,176			$	863			$	5,318
Financing Receivables:
Ending Balance: Individually evaluated for impairment			10,465				19,276				1,405				2,330				33,476
Ending Balance: Collectively evaluated for impairment			55,270				129,100				66,473				43,964				294,807
Totals:		$	65,735			$	148,376			$	67,879			$	46,294			$	328,284

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Allowance for Credit Losses and Recorded Investment in Financing  Receivables (dollars in thousands)
		For the Years Ended December 31, 2010
2010		Commercial				Commercial Real Estate				Consumer				Residential				Total
Allowance for Credit Losses:
Ending Balance: Individually evaluated for impairment		$	195			$	1,708			$	270			$	257			$	2,430
Ending Balance: Collectively evaluated for impairment			278				1,189				937				633				3,037
Totals:		$	473			$	2,897			$	1,207			$	890			$	5,467
Financing Receivables:
Ending Balance: Individually evaluated for impairment			15,969				18,969				1,394				2,240				38,572
Ending Balance: Collectively evaluated for impairment			46,817				124,459				66,895				49,439				287,610
Totals:		$	62,786			$	143,428			$	68,289			$	51,679			$	326,182

 

		Age Analysis of Past Due Financing Receivables as of March 31, 2011 (dollars in thousands)
2011		30-59 Days Past Due				60-89 Days Past Due				Greater than 90 Days				Total Past Due				Current				Total Financing Receivables				Recorded Investment > 90 Days & Accruing
Commercial		$	442			$	—			$	493			$	935			$	64,800			$	65,735			$	—
Commercial Real Estate:
Commercial Mortgages-Owner Occupied			2,317				—				362				2,679				64,309				66,988				—
Commercial Mortgages-Non-Owner Occupied			625				—				2,708				3,333				67,291				70,624				—
Commercial Construction			—				482				207				689				10,075				10,764				—
Consumer:
Consumer Unsecured			3				—				—				3				2,728				2,731				—
Consumer Secured			1,226				62				1,147				2,435				62,713				65,148				—
Residential:
Residential Mortgages			1,841				—				516				2,357				38,468				40,825				—
Residential Consumer Construction			81				—				65				146				5,323				5,464				—
Total		$	6,535			$	544			$	5,498			$	12,577			$	315,707			$	328,284			$	—

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Age Analysis of Past Due Financing Receivables December 31, 2010 (dollars in thousands)
2010		30-59 Days Past Due				60-89 Days Past Due				Greater than 90 Days				Total Past Due				Current				Total Financing Receivables				Recorded Investment > 90 Days & Accruing
Commercial		$	726			$	180			$	576			$	1,482			$	61,304			$	62,786			$	—
Commercial Real Estate:
Commercial Mortgages-Owner Occupied			1,390				299				553				2,242				62,120				64,362				—
Commercial Mortgages-Non-Owner Occupied			1,169				253				2,503				3,925				62,619				66,544				—
Commercial Construction			—				—				923				923				11,599				12,522				—
Consumer:
Consumer Unsecured			8				—				83				91				2,824				2,915				—
Consumer Secured			564				230				731				1,525				63,849				65,374				—
Residential:
Residential Mortgages			1,072				68				793				1,933				39,834				41,767				—
Residential Consumer Construction			—				—				65				65				9,847				9,912				—
Total		$	4,929			$	1,030			$	6,227			$	12,186			$	313,996			$	326,182			$	—

 

		Credit Quality Information - by Class March 31, 2011 (dollars in thousands)
		Pass				Monitor				Special Mention				Substandard				Doubtful				Totals
Commercial		$	45,470			$	3,437			$	10,037			$	6,649			$	142			$	65,735
Commercial Real Estate:
Commercial Mortgages-Owner Occupied			53,679				5,843				1,074				6,244				148				66,988
Commercial Mortgages-Non-Owner Occupied			55,005				2,869				6,425				6,325				—				70,624
Commercial Construction			6,749				533				1,369				2,113				—				10,764
Consumer
Consumer Unsecured			2,701				—				—				30				—				2,731
Consumer Secured			62,161				470				523				1,994				—				65,148
Residential:
Residential Mortgages			37,625				76				260				2,863				—				40,824
Residential Consumer Construction			5,405				—				—				65				—				5,470
Totals		$	268,795			$	13,228			$	19,688			$	26,283			$	290			$	328,284

 

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Note 9 – Loans and allowance for loan losses (continued)

 

		Credit Quality Information - by Class December 31, 2010 (dollars in thousands)
		Pass				Monitor				Special Mention				Substandard				Doubtful				Totals
Commercial		$	41,328			$	2,732			$	9,471			$	9,075			$	180			$	62,786
Commercial Real Estate:
Commercial Mortgages-Owner Occupied			50,485				5,535				1,378				6,814				150				64,362
Commercial Mortgages-Non-Owner Occupied			52,004				2,337				6,354				5,849				—				66,544
Commercial Construction			7,571				855				1,446				2,650				—				12,522
Consumer
Consumer Unsecured			2,805				—				1				34				75				2,915
Consumer Secured			63,225				475				349				1,325				—				65,374
Residential:
Residential Mortgages			38,504				77				—				3,014				172				41,767
Residential Consumer Construction			9,475				—				372				65				—				9,912
Totals		$	265,397			$	12,011			$	19,371			$	28,826			$	577			$	326,182

Note 10 – Subsequent Events

In preparing these financial statements, Financial has evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.

Note 11 – Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (FASB) issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosure guidance significantly expands the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements. The extensive new disclosures of information as of the end of a reporting period became effective for both interim and annual reporting periods ending on or after December 15, 2010. Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures, will be required for periods beginning on or after December 15, 2010. The Company has included the required disclosures in its consolidated financial statements.

 

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Note 11 – Recent Accounting Pronouncements (continued)

 

In December 2010, the FASB issued ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations.” The guidance requires pro forma disclosure for business combinations that occurred in the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period. If comparative financial statements are presented, the pro forma information should be reported as though the acquisition date for all business combinations that occurred during the current year had been as of the beginning of the comparable prior annual reporting period. ASU 2010-29 is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2010, the FASB issued ASU 2010-28, “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

The Securities Exchange Commission (SEC) has issued Final Rule No. 33-9002, “Interactive Data to Improve Financial Reporting”, which requires companies to submit financial statements in XBRL (extensible business reporting language) format with their SEC filings on a phased-in schedule. Large accelerated filers and foreign large accelerated filers using U.S. GAAP were required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2010. All remaining filers are required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2011.

In March 2011, the SEC issued Staff Accounting Bulletin (SAB) 114. This SAB revises or rescinds portions of the interpretive guidance included in the codification of the Staff Accounting Bulletin Series. This update is intended to make the relevant interpretive guidance consistent with current authoritative accounting guidance issued as a part of the FASB’s Codification. The principal changes involve revision or removal of accounting guidance references and other conforming changes to ensure consistency of referencing through the SAB Series. The effective date for SAB 114 is March 28, 2011. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” The amendments in this ASU clarify the guidance on a creditor’s evaluation of whether it has granted a concession to a debtor. They also clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty. The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011. Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, an entity may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company is currently assessing the impact that ASU 2011-02 will have on its consolidated financial statements.

 

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. The words “believe,” “estimate,” “expect,” “intend,” “anticipate,” “plan” and similar expressions and variations thereof identify certain of such forward-looking statements which speak only as of the dates on which they were made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those indicated in the forward-looking statements as a result of various factors. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which we operate); competition for our customers from other providers of financial services; government legislation and regulation relating to the banking industry (which changes from time to time and over which we have no control) including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act; changes in the value of real estate securing loans made by the Bank; changes in interest rates; and material unforeseen changes in the liquidity, results of operations, or financial condition of our customers. Other risks, uncertainties and factors could cause our actual results to differ materially from those projected in any forward-looking statements we make.

GENERAL

Critical Accounting Policies

Bank of the James Financial Group, Inc.’s (“Financial”) financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss ratios as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

The allowance for loan losses is management’s estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450 “Contingencies”, which requires that losses be accrued when they are probable of occurring and are reasonably estimable and (ii) ASC 310 “Impairment of a Loan”, which requires that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Guidelines for determining allowances for loan losses are also provided in the SEC Staff Accounting Bulletin No. 102 – “Selected Loan Loss Allowance Methodology and Documentation Issues” and the Federal Financial Institutions Examination Council’s interagency guidance, “Interagency Policy Statement on the Allowance for Loan and Lease Losses” (the “FFIEC Policy Statement”). See “Management Discussion and Analysis Results of Operations – Allowance for Loan Losses and Loan Loss Reserve” below for further discussion of the allowance for loan losses.

 

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Overview

Financial is a bank holding company headquartered in Lynchburg, Virginia. Our primary business is retail banking which we conduct through our wholly-owned subsidiary, Bank of the James (which we refer to as the “Bank”). We conduct three other business activities, mortgage banking through the Bank’s Mortgage division (which we refer to as “Mortgage”), investment services through the Bank’s Investment division (which we refer to as “Investment”), and insurance activities through BOTJ Insurance, Inc., a subsidiary of the Bank, (which we refer to as “Insurance”).

Financial declared a 10% stock dividend on May 18, 2010 which was paid on July 23, 2010 to shareholders of record on June 21, 2010.

The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia. The Bank was incorporated under the laws of the Commonwealth of Virginia as a state chartered bank in 1998 and began banking operations in July 1999. The Bank was organized to engage in general retail and commercial banking business. The Bank is a community-oriented financial institution that provides varied banking services to individuals, small and medium-sized businesses, and professional concerns in the Central Virginia, Region 2000 area, which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the City of Bedford, Bedford County, Campbell County, and the City of Lynchburg. The Bank strives to provide its customers with products comparable to statewide regional banks located in its market area, while maintaining the prompt response time and level of service of a community bank. Management believes this operating strategy has particular appeal in the Bank’s market area.

The Bank’s principal office is located at 828 Main Street, Lynchburg, Virginia 24504 and its telephone number is (434) 846-2000. The Bank also maintains a website at www.bankofthejames.com.

Our operating results depend primarily upon the Bank’s net interest income, which is determined by the difference between (i) interest and dividend income on earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. The Bank’s net income also is affected by its provision for loan losses, as well as the level of its non-interest income, including loan fees and service charges, and its non-interest expenses, including salaries and employee benefits, occupancy expense, data processing expenses, Federal Deposit Insurance Corporation premiums, expense in complying with the Sarbanes-Oxley Act of 2002, miscellaneous other expenses, franchise taxes, and income taxes.

The Bank intends to enhance its profitability by increasing its market share in the Region 2000 area, providing additional services to its customers, and controlling costs.

The Bank now services its banking customers through the following nine full service branch locations in the Region 2000 area.

 

•

The main office located at 828 Main Street in Lynchburg (opened October 2004) (the “Main Street Office”),

 

•

A branch located at 615 Church Street in Lynchburg (opened July 1999) (the “Church Street Branch”),

 

•

A branch located at 5204 Fort Avenue in Lynchburg (opened November 2000) (the “Fort Avenue Branch”),

 

•

A branch located on South Amherst Highway in Amherst County (opened June 2002) (the “Madison Heights Branch”),

 

•

A branch located at 17000 Forest Road in Forest (opened February 2005) (the “Forest Branch”),

 

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•

A branch located at 4935 Boonsboro Road, Suites C and D in Lynchburg (opened April 2006) (the “Boonsboro Branch”),

 

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A branch located at 164 South Main Street, Amherst, Virginia (opened January 2007) (the “Amherst Branch”),

 

•

A branch located at 1405 Ole Dominion Boulevard in the City of Bedford, Virginia, located off of Independence Boulevard (opened October 2008) (the “Bedford Branch”), and

 

•

A branch located at 1110 Main Street, Altavista, Virginia (relocated from temporary branch in June 2009) (the “Altavista Branch”).

The Bank also has opened a limited-service branch located in the Westminster-Canterbury facilities located at 501 VES Road, Lynchburg, Virginia 24503.

In addition, the Bank, through its mortgage division, originates residential mortgage loans through two offices—one located at the Forest Branch and the other located at 1152 Hendricks Store Road, Moneta, Virginia.

The Investment division operates primarily out of its office located at the Church Street Branch.

The Bank continuously evaluates areas located within Region 2000 to identify additional viable branch locations. Based on this ongoing evaluation, the Bank may acquire one or more additional suitable sites.

Subject to regulatory approval, the Bank anticipates opening additional branches during the next two fiscal years. Although numerous factors could influence the Bank’s expansion plans, the following discussion provides a general overview of the additional branch location that the Bank currently is considering.

Timberlake Road Area, Campbell County (Lynchburg), Virginia. As previously disclosed, the Bank has purchased certain real property located at the intersection of Turnpike and Timberlake Roads, Campbell County, Virginia. The Bank does not anticipate opening a branch at this location prior to 2012. The Bank has determined that the existing structure is not suitable for use as a bank branch.

Rustburg, Virginia. In March, 2011 the Bank purchased certain real property near the intersection of Routes 501 and 24 in Rustburg, Virginia. The structure on the property is being demolished and removed. The Bank does not anticipate opening a branch at this location prior to the first quarter of 2013.

The Bank estimates that the cost of improvements, furniture, fixtures, and equipment necessary to upfit the property will be between $900,000 and $1,500,000 per location.

Although the Bank cannot predict with certainty the financial impact of each new branch, management generally anticipates that each new branch will become profitable within 12 to 18 months of operation.

Subject to terms acceptable to the Bank, the Bank may consider entering into sale-leaseback arrangements for one or more of its branches.

Except as set forth herein, the Bank does not expect to purchase any significant property or equipment in the upcoming 12 months. Future branch openings are subject to regulatory approval.

 

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OFF-BALANCE SHEET ARRANGEMENTS

The Bank is a party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets and could impact the overall liquidity and capital resources to the extent customers accept and/or use these commitments.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments is as follows:

 

		March 31, 2011 (in thousands)
Commitments to extend credit		$	48,040
Letters of Credit			2,107
Total		$	50,147

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the Bank’s credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Collateral is required in instances that the Bank deems necessary.

SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion represents management’s discussion and analysis of the financial condition of Financial as of March 31, 2011 and December 31, 2010 and the results of operations of Financial for the three month period ended March 31, 2011 and 2010. This discussion should be read in conjunction with the financial statements included elsewhere herein and should be read in the context of the length of time for which the Bank has been operating.

All financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.

Financial Condition Summary

March 31, 2011 as Compared to December 31, 2010

Total assets were $430,903,000 on March 31, 2011 compared with $418,928,000 at December 31, 2010, an increase of 2.86%. The increase in total assets is due primarily to an increase in Federal funds sold and securities available-for-sale resulting from an increase in deposits, as explained in the following paragraph.

 

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Total deposits increased from $368,390,000 as of December 31, 2010 to $379,207,000 on March 31, 2011, an increase of 2.94%. This increase occurred because of the Bank’s increased efforts to obtain lower costing demand deposits and the Bank’s increased presence in the market.

Total loans increased to $328,284,000 on March 31, 2011 from $326,182,000 on December 31, 2010. Loans, net of unearned income and allowance, increased to $322,966,000 on March 31, 2011 from $320,715,000 on December 31, 2010, an increase of 0.70%. The following summarizes the position of the Bank’s loan portfolio as of the dates indicated by dollar amount and percentages (dollar amounts in thousands):

 

		March 31, 2011								December 31, 2010
		Amount				Percentage				Amount				Percentage
Commercial		$	65,735				20.02	%		$	62,786				19.25	%
Commercial Real Estate			148,376				45.20	%			143,428				43.97	%
Consumer			67,879				20.68	%			68,289				20.94	%
Residential			46,294				14.10	%			51,679				15.84	%
Total loans		$	328,284				100.00	%		$	326,182				100.00	%

Total nonperforming assets, which consist of non-accrual loans and other real estate owned (“OREO”) decreased to $10,916,000 on March 31, 2011 from $11,806,000 on December 31, 2010. This decrease was primarily due to a decrease in nonperforming loans. The decrease largely resulted from charge-offs of $739,000 in the quarter ended March 31, 2011. Non-accrual loans decreased 16.50% to $6,985,000 on March 31, 2011 from $8,366,000 on December 31, 2010. As discussed in more detail below under “Results of Operations—Allowance for Loan Losses”, management has provided for the anticipated losses on these loans in the loan loss reserve. If interest on non-accrual loans had been accrued, such interest on a cumulative basis would have approximated $837,000 and $1,059,000, as of March 31, 2011 and December 31, 2010, respectively. Loan payments received on non-accrual loans are first applied to principal. When a loan is placed on non-accrual status there are several negative implications. First, all interest accrued but unpaid at the time of the classification is reversed and deducted from the interest income totals for the Bank. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Third, there may be actual losses that necessitate additional provisions for credit losses charged against earnings. These loans were included in the non-performing loan totals listed above.

OREO represents real property owned by the Bank acquired either through purchase at foreclosure or received from the borrower through a deed in lieu of foreclosure. On December 31, 2010, the Bank was carrying 15 OREO properties on its books at a value of $3,440,000. During the quarter ended March 31, 2011, the Bank acquired 7 additional OREO properties and disposed of 5 OREO properties, and as of March 31, 2011 the Bank is carrying 17 OREO properties at a value of $3,931,000. The OREO properties are available for sale and are being actively marketed on the Bank’s website and through other means.

The amount of troubled debt restructurings (“TDR”) included at March 31, 2011 and December 31, 2010 was $5,064,000 and $4,987,000, respectively.

Cash and cash equivalents increased to $23,913,000 on March 31, 2011 from $18,759,000 on December 31, 2010. Cash and cash equivalents consist of cash due from correspondents, cash in vault, and overnight investments (including federal funds sold). This increase is due primarily to routine fluctuations in deposits, including fluctuations in transactional accounts and professional settlement accounts, both of which are subject to fluctuations, and will contribute to variations in cash and cash equivalents.

 

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Because of the call of one bond, securities held-to-maturity decreased slightly to $13,241,000 on March 31, 2011 from $14,297,000 on December 31, 2010. Securities available-for-sale increased to $44,047,000 on March 31, 2011 from $38,586,000 December 31, 2010. During the three months ended March 31, 2011 the Bank received $719,000 in proceeds from maturities and/or calls of securities-available-for sale. The Bank purchased $8,324,000 in securities available-for sale during the same period. The increase from December 31, 2010 in securities available-for-sale was primarily due to the investment of funds received from an increase in deposit accounts.

Financial’s investment in FHLBA stock totaled $1,372,700 at both March 31, 2011 and December 31, 2010. FHLBA stock is generally viewed as a long-term investment and because there is no market for the stock other than other Federal Home Loan Banks or member institutions, FHLBA stock is viewed as a restricted security. Therefore, when evaluating FHLBA stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Effective August 17, 2010, the FHLBA resumed the repurchase of Subclass B2 activity-based stock.

At March 31, 2011, Financial had liquid assets of approximately $67,960,000 in the form of cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold and available-for-sale investments. Management believes that liquid assets were adequate at March 31, 2011. Management anticipates that additional liquidity will be provided by the growth in deposit accounts and loan repayments at the Bank. In addition, the Bank has the ability to purchase federal funds on the open market and borrow from the Federal Reserve Bank’s discount window, if necessary.

In connection with a private placement of unregistered debt securities, Financial issued capital notes in the amount $7,000,000 (the “Notes”) in 2009. The Notes bear interest at the rate of 6% per year with interest payable quarterly in arrears. No principal payments are due until the Notes mature on April 1, 2012, the date on which the Notes mature and the principal and all accrued but unpaid interest on the Notes will be due and payable. During the three months ended March 31, 2011, Financial made an interest payment on the Notes totaling $105,000.

Management is not aware of any trends, events or uncertainties that are reasonably likely to have a material negative impact on Financial’s short-term or long-term liquidity.

At March 31, 2011, the Bank had a leverage ratio of 7.72%, a Tier 1 risk-based capital ratio of 10.23% and a total risk-based capital ratio of 11.49%. As of March 31, 2011 and December 31, 2010 the Bank’s regulatory capital levels exceeded those established for well-capitalized institutions. The following table sets forth the minimum capital requirements and the Bank’s capital position as of March 31, 2011 and December 31, 2010:

Bank Level Only Capital Ratios

 

Analysis of Capital (in 000’s)		March 31, 2011				December 31, 2010
Tier 1 Capital:
Common stock		$	3,743			$	3,742
Surplus			19,325				19,325
Retained earnings			9,570				9,049
Total Tier 1 capital		$	32,638			$	32,116
Tier 2 Capital:
Allowance for loan losses		$	4,003			$	3,989
Total Tier 2 Capital:		$	4,003			$	3,989
Total risk-based capital		$	36,641			$	36,105
Risk weighted assets		$	318,917			$	317,606
Average total assets		$	422,577			$	423,349

 

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		Actual								Regulatory Benchmarks
		March 31, 2011				December 31, 2010				For Capital Adequacy Purposes				For Well Capitalized Purposes
Capital Ratios:
Tier 1 capital to average total assets ratio (leverage ratio)			7.72	%			7.59	%			4.00	%			5.00	%
Tier 1 risk based capital ratio			10.23	%			10.11	%			4.00	%			6.00	%
Total risk-based capital ratio			11.49	%			11.37	%			8.00	%			10.00	%

The above tables set forth the capital position and analysis for the Bank only. Because total assets on a consolidated basis are less than $500,000,000, Financial is not subject to the consolidated capital requirements imposed by the Bank Holding Company Act. Consequently, Financial does not calculate its financial ratios on a consolidated basis. If calculated, the capital ratios for the Company on a consolidated basis would no longer be comparable to the capital ratios of the Bank because the proceeds of the private placement do not qualify as equity capital on a consolidated basis.

Results of Operations

Comparison of the Three Months Ended March 31, 2011 and 2010

Earnings Summary

Financial had net income of $435,000 for the three months ended March 31, 2011 compared to $366,000 for the comparable period in 2010. The basic and diluted earnings per common share for the three months ended March 31, 2011 were $0.13 compared to $0.11 for the same period in 2010. All earnings per share amounts have been adjusted to reflect the 10% stock dividend paid by Financial in July 2010 and all prior stock dividends.

The increase in net income was due in large part to a significant decrease in interest expense.

These operating results represent an annualized return on stockholders’ equity of 6.74% for the three months ended March 31, 2011, compared with 6.13% for the same period in 2010. The Company had an annualized return on average assets for the three months ended March 31, 2011 of 0.42%, compared with 0.35% for the same period in 2010.

Interest Income, Interest Expense, and Net Interest Income

Interest income decreased to $4,942,000 for the three months ended March 31, 2011 from $5,368,000 for the same period in 2010, a decrease of 7.94%. The rate on total average earning assets decreased from 5.55% for the three month period ended March 31, 2010 to 5.11% for the three months ended March 31, 2011 in part because the Bank invested a greater percentage of its earning assets in loans and investment securities rather than federal funds. Although management cannot be certain, management expects that interest rates will remain near historic lows for the remainder of 2011 and may negatively impact our interest income.

 

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Interest expense decreased to $1,235,000 for the three months ended March 31, 2011 from $2,079,000 for the same period in 2010, a decrease of 40.60%. This significant decrease in interest expense resulted in large part from a decrease in the rate paid on those balances. The Bank’s average rate paid on deposits was 2.29% during the three month period ended March 31, 2010 as compared to 1.30% for the same period in 2011. This resulted from management’s efforts to minimize the Bank’s interest expense and maximize its net interest margin.

The fundamental source of the Bank’s revenue is net interest income, which is determined by the difference between (i) interest and dividend income on interest earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. Net interest income for the three months ended March 31, 2011 was $3,707,000 compared with $3,289,000 for the same period in 2010. The net interest margin increased to 3.83% for the three months ended March 31, 2011 from 3.40% in the same period a year ago. The increase in net interest income for the three months ended March 31, 2011 as compared with the comparable three months in 2010 was due to a decrease in the average rate paid on deposits, primarily resulting from a decrease in the balance in and rate paid on the 2010 Savings Account.

Financial’s net interest margin analysis and average balance sheets are shown in Schedule I on page 37.

Non-Interest Income

Non-interest income, which is comprised primarily of fees and charges on transactional deposit accounts, mortgage loan origination fees, commissions on sales of investments and the Bank’s ownership interest in a title insurance agency, decreased to $672,000 ($641,000 exclusive of a gain of $31,000 on the sale of securities) for the three months ended March 31, 2011 from $800,000 ($725,000 exclusive of a gain of $75,000 on the sale of securities). This decrease for the three months ended March 31, 2011 as compared to the same periods last year was due primarily to a decrease in service charges, fees, and commissions.

The Bank, through the Mortgage Division, originates both conforming and non-conforming consumer residential mortgage loans in the Region 2000 area. As part of the Bank’s overall risk management strategy, all of the loans originated and closed by the Mortgage Division are presold to major national mortgage banking or financial institutions. The Mortgage Division assumes no credit or interest rate risk on these mortgages.

Management anticipates that residential mortgage rates will remain near the current historic lows for the remainder of 2011. Management expects that low rates coupled with the Mortgage Division’s reputation in Region 2000 will allow us to continue to grow revenue at the Mortgage Division. Revenue from mortgage origination fees increased in the three month period ended March 31, 2011 as compared to the same period for 2010. Management believes that regulatory pressure may result in a decreased number of competitors to the Mortgage Division and this could result in an increase in market share.

Our Investment division provides brokerage services through an agreement with a third-party broker-dealer. Pursuant to this arrangement, the third party broker-dealer operates a service center adjacent to one of the branches of the Bank. The center is staffed by dual employees of the Bank and the broker-dealer. Investment receives commissions on transactions generated and in some cases ongoing management fees such as mutual fund 12b-1 fees. The Investment division’s financial impact on our consolidated revenue has been immaterial. Although management cannot predict the financial impact of Investment with certainty, management anticipates it will continue to be an immaterial component of revenue in 2011.

In the third quarter of 2008, we began providing insurance and annuity products to Bank customers and others, through the Bank’s Insurance subsidiary. The Bank has one full-time and one part-time

 

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employee that are dedicated to selling insurance products through Insurance. Insurance generates minimal revenue and its financial impact on our consolidated revenue has been immaterial. Management anticipates that Insurance’s impact on noninterest income will remain immaterial in 2011.

Non-Interest Expense

Non-interest expense for the three months ended March 31, 2011 increased to $3,170,000, or 0.38% from $3,158,000 for the comparable period in 2010. This slight increase in non-interest expense from the comparable period in 2010 can be attributed to increased occupancy and outside expenses, loss on sale of OREO and OREO related expenses, as well as increase in the FDIC assessment. These increased expenses were offset in part by a decrease in compensation expense, which resulted primarily from a decrease in commission expense as well as the Bank’s decision to restructure certain departments and the resulting reduced staffing.

Total personnel expense was $1,427,000 for the three month period ended March 31, 2011 as compared to $1,649,000 for the same period in 2010. Compensation for some employees of the Mortgage Division and Investment Division is commission-based and therefore subject to fluctuation.

During the quarter ended March 31, 2011, the FDIC premium expense increased to $229,000 from $192,000 for the three months ended March 31, 2010. FDIC Assessment payments have increased in large part because of i) FDIC coverage on accounts has increased from $100,000 to $250,000; ii) the FDIC is charging additional premiums for participation in the Transactional Account Guarantee Program (TAGP); and iii) an increase in the total base assessment rates needed to replenish the fund.

Allowance for Loan Losses

The provision to the allowance for loan losses is charged to earnings to bring the total allowance to a level deemed appropriate by management and is based upon many factors, including calculations of specific impairment of certain loans, general economic conditions, actual and expected credit losses, loan performance measures, historical trends and specific conditions of the individual borrower. Based on the application of the loan loss calculation, the Bank provided $579,000 to the allowance for loan loss for the three months ended March 31, 2011 compared to provision of $387,000 for the comparable period in 2009.

The increase in the loan loss provision for the quarter ended March 31, 2011 as compared to the same quarter in 2010 was due to the following factors:

 

•

The quality of certain assets, primarily commercial development loans and residential speculative housing construction loans, were impacted by a decline in the value of the collateral supporting the loan. Management’s initial evaluation of these assets classes resulted in the increased provision in the quarter ended March 31, 2011.

 

•

In light of the current economic environment, management continues its ongoing assessment of specific impairment in the Bank’s loan portfolio. The analysis resulted in a decrease in the provision for the quarter ended March 31, 2011 as compared to the same quarter in 2010.

Management believes that the current allowance for loan loss of $5,318,000 (or 1.62% of total loans) at March 31, 2011, as compared to $5,467,000 (or 1.68% of total loans) as of December 31, 2010 is adequate.

 

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The following sets forth the reconciliation of the allowance for loan loss:

 

		Three months ended March  31, (in thousands)
		2011				2010
Balance, beginning of period		$	5,467			$	4,288
Provision for loan losses			579				387
Loans charged off			(739	)			(226	)
Recoveries of loans charged off			11				195
Net Charge Offs			(728	)			(31	)
Balance, end of period			5,318				4,644

Net charge offs increased from $31,000 for the three months ended March 31, 2010 to $728,000 for the same period in 2011. Charged off loans, which are loans that management deems uncollectible, are written against the loan loss reserve and constitute a realized loss. While a charged off loan may subsequently be collected, such recoveries generally are realized over an extended period of time. The decreased balance in the allowance for loan loss reserve (both in amount and percentage of total loans) as of March 31, 2011 as compared to March 31, 2010 resulted from the charge-offs that occurred in the first quarter of 2011.

Income Taxes

For the three months ended March 31, 2011, Financial had an income tax expense of $195,000.

Legislation

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Reform Act”) was signed into law. The Dodd-Frank Reform Act represents a significant overhaul of many aspects of the regulation of the financial services industry, although many of its provisions (e.g., the interchange and trust preferred capital limitations) apply to companies that are significantly larger than Financial. The Dodd-Frank Reform Act directs applicable regulatory authorities to promulgate regulations implementing its provisions, and its effect on Financial and on the financial services industry as a whole will be clarified as those regulations are issued. Major elements of the Dodd-Frank Reform Act include:

 

•

A permanent increase in deposit insurance coverage to $250,000 per account, permanent unlimited deposit insurance on noninterest-bearing transaction accounts, and an increase in the minimum Deposit Insurance Fund reserve requirement for banks having consolidated assets in excess of $10 billion from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits.

 

•

New disclosure and other requirements relating to executive compensation and corporate governance.

 

•

Amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations.

 

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•

The establishment of the Financial Stability Oversight Council, which will be responsible for identifying and monitoring systemic risks posed by financial firms, activities, and practices.

 

•

The development of regulations to limit debit card interchange fees.

 

•

The future elimination of trust preferred securities as a permitted element of Tier 1 capital.

 

•

The creation of a special regime to allow for the orderly liquidation of systemically important financial companies, including the establishment of an orderly liquidation fund.

 

•

The development of regulations to address derivatives markets, including clearing and exchange trading requirements and a framework for regulating derivatives-market participants.

 

•

Enhanced supervision of credit rating agencies through the Office of Credit Ratings within the SEC.

 

•

Increased regulation of asset-backed securities, including a requirement that issuers of asset-backed securities retain at least 5% of the risk of the asset-backed securities.

 

•

The establishment of a Bureau of Consumer Financial Protection, within the Federal Reserve, to serve as a dedicated consumer-protection regulatory body.

 

•

On February 7, 2011, the FDIC issued a final rule redefining the assessment base as required by Dodd-Frank. The final rule adopted a separate risk-based assessment system for large insured depository institutions (institutions with greater than $10 billion in assets). The final rule applies to all insured depository institutions and is effective on April 1, 2011.

Financial continues to evaluate the potential impact of the Dodd-Frank Reform Act.

 

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Schedule I

Net Interest Margin Analysis

Average Balance Sheets

For the Quarter Ended March 31, 2011 and 2010

 

		2011												2010
		Average Balance Sheet				Interest Income/ Expense				Average Rates Earned/ Paid				Average Balance Sheet				Interest Income/ Expense				Average Rates Earned/ Paid
ASSETS
Loans, including fees		$	326,054			$	4,473				5.56	%		$	325,956			$	4,844				6.03	%
Federal funds sold			8,371				5				0.24	%			12,196				7				0.23	%
Securities			55,888				461				3.35	%			52,076				516				4.02	%
Federal agency equities			2,065				3				0.59	%			2,218				1				0.18	%
CBB equity			116				—				—				116				—				—
Total earning assets			392,494				4,942				5.11	%			392,562				5,368				5.55	%
Allowance for loan losses			(5,417	)											(4,368	)
Non-earning assets			36,355												36,073
Total assets		$	423,432											$	424,267
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Demand interest bearing		$	61,945			$	111				0.73	%		$	49,520			$	137				1.12	%
Savings			182,728				501				1.11	%			190,488				1,087				2.31	%
Time deposits			80,968				429				2.15	%			86,324				617				2.90	%
Total interest bearing deposits			325,641				1,041				1.30	%			326,332				1,841				2.29	%
Other borrowed funds
Repurchase agreements			7,206				16				0.90	%			9,553				33				1.40	%
Other borrowings			10,000				73				2.96	%			13,889				100				2.92	%
Capital Notes			7,000				105				6.00	%			7,000				105				6.00	%
Total interest-bearing liabilities			349,847				1,235				1.43	%			356,774				2,079				2.36	%
Non-interest bearing deposits			47,095												42,296
Other liabilities			331												999
Total liabilities			397,273												400,069
Stockholders’ equity			26,159												24,198
Total liabilities and Stockholders equity		$	423,432											$	424,267
Net interest earnings						$	3,707											$	3,289
Net interest margin											3.83	%											3.40	%
Interest spread											3.68	%											3.19	%

 

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Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Not applicable.

 

Item 4.

Controls and Procedures

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Financial’s management, including Financial’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, Financial’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that Financial files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

There have been no significant changes during the quarter ended March 31, 2011, in the Company’s internal controls over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) or in other factors that could have significantly affected those controls subsequent to the date of our most recent evaluation of internal controls over financial reporting, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – OTHER INFORMATION

 

Item 1.

Legal Proceedings

The Bank is not involved in any pending legal proceedings at this time, other than routine litigation incidental to its business.

 

Item 1A.

Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC on March 28, 2011.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

 

Item 3.

Defaults Upon Senior Securities

Not applicable

 

Item 4.

[Removed and Reserved]

 

Item 5.

Other Information

Not applicable.

 

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Item 6.

Exhibits

The following are filed as Exhibits to this Form 10-Q:

 

Exhibit No.		Description of Exhibit
31.1		Certification of Robert R. Chapman III Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 13, 2011
31.2		Certification of J. Todd Scruggs Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 13, 2011
32.1		Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002, dated May 13, 2011

 

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

				BANK OF THE JAMES FINANCIAL GROUP, INC.
Date: May 13, 2011				By		/S/ Robert R. Chapman III
						Robert R. Chapman III, President (Principal Executive Officer)
Date: May 13, 2011				By		/S/ J. Todd Scruggs
						J. Todd Scruggs, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)

 

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Index of Exhibits

 

Exhibit No.		Description of Exhibit
31.1		Certification of Robert R. Chapman III Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 13, 2011
31.2		Certification of J. Todd Scruggs Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated May 13, 2011
32.1		Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002, dated May 13, 2011

 

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