MOUNTAIN NATIONAL BANCSHARES INC - FORM 10-Q

Attached files

file	filename
EX-32.1 - EXHIBIT 32.1 - MOUNTAIN NATIONAL BANCSHARES INC	c17358exv32w1.htm
EX-32.2 - EXHIBIT 32.2 - MOUNTAIN NATIONAL BANCSHARES INC	c17358exv32w2.htm
EX-31.1 - EXHIBIT 31.1 - MOUNTAIN NATIONAL BANCSHARES INC	c17358exv31w1.htm
EX-31.2 - EXHIBIT 31.2 - MOUNTAIN NATIONAL BANCSHARES INC	c17358exv31w2.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)


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

For the quarterly period ended March 31, 2011


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

For the transition period from to

Commission File Number: 0-49912

MOUNTAIN NATIONAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)


Tennessee		75-3036312
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)


300 East Main Street
Sevierville, Tennessee		37862
(Address of principal executive offices)		(Zip Code)

(865) 428-7990
(Registrant’s telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report)

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 such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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 o No o

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


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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date. Common stock outstanding: 2,631,611 shares as of May 1, 2011.

MOUNTAIN NATIONAL BANCSHARES, INC.
Quarterly Report on Form 10-Q
For the quarter ended March 31, 2011

Table of Contents


Item	Page
Number	Number

Part I — Financial Information

1. Financial Statements (Unaudited)

Consolidated Balance Sheets — March 31, 2011 and December 31, 2010		3

Consolidated Statements of Operations — Three months ended March 31, 2011 and 2010		4

Consolidated Statements of Changes in Shareholders’ Equity — Three months ended March 31, 2011 and 2010		5

Consolidated Statements of Cash Flows — Three months ended March 31, 2011 and 2010		6

Notes to Consolidated Financial Statements		7

2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		25

4. Controls and Procedures		48

Part II — Other Information

1A. Risk Factors		50

6. Exhibits		50

Signatures		51

Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I — FINANCIAL INFORMATION


ITEM 1.		FINANCIAL STATEMENTS

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS


	March 31,			December 31,
	2011			2010
	(unaudited)
ASSETS

Cash and due from banks	$	9,645,502		$	30,039,647
Federal funds sold		6,249,007			2,536,173


Total cash and cash equivalents		15,894,509			32,575,820

Securities available for sale		89,765,600			86,316,591
Securities held to maturity, fair value $1,350,730 at March 31, 2011 and $1,303,080 at December 31, 2010		1,333,297			1,317,951
Restricted investments, at cost		3,843,150			3,843,150
Loans, net of allowance for loan losses of $10,037,471 at March 31, 2011 and $10,942,414 at December 31, 2010		355,090,981			363,413,050
Investment in partnership		4,306,002			4,303,600
Premises and equipment		32,276,720			32,600,673
Accrued interest receivable		1,661,787			1,495,869
Cash surrender value of company owned life insurance		11,871,917			11,774,605
Other real estate owned		12,936,232			13,140,698
Other assets		4,505,183			6,424,504


Total assets	$	533,485,378		$	557,206,511


LIABILITIES AND SHAREHOLDERS’ EQUITY

Deposits:
Noninterest-bearing demand deposits	$	48,492,160		$	47,638,792
NOW accounts		54,389,421			57,344,798
Money market accounts		48,809,424			49,701,122
Savings accounts		23,608,702			23,733,795
Time deposits		254,098,323			271,172,901


Total deposits		429,398,030			449,591,408


Securities sold under agreements to repurchase		866,045			432,016
Accrued interest payable		658,391			719,133
Subordinated debentures		13,403,000			13,403,000
Federal Home Loan Bank advances		55,200,000			55,200,000
Other liabilities		1,116,903			2,186,784


Total liabilities		500,642,369			521,532,341


Commitments and contingencies

Shareholders’ equity:
Preferred stock, no par value; 1,000,000 shares authorized; 0 shares issued and outstanding		—			—
Common stock, $1.00 par value; 10,000,000 shares authorized; 2,631,611 issued and outstanding		2,631,611			2,631,611
Additional paid-in capital		42,255,363			42,229,713
Retained earnings (deficit)		(11,501,513	)		(8,122,476	)
Accumulated other comprehensive income (loss)		(542,452	)		(1,064,678	)


Total shareholders’ equity		32,843,009			35,674,170


Total liabilities and shareholders’ equity	$	533,485,378		$	557,206,511

See accompanying Notes to Consolidated Financial Statements

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)


	Three months ended March 31,
	2011			2010

INTEREST INCOME
Loans	$	4,609,498		$	5,148,435
Taxable securities		553,167			768,934
Tax-exempt securities		57,914			102,757
Federal funds sold and deposits in other banks		5,884			10,698


Total interest income		5,226,463			6,030,824

INTEREST EXPENSE
Deposits		1,453,299			2,179,182
Repurchase agreements		2,690			5,919
Federal Reserve and Federal Home Loan Bank advances		554,574			638,156
Subordinated debentures		76,749			80,051


Total interest expense		2,087,312			2,903,308


Net interest income		3,139,151			3,127,516

Provision for loan losses		3,000,000			212,300


Net interest income after provision for loan losses		139,151			2,915,216


NONINTEREST INCOME
Service charges on deposit accounts		378,072			398,212
Other fees and commissions		330,599			326,444
Gain on sale of mortgage loans		22,655			45,713
Investment gains and losses, net		—			953,609

Other real estate gains and losses, net		13,673			59,029
Other noninterest income		141,860			192,459


Total noninterest income		886,859			1,975,466


NONINTEREST EXPENSE
Salaries and employee benefits		1,995,418			2,342,353
Occupancy expenses		454,008			448,700
FDIC assessment expense		351,832			312,312
Other operating expenses		1,504,554			1,479,988


Total noninterest expense		4,305,812			4,583,353


Income (loss) before income tax expense (benefit)		(3,279,802	)		307,329

Income tax expense (benefit)		99,235			(21,785	)


Net income (loss)	$	(3,379,037	)	$	329,114


EARNINGS (LOSS) PER SHARE
Basic	$	(1.28	)	$	0.13
Diluted	$	(1.28	)	$	0.13

See accompanying Notes to Consolidated Financial Statements

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Three Months Ended March 31, 2011 and 2010

(unaudited)


											Accumulated
						Additional		Retained			Other			Total
	Comprehensive			Common		Paid-in		Earnings			Comprehensive			Shareholders’
	Income (Loss)			Stock		Capital		(Deficit)			Income/(Loss)			Equity

BALANCE, January 1, 2010				$	2,631,611	$	42,125,828	$	2,328,702		$	283,014		$	47,369,155

Share-based compensation							2,110								2,110

Comprehensive income (loss):
Net income	$	329,114							329,114						329,114

Other comprehensive income:
Change in unrealized gains (losses) on securities available-for-sale		(273,412	)									(273,412	)		(273,412	)


Total comprehensive income		55,702


BALANCE, March 31, 2010					2,631,611		42,127,938		2,657,816			9,602			47,426,967


BALANCE, January 1, 2011				$	2,631,611	$	42,229,713	$	(8,122,476	)	$	(1,064,678	)	$	35,674,170

Share-based compensation							25,650								25,650

Comprehensive income (loss):
Net loss		(3,379,037	)						(3,379,037	)					(3,379,037	)

Other comprehensive income:
Change in unrealized gains (losses) on securities available-for-sale		522,226										522,226			522,226


Total comprehensive loss	$	(2,856,811	)


BALANCE, March 31, 2011				$	2,631,611	$	42,255,363	$	(11,501,513	)	$	(542,452	)	$	32,843,009

See accompanying Notes to Consolidated Financial Statements

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)


	Three months ended March 31,
	2011			2010

CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	(3,379,037	)	$	329,114
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		378,983			406,869
Net realized gains on securities available for sale		—			(942,085	)
Net realized gains on securities held to maturity		—			(11,524	)
Net amortization on available for sale securities		312,997			184,137
Increase in held to maturity due to accretion		(15,347	)		(16,232	)
Provision for loan losses		3,000,000			212,300
Net gain on other real estate		(13,673	)		(59,029	)
Gross mortgage loans originated for sale		(1,516,801	)		(4,352,282	)
Gross proceeds from sale of mortgage loans		1,602,956			3,527,245
Gain on sale of mortgage loans		(22,655	)		(45,713	)
Increase in cash surrender value of life insurance		(97,312	)		(102,000	)
Investment in partnership		(2,402	)		(71,650	)
Share-based compensation		25,650			2,110
Change in operating assets and liabilities:
Accrued interest receivable		(165,918	)		549,473
Accrued interest payable		(60,742	)		50,315
Other assets and liabilities		849,441			86,005


Net cash provided by (used in) operating activities		896,140			(252,947	)


CASH FLOWS FROM INVESTING ACTIVITIES
Activity in available-for-sale securities:
Proceeds from sales		—			80,373,113
Proceeds from maturities, prepayments and calls		7,034,461			29,269,199
Purchases		(10,274,241	)		(121,850,168	)
Activity in held-to-maturity securities:
Proceeds from sales		—			520,000
Purchases of restricted investments		—			(26,100	)
Loan originations and principal collections, net		5,068,569			3,198,491
Purchase of premises and equipment		(55	)		(90,611	)
Proceeds from sale of other real estate		353,164			851,762


Net cash provided by (used in) investing activities		2,181,898			(7,754,314	)


CASH FLOWS FROM FINANCING ACTIVITIES
Net (decrease) increase in deposits		(20,193,378	)		7,022,708
Net decrease in securities sold under agreements to repurchase		434,029			398,924


Net cash (used in) provided by financing activities		(19,759,349	)		7,421,632


NET DECREASE IN CASH AND CASH EQUIVALENTS		(16,681,311	)		(585,629	)

CASH AND CASH EQUIVALENTS, beginning of period		32,575,820			14,104,636


CASH AND CASH EQUIVALENTS, end of period	$	15,894,509		$	13,519,007


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for:
Interest	$	2,148,054		$	2,852,993
Income taxes		—			—
Non-cash investing and financing activities:
Transfers from loans to other real estate owned		190,000			760,692
Loans advanced for sales of other real estate		—			109,350
Transfers from held-to-maturity to available-for-sale securities		—			439,097

See accompanying Notes to Consolidated Financial Statements

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation and Accounting Policies

The unaudited consolidated financial statements in this report have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions of Form 10-Q and Rule 10-01 of Regulation S-X. The consolidated financial statements include the accounts of Mountain National Bancshares, Inc., a Tennessee corporation (the “Company”), and its subsidiaries. The Company’s principal subsidiary is Mountain National Bank, a national association (the “Bank”). All material intercompany accounts and transactions have been eliminated in consolidation.

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are now such matters that will have a material effect on the financial statements.

Certain information and note disclosures normally included in the Company’s annual audited financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted from the unaudited financial statements in this report. Consequently, the quarterly financial statements should be read in conjunction with the notes included herein and the notes to the audited financial statements presented in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The unaudited quarterly financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of the results of operations for interim periods presented. All such adjustments were of a normal, recurring nature. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the complete fiscal year.

Reclassifications: Some items in prior year financial statements were reclassified to conform to current presentation.

Note 2. New Accounting Standards

In July 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-20, “Receivables (Topic 310) — Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” ASU No. 2010-20 expands the disclosures about the credit quality of financing receivables and the related allowance for credit losses. The ASU also requires disaggregation of existing disclosures by portfolio segment. The amendments that require disclosures as of the end of a reporting period were effective for periods ending on or after December 15, 2010. The amendments that require disclosures about activity that occurs during a reporting period are effective for periods beginning on or after December 15, 2010. The adoption of this guidance expanded the Company’s disclosures surrounding credit quality of financing receivables and the related allowance for credit losses.

In April, 2011, the FASB issued ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” ASU No. 2011-02 intended to provide additional guidance to assist creditors in determining whether a restructuring of a receivable meets the criteria to be considered a Troubled Debt Restructuring (“TDR”). The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and are to be applied retrospectively to the beginning of the annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered TDRs. The Company is continuing to evaluate the impact of adoption of this ASU.

Note 3. Investment Securities

The following table summarizes the amortized cost and fair value of the available-for-sale and held-to-maturity investment securities portfolio at March 31, 2011 and December 31, 2010 and the corresponding amounts of unrealized gains and losses therein.


			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
March 31, 2011
Available-for-sale
U. S. Government securities	$	249,967	$	22	$	—		$	249,989
Obligations of states and political subdivisions		5,210,513		38,041		(259,571	)		4,988,983
Mortgage-backed securities-residential		84,671,859		287,144		(432,375	)		84,526,628

Total available-for-sale securities	$	90,132,339	$	325,207	$	(691,946	)	$	89,765,600


Held-to-maturity
Obligations of states and political subdivisions	$	1,333,297	$	17,433	$	—		$	1,350,730


December 31, 2010
Available-for-sale
U. S. Government securities	$	249,879	$	—	$	(13	)	$	249,866
Obligations of states and political subdivisions		5,201,492		17,407		(296,786	)		4,922,113
Mortgage-backed securities-residential		81,754,184		134,557		(744,129	)		81,144,612

Total available-for-sale securities	$	87,205,555	$	151,964	$	(1,040,928	)	$	86,316,591


Held-to-maturity
Obligations of states and political subdivisions	$	1,317,951	$	—	$	(14,871	)	$	1,303,080

The amortized cost and fair value of the investment securities portfolio are shown below by expected maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.


	March 31, 2011
	Amortized		Fair
	Cost		Value
Maturity
Available-for-sale
Within one year	$	249,967	$	249,989
One to five years		267,402		265,050
Five to ten years		1,190,455		1,206,613
Beyond ten years		3,752,656		3,517,320
Mortgage-backed securities-residential		84,671,859		84,526,628

Total	$	90,132,339	$	89,765,600


Held-to-maturity
Five to ten years		730,360		733,190
Beyond ten years		602,937		617,540

Total	$	1,333,297	$	1,350,730

The following table summarizes the investment securities with unrealized losses at March 31, 2011 and December 31, 2010 aggregated by major security type and length of time in a continuous unrealized loss position.


	Less than 12 Months					12 Months or Longer					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Loss			Value		Loss			Value		Loss
March 31, 2011
Available-for-sale
Obligations of states and political subdivisions	$	1,735,275	$	(72,520	)	$	1,589,233	$	(187,051	)	$	3,324,508	$	(259,571	)
Mortgage-backed securities-residential		47,584,756		(432,375	)		—		—			47,584,756		(432,375	)

Total available-for-sale	$	49,320,031	$	(504,895	)	$	1,589,233	$	(187,051	)	$	50,909,264	$	(691,946	)


December 31, 2010
Available-for-sale
U. S. Government securities	$	249,866	$	(13	)	$	—	$	—		$	249,866	$	(13	)
Obligations of states and political subdivisions		3,632,820		(112,755	)		1,571,970		(198,902	)		5,204,790		(311,657	)
Mortgage-backed securities-residential		57,369,268		(744,129	)		—		—			57,369,268		(744,129	)

Total available-for-sale	$	61,251,954	$	(856,897	)	$	1,571,970	$	(198,902	)	$	62,823,924	$	(1,055,799	)

Proceeds from sales of securities were approximately $80 million for the three months ended March 31, 2010. No securities were sold during the first quarter of 2011. Gross gains of $1,012,979 and gross losses of $59,370 were realized on these sales during the first three months of 2010.

During the first quarter of 2010, the Bank sold one security classified as held-to-maturity. The remaining held-to-maturity security in the Bank’s portfolio was reclassified as available for sale. The approximately $1.3 million residual balance in held-to-maturity securities at March 31, 2011 represents securities held in the portfolio of MNB Investments, Inc., a consolidated subsidiary of the Bank. MNB Investments, Inc. does not intend and it is not more likely than not that it would be required to sell these securities prior to maturity.

Other-Than-Temporary-Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (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) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

As of March 31, 2011, the Company’s securities portfolio consisted of 83 securities, 41 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s mortgage-backed securities and obligations of states and political subdivisions, as discussed below.

Unrealized losses on mortgage-backed securities and obligations of states and political subdivisions have not been recognized into income because the issuer(s)’ bonds are of high credit quality, the decline in fair value is largely due to changes in interest rates and other market conditions, and because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. The Company does not consider these securities to be other-than-temporarily impaired at March 31, 2011.

Note 4. Net Earnings (Loss) Per Common Share

Net earnings (loss) per common share are based on the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the effects of potential common shares outstanding, including shares issuable upon the exercise of options for which the exercise price is lower than the market price of the common stock, during the period.

The following is a summary of the basic and diluted earnings (loss) per share calculation for the three months ended March 31, 2011 and 2010:


	Three-Months Ended
	March 31,
	2011			2010
Basic earnings (loss) per share calculation:

Numerator — Net income (loss)	$	(3,379,037	)	$	329,114
Denominator — Average common shares outstanding		2,631,611			2,631,611

Basic net income (loss) per share	$	(1.28	)	$	0.13

Diluted earnings (loss) per share calculation:

Numerator — Net income (loss)		(3,379,037	)		329,114
Denominator — Average common shares outstanding		2,631,611			2,631,611
Dilutive shares contingently issuable		—			—

Average dilutive common shares outstanding		2,631,611			2,631,611

Diluted net income (loss) per share	$	(1.28	)	$	0.13

During the three months ended March 31, 2011 and 2010, there were options for the purchase of 122,133 and 125,086 shares, respectively, outstanding during each time period that were antidilutive. These shares were accordingly excluded from the calculations above.

Note 5. Loans and Allowance for Loan Losses

At March 31, 2011 and December 31, 2010, the Bank’s loans consisted of the following (in thousands):


	March 31,			December 31,
	2011			2010

Mortgage loans on real estate:
Residential 1-4 family	$	82,661		$	86,403
Residential multifamily		6,106			6,147
Commercial real estate		133,339			133,917
Construction and land development		78,784			83,543
Second mortgages		8,616			8,880
Equity lines of credit		24,808			25,391


		334,314			344,281


Commercial loans		25,911			24,944


Consumer installment loans:
Personal		2,607			2,855
Credit cards		2,296			2,275


		4,903			5,130


Total Loans		365,128			374,355
Less: Allowance for loan losses		(10,037	)		(10,942	)


Loans, net	$	355,091		$	363,413

Loans held for sale at March 31, 2011 and December 31, 2010 were $153,000 and $216,500, respectively. These loans are included in residential 1-4 family loans in the table above.

The following table presents the recorded investment in loans and the balance in the allowance for loan losses (“ALLL”) by portfolio segment and based on impairment method as of March 31, 2011 and December 31, 2010 (in thousands):


	Collectively Evaluated				Individually Evaluated
	for Impairment				for Impairment				Total
	March 31,		December 31,		March 31,		December 31,		March 31,		December 31,
	2011		2010		2011		2010		2011		2010
Loans:
Construction and development	$	39,041	$	42,026	$	39,743	$	41,517	$	78,784	$	83,543
Residential real estate		92,550		97,639		29,641		29,182		122,191		126,821
Commercial real estate		111,552		112,389		21,787		21,529		133,339		133,918
Commercial		25,798		24,831		113		113		25,911		24,944
Consumer/other		2,592		2,839		15		15		2,607		2,854
Credit cards		2,296		2,275		—		—		2,296		2,275

Total ending loan balance	$	273,829	$	281,999	$	91,299	$	92,356	$	365,128	$	374,355


Allowance for loan losses:
Construction and development	$	2,228	$	1,445	$	1,731	$	1,647	$	3,959	$	3,092
Residential real estate		2,784		1,653		1,085		2,444		3,869		4,097
Commercial real estate		1,160		1,444		272		617		1,432		2,061
Commercial		605		395		5		1		610		396
Consumer/other		46		97		—		1		46		98
Credit cards		121		121		—		—		121		121
Unallocated		—		1,077		—		—		—		1,077

Total ending allowance balance	$	6,944	$	6,232	$	3,093	$	4,710	$	10,037	$	10,942

The following table details the changes in the allowance for loan losses from December 31, 2010 to March 31, 2011 by portfolio segment (in thousands):


	For the quarter ended March 31, 2011
	Construction and			Residential			Commercial					Consumer /			Credit
	Development			Real Estate			Real Estate			Commercial		Other			Cards			Unallocated			Total
Beginning balance	$	3,092		$	4,097		$	2,061		$	396	$	98		$	121		$	1,077		$	10,942
Charged-off loans		(839	)		(2,827	)		(225	)		—		(13	)		(56	)		—			(3,960	)
Recovery of previously charged-off loans		—			1			48			—		5			1						55
Provision for loan losses		1,706			2,598			(452	)		214		(44	)		55			(1,077	)		3,000

Ending balance	$	3,959		$	3,869		$	1,432		$	610	$	46		$	121		$	—		$	10,037

A summary of transactions in the ALLL for the three months ended March 31, 2010 is as follows (in thousands):


	Three Months Ended
	March 31, 2010
Balance, beginning of year	$	11,353
Loans charged-off		(609	)
Recoveries of loans previously charged-off		19
Provision for loan losses		212


Balance, end of year	$	10,975

Credit Quality Indicators:

The Company uses several credit quality indicators, which are updated at least annually, to manage credit risk in an ongoing manner. The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company uses an internal credit risk rating system that categorizes loans into pass, special mention or classified categories. Credit risk ratings are applied to all loans individually with the exception of credit cards.

The following are the definitions of the Company’s risk ratings:


Pass:		Loans that are not adversely rated, are contractually current as to principal and interest and are otherwise in compliance with the contractual terms of the loan or lease agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.

Special Mention:		Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Substandard/ Accruing:		Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Substandard/ Nonaccrual:		A loan classified as nonaccrual has all the deficiencies of a loan graded substandard but collection of the full amount of principal and interest owed is uncertain or unlikely and collateral support, if any, may be weak.

Doubtful:		Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing estimations, facts, conditions and values, highly questionable and improbable. Doubtful loans include only the portion of each specific loan deemed uncollectible and the classification can change as certain current information and facts are ascertained.

The following table presents by class and by risk category, the recorded investment in the Company’s loans as of March 31, 2011 and December 31, 2010 (in thousands):


	As of March 31, 2011
	Not				Special		Substandard		Substandard
	Rated		Pass		Mention		Accruing		Nonaccrual		Doubtful
Construction and development	$	—	$	43,403	$	419	$	4,930	$	29,081	$	951
Commercial real estate — mortgage		—		110,770		3,357		11,868		7,344		—
Commercial and industrial		—		25,279		156		476		—		—
Residential real estate
Residential mortgage		—		62,459		2,879		1,761		15,562		—
Home equity and junior liens		—		30,222		509		1,257		1,436		—
Multi-family		—		4,409		—		1,697		—		—

Total residential real estate		—		97,090		3,388		4,715		16,998		—

Consumer and other		—		2,493		68		38		8		—
Credit cards		2,296		—		—		—		—		—

Total	$	2,296	$	279,035	$	7,388	$	22,027	$	53,431	$	951


	As of December 31, 2010
	Not				Special		Substandard		Substandard
	Rated		Pass		Mention		Accruing		Nonaccrual		Doubtful
Construction and development	$	—	$	36,086	$	284	$	19,244	$	26,977	$	952
Commercial real estate — mortgage		—		99,649		1,044		26,863		6,362		—
Commercial and industrial		—		24,274		207		395		67		—
Residential real estate
Residential mortgage		—		54,332		2,905		11,720		17,446		—
Home equity and junior liens		—		30,841		669		1,561		1,201		—
Multi-family		—		4,454		—		1,692		—		—

Total residential real estate		—		89,627		3,574		14,973		18,647		—

Consumer and other		—		2,755		41		59		—		—
Credit cards		2,275		—		—		—		—		—

Total	$	2,275	$	252,391	$	5,150	$	61,534	$	52,053	$	952

The following table presents the aging of the recorded investment in past due loans, including the payment status of loans on non-accrual which have been incorporated into the table, as of March 31, 2011 and December 31, 2010 by class of loans (in thousands):


	As of March 31, 2011
	30-59		60-89		Greater Than
	Days		Days		90 Days		Total				Total
	Past Due		Past Due		Past Due		Past Due		Current		Loans
Construction and development	$	5,317	$	1,680	$	2,073	$	9,070	$	69,714	$	78,784
Commercial real estate — mortgage		1,903		—		1,034		2,937		130,402		133,339
Commercial and industrial		560		—		—		560		25,351		25,911
Residential real estate
Residential mortgage		5,015		1,827		409		7,251		75,410		82,661
Home equity and junior liens		144		175		1,092		1,411		32,013		33,424
Multi-family		—		—		—		—		6,106		6,106

Total residential real estate		5,159		2,002		1,501		8,662		113,529		122,191

Consumer and other		8		—		—		8		2,599		2,607
Credit cards		3		44		—		47		2,249		2,296

Total	$	12,950	$	3,726	$	4,608	$	21,284	$	343,844	$	365,128


	As of December 31, 2010
	30-59		60-89		Greater Than
	Days		Days		90 Days		Total				Total
	Past Due		Past Due		Past Due		Past Due		Current		Loans
Construction and development	$	265	$	49	$	394	$	708	$	82,835	$	83,543
Commercial real estate — mortgage		214		326		2,573		3,113		130,805		133,918
Commercial and industrial		—		—		—		—		24,944		24,944
Residential real estate
Residential mortgage		948		2,580		—		3,528		82,875		86,403
Home equity and junior liens		—		409		62		471		33,800		34,271
Multi-family		—		—		—		—		6,146		6,146

Total residential real estate		948		2,989		62		3,999		122,821		126,820

Consumer and other		14		10		—		24		2,831		2,855
Credit cards		43		1		19		63		2,212		2,275

Total	$	1,484	$	3,375	$	3,048	$	7,907	$	366,448	$	374,355

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Generally, loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, which usually requires a minimum of six months sustained repayment performance.

Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified as impaired loans.

The following table presents the recorded investment in nonperforming loans by class of loans as of March 31, 2011 and December 31, 2010 (in thousands):


	As of March 31, 2011
			Loans Past Due Over
	Nonaccrual		90 Days Still Accruing
Construction and development	$	30,032	$	110
Commercial real estate — mortgage		7,344		—
Residential real estate
Residential mortgage		15,562		—
Home equity and junior liens		1,436		—

Total residential real estate		16,998		—

Consumer and other		8		—

Total nonperforming loans	$	54,382	$	110


	As of December 31, 2010
			Loans Past Due Over
	Nonaccrual		90 Days Still Accruing
Construction and development	$	27,929	$	—
Commercial real estate — mortgage		6,362		413
Commercial and industrial		67		—
Residential real estate
Residential mortgage		17,446		—
Home equity and junior liens		1,201		—

Total residential real estate		18,647		—

Credit cards		—		19

Total nonperforming loans	$	53,005	$	432

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2011 and December 31, 2010 (in thousands):


	As of March 31, 2011
	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
	Balance		Investment		Allocated
With no related allowance recorded:
Construction and development	$	16,921	$	11,808	$	—
Commercial real estate — mortgage		6,374		5,446		—
Residential real estate
Residential mortgage		10,473		7,882		—
Home equity and junior liens		1,705		1,261		—

Total residential real estate		12,178		9,143		—

Total with no related allowance recorded	$	35,473	$	26,397	$	—


With an allowance recorded:
Construction and development	$	28,184	$	27,936	$	1,731
Commercial real estate — mortgage		16,390		16,341		272
Commercial and industrial		113		113		5
Residential real estate
Residential mortgage		17,533		17,485		898
Home equity and junior liens		1,321		1,321		95
Multi-family		1,692		1,692		92

Total residential real estate		20,546		20,498		1,085

Consumer and other		14		14		—

Total with an allowance recorded	$	65,247	$	64,902	$	3,093

Total impaired loans	$	100,720	$	91,299	$	3,093


	As of December 31, 2010
	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
	Balance		Investment		Allocated
With no related allowance recorded:
Construction and development	$	18,005	$	13,216	$	—
Commercial real estate — mortgage		5,559		4,834		—
Residential real estate
Residential mortgage		4,358		4,336		—
Home equity and junior liens		468		468		—

Total residential real estate		4,826		4,804		—

Total with no related allowance recorded	$	28,390	$	22,854	$	—


With an allowance recorded:
Construction and development	$	28,505	$	28,301	$	1,647
Commercial real estate — mortgage		16,743		16,695		617
Commercial and industrial		113		113		1
Residential real estate
Residential mortgage		22,349		22,298		2,335
Home equity and junior liens		388		388		17
Multi-family		1,692		1,692		92

Total residential real estate		24,429		24,378		2,444

Consumer and other		15		15		1

Total with an allowance recorded	$	69,805	$	69,502	$	4,710

Total impaired loans	$	98,195	$	92,356	$	4,710

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans for the three months ended March 31, 2011 (in thousands):


	As of March 31, 2011
	Average Recorded		Interest Income
	Investment		Recognized
With no related allowance recorded:
Construction and development	$	12,512	$	1
Commercial real estate — mortgage		5,140		—
Residential real estate
Residential mortgage		6,109		4
Home equity and junior liens		865		—

Total residential real estate		6,974		4
Total with no related allowance recorded	$	24,626	$	5


With an allowance recorded:
Construction and development	$	28,119	$	106
Commercial real estate — mortgage		16,518		142
Commercial and industrial		113		1
Residential real estate
Residential mortgage		19,892		105
Home equity and junior liens		855		12
Multi-family		1,692		—

Total residential real estate		22,439		117

Consumer and other		15		—

Total with an allowance recorded	$	67,204	$	366

Total impaired loans	$	91,830	$	371

For the three months ended March 31, 2011, the amount of interest income recognized by the Company within the period that the loans were impaired was primarily related to loans modified in a troubled debt restructuring that remained on accrual status. For the three months ended March 31, 2011, the amount of interest income recognized using a cash-basis method of accounting during the period that the loans were impaired was not material.

Troubled Debt Restructurings:

Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur. These loans are classified as impaired loans and, if on nonaccruing status as of the date of the restructuring, the loans are included in the nonperforming loan balances noted above. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date.

The Company had allocated approximately $2,628,000 and $3,700,000 of specific reserves to customers whose loan terms have been modified in TDRs as of March 31, 2011 and December 31, 2010, respectively. The decrease in specific reserves allocated to TDRs during the first quarter of 2011 of approximately $1,072,000 was primarily attributable to partial chargeoffs of collateral dependent loans that are also TDRs. The Company had approximately $82,222,000 outstanding to customers whose loans were classified as TDRs at March 31, 2011 as compared to approximately $82,443,000 at December 31, 2010. Currently, the Company has committed to lend additional amounts totaling approximately $1,550,000 related to loans classified as TDRs. At March 31, 2011 and December 31, 2010, there were approximately $35,898,000 and $35,752,000, respectively, of accruing restructured loans that remain in a performing status; however, these loans are included in impaired loan totals.

Loans are stated at unpaid principal balances, less the allowance for loan losses. The “recorded investment” in loans presented throughout the Notes to the Consolidated Financial Statements is defined as the outstanding principal balance of loans. Interest income is accrued on the unpaid principal balance.

Note 6. Comprehensive Income (Loss)

Comprehensive income (loss) is made up of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is made up of changes in the unrealized gain (loss) on securities available for sale. Comprehensive income (loss) for the three months ended March 31, 2011 was ($2,856,811) as compared to $55,702 for the three months ended March 31, 2010.

Note 7. Fair Value

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities Available for Sale — Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent service provider. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U. S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the securities’ terms and conditions, among other things.

Impaired Loans — The fair value of impaired loans with specific allocations of the allowance for loan losses may be based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. If the recorded investment in an impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan losses or the expense is recognized as a charge-off. As a result of partial charge-offs, certain impaired loans are carried at fair value with no allocation. Certain impaired loans are not measured at fair value, which generally includes troubled debt restructurings that are measured for impairment based upon the present value of expected cash flows discounted at the loan’s original effective interest rate, and are excluded from the assets measured on a nonrecurring basis.

Other Real Estate — The fair value of other real estate (“ORE”) is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the AFLL. Gains or losses on sale and any subsequent adjustments to the value are recorded as a gain or loss on ORE. ORE is classified within Level 3 of the hierarchy.

Assets and Liabilities Measured on a Recurring Basis

The following table summarizes assets and liabilities measured at fair value on a recurring basis as of March 31, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:


			Fair Value Measurements at
			March 31, 2011 Using:
			Significant Other
			Observable Inputs
	Carrying Value		(Level 2)
Assets:
Available for sale securities:
U. S. Government securities	$	249,989	$	249,989
Obligations of states and political subdivisions		4,988,983		4,988,983
Mortgage-backed securities-residential		84,526,628		84,526,628

Total available for sale securities	$	89,765,600	$	89,765,600


			Fair Value Measurements at
			December 31, 2010 Using:
			Significant Other
			Observable Inputs
	Carrying Value		(Level 2)
Assets:
Available for sale securities:
U. S. Government securities	$	249,866	$	249,866
Obligations of states and political subdivisions		4,922,113		4,922,113
Mortgage-backed securities-residential		81,144,612		81,144,612

Total available for sale securities	$	86,316,591	$	86,316,591

For the quarter ended March 31, 2011, there were no transfers between Level 1 and Level 2.

Assets and Liabilities Measured on a Non-Recurring Basis

Certain assets and liabilities are measured at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following table summarizes assets and liabilities measured at fair value on a non-recurring basis as of March 31, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:


			Fair Value Measurements at
			March 31, 2011 Using:
			Significant
			Unobservable Inputs
	Carrying Value		(Level 3)
Assets:
Impaired loans:
Construction and development	$	8,467,964	$	8,467,964
Commercial real estate		5,855,123		5,855,123
Residential real estate		4,073,359		4,073,359

Total impaired loans		18,396,446		18,396,446

Other real estate:
Construction and development		2,257,161		2,257,161
Commercial real estate		1,404,833		1,404,833
Residential real estate		7,284,704		7,284,704

Total other real estate		10,946,698		10,946,698
Total Assets Measured at Fair
Value on a Non-Recurring Basis	$	29,343,144	$	29,343,144


			Fair Value Measurements at
			December 31, 2010 Using:
			Significant
			Unobservable Inputs
	Carrying Value		(Level 3)
Assets:
Impaired loans:
Construction and development	$	8,826,040	$	8,826,040
Commercial real estate		3,378,152		3,378,152
Residential real estate		4,045,756		4,045,756

Total impaired loans		16,249,948		16,249,948

Other real estate:
Construction and development		2,229,161		2,229,161
Commercial real estate		1,404,833		1,404,833
Residential real estate		7,518,670		7,518,670

Total other real estate		11,152,664		11,152,664
Total Assets Measured at Fair
Value on a Non-Recurring Basis	$	27,402,612	$	27,402,612

At March 31, 2011, impaired loans measured at fair value, which are evaluated for impairment using the fair value of collateral, had a carrying amount of $18,703,642, with a valuation allowance of $307,196 resulting in an additional provision for loan losses of $2,024,413 for the three-month period ended March 31, 2011. At December 31, 2010, impaired loans measured at fair value had a carrying amount of $17,718,189, with a valuation allowance of $1,468,241 resulting in an additional provision for loan losses of $4,514,585 for the year ended December 31, 2010. Impaired loans carried at fair value include loans that have been written down to fair value through the partial charge-off of principal balance. Accordingly, these loans do not have a specific valuation allowance as their balances represent fair value.

The March 31, 2011 carrying amount of ORE includes net valuation adjustments of approximately $33,000 for the three months ended March 31, 2011. The December 31, 2010 carrying amount of ORE includes net valuation adjustments of approximately $1,211,000. Valuation adjustments include both charge offs and holding gains and losses. The fair value of ORE is based upon appraisals performed by qualified, licensed appraisers. Appraisals are obtained at the time of foreclosure and at least annually thereafter or more often if management determines property values have significantly declined.

Fair Value of Financial Instruments

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.

Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

Cash and cash equivalents:

For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Investment Securities:

The fair value of securities is estimated as previously described for securities available for sale, and in a similar manner for securities held to maturity.

Restricted investments:

Restricted investments consist of Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank stock. It is not practicable to determine the fair value due to restrictions placed on the transferability of the stock.

Loans:

The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs. The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The allowance for loan losses is considered a reasonable discount for credit risk.

Deposits:

The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Federal funds purchased, Federal Reserve Bank advances and securities sold under agreements to repurchase:

The estimated value of these liabilities, which are extremely short term, approximates their carrying value.

Subordinated debentures:

For the subordinated debentures with a floating interest rate tied to LIBOR, the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the most recent offering rates available for subordinated debentures of similar amounts and remaining maturities.

Federal Home Loan Bank advances:

For FHLB advances the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for FHLB advances of similar amounts and remaining maturities.

Accrued interest receivable and payable:

The carrying amounts of accrued interest receivable and payable approximate their fair value.

Commitments to extend credit, letters of credit and lines of credit:

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of these commitments are insignificant and are not included in the table below.

The carrying amounts and estimated fair values of the Company’s financial instruments at March 31, 2011 and December 31, 2010, not previously presented, are as follows (in thousands):


	March 31, 2011				December 31, 2010
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	15,895	$	15,895	$	32,576	$	32,576
Investment securities held to maturity		1,333		1,351		1,318		1,303
Restricted investments		3,843		N/A		3,843		N/A
Loans, net		355,091		347,116		363,413		358,587
Accrued interest receivable		1,662		1,662		1,496		1,496

Liabilities:
Noninterest-bearing demand deposits	$	48,492	$	48,492	$	47,639	$	47,639
NOW accounts		54,389		54,389		57,345		57,345
Savings and money market accounts		72,418		72,418		73,435		73,435
Time deposits		254,098		255,160		271,173		272,304
Subordinated debentures		13,403		7,333		13,403		7,276
Federal funds purchased and securities sold under agreements to repurchase		866		866		432		432
Federal Reserve/Federal Home Loan Bank advances		55,200		60,447		55,200		61,136
Accrued interest payable		658		658		719		719

Note 8. Regulatory Matters

The Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action applicable to the Bank, the Bank and Company must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank and Company to maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). In addition, the Company’s and the Bank’s regulators may impose additional capital requirements on financial institutions and their bank subsidiaries, like the Company and the Bank, beyond those provided for statutorily, which standards may be in addition to, and require higher levels of capital, than the general capital adequacy guidelines. As discussed below, the Bank has agreed to maintain certain of its capital ratios above statutory levels. As of March 31, 2011 and discussed below, the Bank failed to meet all capital adequacy requirements to which it is subject.

As a result of a regulatory examination conducted during the first quarter of 2009, the Bank has entered into a formal written agreement in which it made certain commitments to the OCC, including commitments to, among other things, implement a written program to reduce the high level of credit risk in the Bank including strengthening credit underwriting and problem loan workouts and collections, reduce its level of criticized assets, implement a concentration risk management program related to commercial real estate lending, improve procedures related to the maintenance of the Bank’s ALLL, strengthen the Bank’s internal loan review program, strengthen the Bank’s loan workout department, and develop a liquidity plan that improves the Bank’s reliance on wholesale funding sources.

In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. The OCC imposed this requirement to maintain capital at higher levels than those required by applicable federal regulations because the OCC believed that the Bank’s capital levels were less than satisfactory given the level of credit risk in the Bank, specifically the high level of nonperforming assets and provision for loan losses. As noted below under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Funding Resources, Capital Adequacy and Liquidity, the Bank had 8.62% of Tier 1 capital to average assets and 12.74% of total capital to risk-weighted assets ratio at March 31, 2011, and was therefore not in compliance with the minimum levels required by the OCC. As a result, the OCC may bring additional enforcement actions, including a consent order, against the Bank.

In the fourth quarter of 2010, the OCC informed the Bank that, because the OCC does not believe that the Bank has fully satisfied the requirements of the formal written agreement, it will be requested to replace the formal written agreement with a consent order (the “Consent Order”) containing commitments for further improvements in the Bank’s operations. While the requirements of the Consent Order are not currently known to the Bank, the OCC has informed the Bank’s management that the Consent Order will likely contain provisions similar to those currently contained in the existing minimum capital commitment that the Bank made to the OCC in connection with the Bank’s entering into the formal written agreement, requiring the Bank to maintain a minimum Tier 1 leverage capital ratio of 9% and a minimum total risk-based capital ratio of 13%. If the Bank fails to comply with the requirements of the Consent Order, the OCC may impose additional limitations, restraints, commitments or conditions on the Bank. Once the Consent Order is effective, the Bank will be deemed to be “adequately capitalized” even if the Bank’s capital ratios exceed those minimum amounts necessary to be considered “well capitalized” under federal banking regulations as well as the minimum ratios set forth in the Consent Order.

Since the Bank agreed to the capital requirement, certain actions have been taken, and are ongoing, that are designed to improve the Bank’s capital ratios by influencing the underlying metrics. The reduction of total assets of the Bank can have a significant impact on the Tier 1 capital ratio. Since December 31, 2009 the Bank has reduced total assets approximately $107,000,000 from approximately $640,000,000 to approximately $533,000,000 at March 31, 2011. This reduction in assets was accomplished by reducing wholesale funding including brokered deposits and Federal Home Loan Bank advances as well as the reduction of public funds deposits. Additionally, loans outstanding and the bond investment portfolio were reduced subsequent to the capital requirement. Expense reduction measures were put in place during the first and second quarter of 2010 which included a significant reduction of salaries and benefits. In addition, the Company is actively exploring other potential transactions to raise capital at the holding company that could provide additional capital for the Bank.


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

The following discussion and analysis is designed to provide a better understanding of various factors related to the financial condition and results of operations of the Company and its subsidiaries, including the Bank. This section should be read in conjunction with the financial statements and notes thereto which are contained in Item 1 above and the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, including Management’s Discussion and Analysis of Financial Condition and Results of Operations.

To better understand financial trends and performance, the Company’s management analyzes certain key financial data in the following pages. This analysis and discussion reviews the Company’s results of operations and financial condition for the three months ended March 31, 2011. This discussion is intended to supplement and highlight information contained in the accompanying unaudited consolidated financial statements as of and for the three-month period ended March 31, 2011. The Company has also provided some comparisons of the financial data for the three-month period ended March 31, 2011, against the same period in 2010, as well as the Company’s year-end results as of and for the year ended December 31, 2010, to illustrate significant changes in performance and the possible results of trends revealed by that historical financial data. This discussion should be read in conjunction with our financial statements and notes thereto, which are included under Item 1 above.

Special Cautionary Notice Regarding Forward-Looking Statements

Certain of the statements made herein are “forward-looking statements” within the meaning of, and subject to the protections of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may”, “will”, “anticipate”, “assume”, “should”, “indicate”, “attempt”, “would”, “believe”, “contemplate”, “expect”, “seek”, “estimate”, “continue”, “plan”, “point to”, “project”, “predict”, “could”, “intend”, “target”, “potential”, and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including those risk factors set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 and below under Part II, Item 1A. “Risk Factors” and, without limitation:

	•		the effects of greater than anticipated deterioration in economic and business conditions (including in the residential and commercial real estate construction and development segment of the economy) nationally and in our local market;

	•		deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;

	•		increased levels of non-performing and repossessed assets;

	•		lack of sustained growth in the economy in the Sevier County and Blount County, Tennessee area;

	•		government monetary and fiscal policies as well as legislative and regulatory changes, including changes in banking, securities and tax laws and regulations;

	•		the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;

	•		the effects of competition from a wide variety of local, regional, national and other providers of financial, and investment services;

	•		the failure of assumptions underlying the establishment of reserves for possible loan losses and other estimates;

	•		the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and the possible failure to achieve expected gains, revenue growth and/or expense savings from such transactions;

	•		the effects of failing to comply with our regulatory commitments;

	•		changes in accounting policies, rules and practices;

	•		changes in technology or products that may be more difficult, or costly, or less effective, than anticipated;

	•		the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions;

	•		results of regulatory examinations;

	•		the remediation efforts related to the Company’s material weakness in internal control over financial reporting;

	•		the ability to raise additional capital;

	•		the prepayment of FDIC insurance premiums and higher FDIC assessment rates;

	•		the effects of negative publicity;

	•		the effectiveness of the Company’s activities in improving, resolving or liquidating lower quality assets;

	•		the Company’s recording of a further allowance related to its deferred tax asset; and

	•		other factors and information described in this report and in any of our other reports that we make with the Securities and Exchange Commission (the “Commission”) under the Exchange Act.

All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. Except as required by the Federal securities laws, we have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

Recent Regulatory Developments

In the first quarter of 2009, the OCC conducted an examination of the Bank and found that the Bank’s condition had significantly deteriorated since the OCC’s most recent examination of the Bank. The Bank’s asset quality and earnings had both significantly declined since the OCC’s last examination of the Bank and the Bank’s dependence on brokered deposits and other sources of non-core funding was too high.

Despite the Bank’s efforts to comply with the requirements of the examination report, the OCC concluded that the Bank had not satisfactorily responded to the matters requiring attention identified in the examination report and requested that the Bank consent to the issuance of a formal written agreement with the OCC in order to improve its asset quality and reduce losses and to correct weaknesses that were the subject of examination criticism. Following discussions with the OCC, the Bank’s board of directors entered into a formal written agreement requiring that the Bank take a number of actions to improve the Bank’s operations including the following:

	•		reduce the high level of credit risk and strengthen the Bank’s credit underwriting, particularly in the commercial real estate portfolio, including improving its management and training of commercial real estate lending personnel;

	•		strengthen its problem loan workouts and collection department;

	•		improve its loan review program, including its internal loan review staffing;

	•		reduce the level of criticized assets and the concentrations of commercial real estate loans;

	•		improve its credit underwriting standards for commercial real estate;

	•		engage in portfolio stress testing and sensitivity analysis of the Bank’s commercial real estate concentrations;

	•		improve its methodology of calculating the allowance for loan and lease losses; and

	•		reduce its levels of brokered deposits and other wholesale funding.

Since its issuance, the board of directors and members of the Bank’s management have sought to comply with the terms of the formal written agreement and have taken a number of actions in an effort to so comply, including:

	•		the hiring of a new Chief Credit Officer, a new Loan Review Officer and other credit personnel;

	•		the retention of a third party loan reviewer to review over 80 percent of the total outstanding loans in the loan portfolio;

	•		the adoption of action plans for all criticized assets, along with revised procedures for eliminating the basis for criticism of problem credit and disposing of nonperforming assets;

	•		the adoption of a revised credit risk management program and enhanced credit risk review process;

	•		improvements to the Bank’s allowance methodology;

	•		implementation of a full-time special assets department with improvised policies; and

	•		adoption of revised liquidity plans.

Following its most recent examination by the OCC in the first quarter of 2010, the Bank has sought to further improve its strategic, capital and liquidity planning, reviewed the results of a management study, further improved its policies on recognition of non-accrual loans, incorporated a historical loss rates migration analysis into its quarterly determination of the allowance for loan losses and further refined its credit policies and credit review process.

Although the Bank has instituted a number of improvements to its practices in an effort to comply with the terms of the formal written agreement, the OCC has informed the Bank that, because the OCC does not believe that the Bank has fully satisfied the requirements of the formal written agreement, it will be requested to replace the formal written agreement with a consent order (the “Consent Order”) containing commitments for further improvements in the Bank’s operations. While the requirements of the Consent Order are not currently known to the Bank, the OCC has informed the Bank’s management that the Consent Order will likely contain provisions similar to those currently contained in the existing minimum capital commitment that the Bank made to the OCC in connection with the Bank’s entering into the formal written agreement, requiring the Bank to achieve and maintain a minimum Tier 1 leverage capital ratio of 9% and a minimum total risk-based capital ratio of 13%. As a result of losses in the year ended December 31, 2010 and continued losses in the three months ended March 31, 2011, the Bank is not currently in compliance with these requirements. As a result of such requirements being included in the Consent Order, the Bank will be deemed not to be “well capitalized” under the applicable federal banking regulations even if the Bank’s actual capital ratios exceed those required to be considered “well capitalized” under the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvements Act (“FDICIA”) or those that it is required to maintain under the Consent Order. As a result, the Bank will be required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits or pay interest on deposits above certain federally established rates.

Overview

We conduct our operations, which consist primarily of traditional commercial banking operations, through the Bank. Through the Bank we offer a broad range of traditional banking services from our corporate headquarters in Sevierville, Tennessee, our Blount County regional headquarters in Maryville, Tennessee, through eight additional branches in Sevier County, Tennessee, and two additional branches in Blount County, Tennessee. Our banking operations primarily target individuals and small businesses in Sevier and Blount Counties and the surrounding area. The retail nature of the Bank’s commercial banking operations allows for diversification of depositors and borrowers, and we believe that the Bank is not dependent upon a single or a few customers. But, due to the predominance of the tourism industry in Sevier County, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry, including the residential real estate and commercial real estate segments of that industry. The predominance of the tourism industry also makes our business more seasonal in nature, particularly with respect to deposit levels, than may be the case with banks in other market areas. The tourism industry in Sevier County has remained relatively strong during recent years and we anticipate that this trend will continue during the remainder of 2011. Additionally, we have a significant concentration of commercial and residential real estate construction and development loans. Economic downturns relating to sales of these types of properties have adversely affected the Bank’s operations creating risk independent of the tourism industry.

In addition to our twelve existing locations, we own one property in Knox County for use in future branch expansion. This property is not currently under development. Management does not anticipate construction of any additional branches during 2011.

The net loss for the three-month period ended March 31, 2011 as compared to net income for the same period during 2010 was as follows:


	3/31/2011			3/31/2010		$ change			% change
Three months ended
Net Income		(3,379,037	)		329,114		(3,708,151	)		-1126.71	%

The net loss for the first three months of 2011 was primarily attributable to the Company’s provision for loan losses as discussed in more detail below under Provision for Loan Losses. The decrease from net income for the first quarter of 2010 to a net loss for the first quarter of 2011 was also the result of a reduction in net investment gains, included in noninterest income, as discussed in more detail below under Investment Securities. The net loss was positively impacted during the first three months of 2011 by a decrease in noninterest expense that was primarily attributable to the decrease in salary and employee benefit expense. Noninterest expense is discussed in more detail under the heading Noninterest Expense below.

Basic and diluted earnings per share decreased from basic and diluted earnings per share of $0.13 and $0.13, respectively, in the first three months of 2010 to basic and diluted loss per share of ($1.28) and ($1.28), respectively, in the first three months of 2011. The change in net loss per share for the three months ended March 31, 2011, as compared to net earnings per share for the same period in 2010, was due primarily to the change from net income in the first quarter of 2010 to a net loss in the first quarter of 2011.

The change in total assets, total liabilities and shareholders’ equity for the three months ended March 31, 2011, was as follows:


	3/31/11		12/31/10		$ change			% change
Total Assets	$	533,485,378	$	557,206,511	$	(23,721,133	)		-4.26	%
Total Liabilities		500,642,369		521,532,341		(20,889,972	)		-4.01	%
Shareholders’ Equity		32,843,009		35,674,170		(2,831,161	)		-7.94	%

The net decrease in total liabilities was primarily attributable to a decrease in time deposits of approximately $17 million and a decrease in NOW accounts of approximately $3 million, as discussed in more detail below under Deposits. The net decrease in total assets was primarily the result of a decrease in cash and cash equivalents of approximately $17 million and a decrease in net loans of approximately $8 million, as discussed in more detail below under Loans.

The decrease in shareholders’ equity was primarily attributable to the net loss for the three months ended March 31, 2011. The decrease in shareholders’ equity was partially offset by a decrease in accumulated other comprehensive loss which represents the net unrealized gains (losses) on securities available-for-sale.

Balance Sheet Analysis

The following table presents an overview of selected period-end balances at March 31, 2011 and December 31, 2010, as well as the dollar and percentage change for each:


	3/31/11		12/31/10		$ change			% change
Cash and equivalents	$	15,894,509	$	32,575,820	$	(16,681,311	)		-51.21	%
Loans		365,128,452		374,355,464		(9,227,012	)		-2.46	%
Allowance for loan losses		10,037,471		10,942,414		(904,943	)		-8.27	%
Investment securities		91,098,897		87,634,542		3,464,355			3.95	%
Premises and equipment		32,276,720		32,600,673		(323,953	)		-0.99	%
Other real estate owned		12,936,232		13,140,698		(204,466	)		-1.56	%

Noninterest-bearing deposits		48,492,160		47,638,792		853,368			1.79	%
Interest-bearing deposits		380,905,870		401,952,616		(21,046,746	)		-5.24	%

Total deposits		429,398,030		449,591,408		(20,193,378	)		-4.49	%

Federal Reserve/Federal Home Loan Bank advances	$	55,200,000	$	55,200,000	$	—			0.00	%

Loans

At March 31, 2011, loans comprised 76.3% of the Bank’s earning assets. The decrease in our loan portfolio was primarily attributable to the decrease in construction and land development loans and 1-4 family residential loans, which was primarily the result of the general pay down of loan balances pursuant to management’s strategy to reduce loans during this period of economic stress. Additionally, net charge-offs of approximately $3.9 million were recorded during the first three months of 2011 as discussed in more detail under Provision for Loan Losses. Total earning assets, as a percentage of total assets, were 89.7% at March 31, 2011, compared to 86.8% at December 31, 2010, and 87.7% at March 31, 2010. Total earning assets relative to total assets increased for the three-month period ended March 31, 2011 due to the increase in federal funds sold and investment securities and the decrease in total assets. The percentage increased when compared to March 31, 2010 due to the increase in federal funds sold and the decrease in total assets. The average yield on loans, including loan fees, during the first three months of 2011 was 5.03% compared to 5.13% for the first three months of 2010. The decrease in the average yield on loans was the result of several factors including the increase in TDRs involving interest rate concessions and the increase in average non-accrual loans.

The decrease in the Bank’s ORE balance during the three month period ended March 31, 2011 was the net result of the foreclosure of additional properties offset by the sale of certain properties previously held as ORE. One property, an operating nightly condo rental operation located in Pigeon Forge, Tennessee, which previously secured a loan for approximately $5,116,000, represents approximately $4,585,000, or 35%, of the ORE balance at March 31, 2011 (included in multifamily residential properties in the table below). The condos are currently under management contract with an experienced nightly rental management company as we seek to market the sale of the properties.

The following table presents the Company’s total ORE balance by property type:


	March 31, 2011		December 31, 2010
	(in thousands)
Construction, land development and other land	$	2,623	$	2,595
1-4 family residential properties		3,621		3,799
Multifamily residential properties		4,585		4,640
Nonfarm nonresidential properties		2,107		2,107

Total	$	12,936	$	13,141

Allowance for Loan Losses

The allowance for loan losses represents management’s assessment and estimates of the risks associated with extending credit and its evaluation of the quality of our loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain the allowance for loan losses at a level believed to be adequate to absorb probable incurred loan losses. In assessing the adequacy of the allowance, management reviews the size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank’s loan loss experience, the amount of past due and nonperforming loans, impairment of loans, specific known risks, the status, amounts and values of nonperforming assets (including loans), underlying collateral values securing loans, current and anticipated economic conditions and other factors which affect the allowance for potential credit losses. Based on an analysis of the credit quality of the loan portfolio prepared by the Bank’s risk officer, the CFO presents a quarterly analysis of the adequacy of the allowance for loan losses for review by our board of directors.

Our allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the level of risk in the loan portfolio. During their routine examinations of banks, regulatory agencies may advise a bank to make additional provisions to its allowance for loan losses, which would negatively impact a bank’s results of operations, when the opinion of the regulators regarding credit evaluations and allowance for loan loss methodology differ materially from those of the bank’s management. During the regular safety and soundness examination conducted by the Bank’s regulatory agency during the first quarter of 2011, significant changes were incurred due to required provisions to the allowance based on loans determined to be collateral dependent by the OCC. These changes have been recognized and incorporated into the results of operations as of both December 31, 2010 and March 31, 2011.

Concentrations of credit risk typically involve loans to one borrower, an affiliated group of borrowers, borrowers engaged in or dependent upon the same industry, or a group of borrowers whose loans are secured by the same type of collateral. Our most significant concentration of credit risks lies in the high proportion of our loans to businesses and individuals dependent on the tourism industry and loans to subdividers and developers of land. The Bank assesses loan risk by primary concentrations of credit by industry and loans directly related to the tourism industry are monitored carefully. At March 31, 2011, approximately $171 million in loans, or 47% of total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve as compared to approximately $192 million in loans, or 51% of total loans, at December 31, 2010. The most significant decreases in this category were loans to overnight rentals by agency and loans to subdividers and developers which decreased approximately $14 million and $5 million, respectively.

While it is the Bank’s policy to charge off in the current period loans for which a loss is considered confirmed, there are additional risks of losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because the risk of loss includes unpredictable factors, such as the state of the economy and conditions affecting individual borrowers, management’s judgments regarding the appropriate size of the allowance for loan losses is necessarily approximate and imprecise, and involves numerous estimates and judgments that may result in an allowance that is insufficient to absorb all incurred loan losses.

Management is not aware of any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been identified and sufficiently provided for in the allowance for loan losses which (1) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

Individually impaired loans are loans that the Bank does not expect to collect all amounts due according to the contractual terms of the loan agreement and include any loans that meet the definition of a TDR, as discussed in more detail below. In some cases, collection of amounts due becomes dependent on liquidating the collateral securing the impaired loan. Collateral dependent loans do not necessarily result in the loss of principal or interest amounts due; rather the cash flow is disrupted until the underlying collateral can be liquidated. As a result, the Bank’s impaired loans may exceed nonaccrual loans which are placed on nonaccrual status when questions arise about the future collectability of interest due on these loans. The status of impaired loans is subject to change based on the borrower’s financial position.

Problem loans are identified and monitored by the Bank’s watch list report which is generated during the loan review process. This process includes review and analysis of the borrower’s financial statements and cash flows, delinquency reports and collateral valuations. The watch list includes all loans determined to be impaired. Management determines the proper course of action relating to these loans and receives monthly updates as to the status of the loans.

The following table presents impaired loans as of March 31, 2011 and December 31, 2010:


	March 31, 2011					December 31, 2010
	Impaired		% of total			Impaired		% of total
	Loans		loans			Loans		loans
	($ in thousands)
Construction, land development and other land loans	$	39,743		10.88	%	$	41,517		11.09	%
Commercial real estate		21,787		5.97	%		21,529		5.75	%
Consumer real estate		29,641		8.12	%		29,182		7.80	%
Other loans		128		0.04	%		128		0.03	%

Total	$	91,299		25.00	%	$	92,356		24.67	%

The slight decrease in impaired loans from December 31, 2010 to March 31, 2011 was primarily the result of the partial charge-off of collateral dependent loans during the first quarter of 2011. Otherwise, the sustained, high level of impaired loans continues to relate to the weak residential and commercial real estate market in the Bank’s market areas. Within this segment of the portfolio, the Bank has traditionally made loans to, among other borrowers, home builders and developers of land. These borrowers have continued to experience stress during the current real estate recession due to a combination of declining demand for residential real estate, excessive volume of properties available and the resulting price and collateral value declines. In addition, housing starts in the Bank’s market areas continue to be at historically low levels. An extended recessionary period in real estate will likely cause the Bank’s real estate mortgage loans, which include construction and land development loans, to continue to underperform and may result in increased levels of impaired loans and non-performing assets, which may negatively impact the Company’s results of operations.

Forty-two impaired loans with a total balance of approximately $24,974,000 were considered to be collateral dependent at March 31, 2011, and of this amount approximately $19,873,000 are troubled debt restructurings discussed in more detail below. Collateral dependent loans are recorded at the lower of cost or the appraised value net of estimated selling costs. Repayment of these loans is anticipated to be from the sale or liquidation of the collateral securing the loans. Management obtains independent appraisals of the collateral securing collateral dependent loans at least annually from independent licensed real estate appraisers and the carrying amount of the loans that exceed the appraised value net of estimated selling costs is taken as a charge against the allowance for loan losses and may result in additional charges to the provision expense. All loans considered collateral dependent are nonaccrual loans and included in the nonperforming loan balances. Management has recorded partial charge offs on these collateral dependent loans totaling approximately $9,047,000 as of March 31, 2011.

Due to the weakening credit status of a borrower, we may elect to formally restructure certain loans to facilitate a repayment plan that minimizes the potential losses, if any, that we might incur. All restructured loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. At March 31, 2011 and December 31, 2010, there were $35.9 million and $36.0 million, respectively, of accruing restructured loans that remain in a performing status.

TDRs are restructured loans due to a borrower experiencing financial difficulty and the Bank granting concessions it would not normally otherwise grant. These concessions generally include a reduced interest rate for a limited period of time to allow the borrower to improve their economic position, especially during this period of economic downturn. Management has made an attempt to identify all loans where, by granting certain concessions, borrowers have additional time to recover from the economic downturn, and in certain instances, have been able to significantly reduce or repay their loans. During 2011, Management intends to identify problem loans that have not improved sufficiently to warrant further concessions and take appropriate actions to liquidate these loans.

TDRs at March 31, 2011 totaled approximately $82,222,000 which is 90.1% of total impaired loans. The TDRs related primarily to construction and development loans totaling approximately $37,084,000, or 40.6% of impaired loans, 1-4 family residential loans totaling approximately $24,789,000, or 27.2% of impaired loans and commercial real estate loans totaling approximately $20,222,000, or 22.1% of impaired loans. The Bank’s TDRs are due to lack of real estate sales and weak or insufficient cash flows of the guarantors of the loans due to the current economic climate. The majority of the TDRs are for a limited term, in most instances, of one to two years.

The Bank’s allowance for loan losses as a percentage of total loans at March 31, 2011 and December 31, 2010 was as follows:


	Allowance for		Total		% of total
	loan losses		loans		loans
	($ in thousands)
As of:
March 31, 2011	$	10,037	$	365,128		2.75	%
December 31, 2010		10,942		374,355		2.92	%

Our allowance for loan losses decreased approximately $905,000 during the first quarter of 2011 since provision for loan losses was exceeded by net chargeoffs. The allowance for loan losses as a percentage of total loans and non-accrual loans at March 31, 2011 was 2.75% and 18.46%, respectively, compared to 2.92% and 20.64%, respectively, at December 31, 2010. The allowance for loan losses attributable to loans collectively evaluated for impairment, also identified as the general component and described in more detail in the following paragraph, increased 33 basis points during the first quarter of 2011 from 2.21% at December 31, 2010, to 2.54% at March 31, 2011. Management continues to evaluate and adjust our allowance for loan losses, and presently believes the allowance for loan losses is adequate to provide for probable losses inherent in the loan portfolio. Management believes the loans, including those loans that were delinquent at March 31, 2011, that will result in additional charge-offs have been identified and adequate provision has been made in the allowance for loan loss balance. No assurance can be given, however, that adverse economic circumstances, declines in real estate values or other events or changes in borrowers’ financial conditions, particularly borrowers in the real estate construction and development business, will not result in increased losses in the Bank’s loan portfolio or in the need for increases in the allowance for loan losses through additional provision expense in future periods.

Within the allowance, there are specific and general loss components as disclosed in more detail under Note 5. Loans and Allowance for Loan Losses. The specific loss component is assessed for non-homogeneous loans that management believes to be impaired. Loans are considered to be impaired when it is determined that the obligor will not pay all contractual principal and interest due. For loans determined to be impaired, the loan’s carrying value is compared to its fair value using one of the following fair value measurement techniques: present value of expected future cash flows, observable market price, or fair value of the associated collateral less costs to sell. An allowance is established when the fair value is lower than the carrying value of that loan. The general component covers non-classified and classified non-impaired loans and is based on a three-year historical average loss experience adjusted for current factors. These loans are segregated by major product type and/or risk grade with an estimated loss ratio applied against each product type and/or risk grade. The loss ratio is generally based upon historic loss experience for each loan type as adjusted for certain environmental factors management believes to be relevant.

Past Due Loans

The following table presents the Bank’s delinquent and nonaccrual loans for the periods indicated:


	Past due 30 to					Past due 90 days
	89 days and still		% of total			or more and		% of total					% of total
	accruing		loans			still accruing		loans			Nonaccrual		loans
	($ in thousands)
As of March 31, 2011
Construction, land development and other land loans	$	2,592		0.71	%	$	110		0.03	%	$	30,032		8.23	%
Commercial real estate		—		0.00	%		—		0.00	%		7,344		2.01	%
Consumer real estate		2,098		0.57	%		—		0.00	%		16,998		4.66	%
Commercial loans		560		0.15	%		—		0.00	%		—		0.00	%
Consumer loans		56		0.02	%		—		0.00	%		8		0.00	%

Total	$	5,306		1.45	%	$	110		0.03	%	$	54,382		14.89	%


As of December 31, 2010
Construction, land development and other land loans	$	265		0.07	%	$	—		0.00	%	$	27,929		7.46	%
Commercial real estate		541		0.14	%		413		0.11	%		6,362		1.70	%
Consumer real estate		1,130		0.30	%		—		0.00	%		18,647		4.98	%
Commercial loans		—		0.00	%		—		0.00	%		67		0.02	%
Consumer loans		68		0.02	%		19		0.01	%		—		0.00	%

Total	$	2,004		0.54	%	$	432		0.12	%	$	53,005		14.16	%

Delinquent and nonaccrual loans at both March 31, 2011 and December 31, 2010 consisted primarily of construction and land development loans and commercial and consumer real estate loans. The majority of the increase in loans delinquent 30 to 89 days, which was largely isolated to construction and land development and consumer real estate loans, was attributable to one relationship in each category, approximately $2.4 million and $1.5 million, respectively, rather than a further deterioration of the portfolio generally. The increase in nonaccrual loans was the result of continued stress in the local real estate market as discussed in more detail below. Certain nonaccrual loans are carried on a cash basis nonaccrual status until an acceptable payment history can be established to support placing the loan back on accrual. During this time, the loans continue to be reported as non-performing assets while payments are being collected.

Notwithstanding the general favorable trends in tourism in Sevier County, residential and commercial real estate sales continued to be weak during first three month of 2011, following the same pattern that began during the second half of 2008 and continued throughout 2010. The reduced sales have negatively impacted past due, nonaccrual and charged-off loans. Price declines during 2009 and 2010 have had an adverse impact on overall real estate values. These trends have had the greatest effect on the construction and development and commercial real estate portfolios resulting in the significant increase in nonaccrual loans beginning in 2009 and continuing through the first quarter of 2011. Many of the borrowers in these categories are dependent upon real estate sales to generate the cash flows used to service their debt. Since real estate sales have been depressed, many of these borrowers have experienced greater difficulty meeting their obligations, and to the extent that sales remain depressed, these borrowers may continue to have difficulty meeting their obligations.

Investment Securities

Our investment portfolio consists of U.S. Treasury securities, securities of U.S. government agencies, mortgage-backed securities and municipal securities. The investment securities portfolio is the second largest component of our earning assets and represented 17.1% of total assets at quarter-end, down from 15.7% at December 31, 2010, reflecting an increase in investment securities and a decrease in total assets during the first three months of 2011. The approximately $3 million increase in investment securities during the three months ended March 31, 2011 was primarily attributable to increased pledging requirements related to municipal deposits. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. In addition to securing public deposits, we also use our investment securities portfolio to meet pledging requirements for borrowings. The average yield on our investment securities portfolio during the first three months of 2011 was 2.67% versus 2.32% for the first three months of 2010. Net unrealized losses on securities available for sale, included in accumulated other comprehensive income (loss), decreased by approximately $522,000, net of income taxes, during the first three months of 2011 from approximately $1,064,000 at December 31, 2010, to approximately $542,000 at March 31, 2011.

Deposits

The table below sets forth the total balances of deposits by type as of March 31, 2011 and December 31, 2010, and the dollar and percentage change in balances over the intervening period:


	March 31,		December 31,		$			%
	2011		2010		change			change
	(in thousands)

Non-interest bearing accounts	$	48,492	$	47,638	$	854			1.79	%

NOW accounts		54,389		57,345		(2,956	)		-5.15	%

Money market accounts		48,809		49,701		(892	)		-1.79	%

Savings accounts		23,609		23,734		(125	)		-0.53	%

Certificates of deposit		213,289		222,550		(9,261	)		-4.16	%

Brokered deposits		19,947		27,019		(7,072	)		-26.17	%

Individual retirement accounts		20,863		21,604		(741	)		-3.43	%


TOTAL DEPOSITS	$	429,398	$	449,591	$	(20,193	)		-4.49	%

The balance in NOW accounts primarily consists of public funds deposits that are generally obtained through a bidding process under varying terms.

The decrease in certificates of deposit was the result of seasonal reductions. At March 31, 2011, brokered deposits represented approximately 4.6% of total deposits and management intends to seek to further reduce the level of brokered deposits approximately $3 million during the remainder of 2011 based on scheduled maturities. Because we anticipate that the Consent Order will establish specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of March 31, 2011, brokered deposits maturing in the next 24 months totaled approximately $16.7 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities.

Because the Bank will not be considered “well capitalized” following issuance of the Consent Order, it will also not be permitted to pay interest on deposits at rates that are more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC. These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers.

The total average cost of interest-bearing deposits (including demand, savings and certificate of deposit accounts) for the three-month period ended March 31, 2011 was 1.52%, down from 1.82% for the same period a year ago primarily reflecting the continued downward repricing of the Bank’s time deposits as they mature and are renewed at current market rates. Competitive pressures in our markets, however, have limited, and are likely to continue to limit, our ability to realize the full effect of the ongoing low interest rate environment.

Funding Resources, Capital Adequacy and Liquidity

Our funding sources primarily include deposits and repurchase accounts. The Bank, being situated in a market area that relies on tourism as its principal industry, can be subject to periods of reduced deposit funding because tourism in Sevier County and Blount County is seasonably slower in the winter months. The Bank manages seasonal deposit outflows through its secured and unsecured Federal Funds lines of credit at several correspondent banks. Available lines totaled $33 million with $10 million secured and accessible as of March 31, 2011, and are available on one day’s notice. The Bank also has a cash management line of credit in the amount of $100 million from the FHLB as well as a line of credit from the Federal Reserve Discount Window that totaled approximately $13 million at March 31, 2011, none of which was borrowed as of that date. The borrowing capacity can be increased based on the amount of collateral pledged.

Capital adequacy is important to the Bank’s continued financial safety and soundness and growth. Our banking regulators have adopted risk-based capital and leverage guidelines to measure the capital adequacy of national banks. In addition, the Company’s and the Bank’s regulators may impose additional capital requirements on financial institutions and their bank subsidiaries, like the Company and the Bank, beyond those provided for statutorily, which standards may be in addition to, and require higher levels of capital, than the general capital adequacy guidelines. As discussed below, the Bank has agreed to maintain certain of its capital ratios above statutory levels and expects that the Consent Order will contain a provision requiring the Bank to maintain a minimum Tier 1 leverage capital ratio of 9% and a total risk-based capital ratio of 13%.

Following passage of the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”), bank holding companies like the Company must be subject to capital requirements that are at least as severe as those imposed on banks under current federal regulations. Trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies with over $10 billion in total assets at December 31, 2009 following passage of the Reform Act, but trust preferred securities issued by bank holding companies with under $10 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. Accordingly, the Company’s trust preferred securities will continue to count as Tier 1 capital.

The table below sets forth the Company’s capital ratios as of the periods indicated.


	March 31,			December 31,
	2011			2010
Tier 1 Risk-Based Capital		11.02	%		11.87	%
Regulatory Minimum		4.00	%		4.00	%

Total Risk-Based Capital		12.75	%		13.27	%
Regulatory Minimum		8.00	%		8.00	%

Tier 1 Leverage		8.28	%		8.34	%
Regulatory Minimum		4.00	%		4.00	%

The table below sets forth the Bank’s capital ratios as of the periods indicated.


	March 31,			December 31,
	2011			2010
Tier 1 Risk-Based Capital		11.47	%		11.97	%
Regulatory Minimum		4.00	%		4.00	%
Well-capitalized minimum		6.00	%		6.00	%

Total Risk-Based Capital		12.74	%		13.23	%
Regulatory Minimum		8.00	%		8.00	%
Well-capitalized minimum		10.00	%		10.00	%
Level required by OCC (see below)		13.00	%		13.00	%

Tier 1 Leverage		8.62	%		8.41	%
Regulatory Minimum		4.00	%		4.00	%
Well-capitalized minimum		5.00	%		5.00	%
Level required by OCC (see below)		9.00	%		9.00	%

In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. As noted above, the Bank had 8.62% of Tier 1 capital to average assets and 12.74% of total capital to risk-weighted assets at March 31, 2011 and thus was not in compliance with such requirements. The Bank’s Tier 1 capital at March 31, 2011 was approximately $2,052,000 below the amount needed to meet the agreed-upon Tier 1 capital to average assets ratio of 9%. The Bank’s total risk-based capital at March 31, 2011 was approximately $1,050,000 below the amount needed to meet the agreed-upon total capital to risk-weighted assets ratio of 13%. As a result of its non-compliance with these requirements, the OCC may bring further enforcement actions, including a consent order, against the Bank. Management’s strategy to reduce total assets described above in Note 8. Regulatory Matters positively affected the Company’s and the Bank’s Tier 1 capital to average assets ratio during the first quarter of 2011 and should continue to positively impact the ratio during the remainder of the year. However, as noted above, these measures were not significant enough for the Bank to maintain its Tier 1 capital to average assets and total capital to risk-weighted assets ratios above the levels agreed upon with the OCC. The Company is actively exploring other potential transactions to raise capital at the holding company that could provide additional capital for the Bank.

As described above, the Company anticipates that the Bank will be requested to replace the formal written agreement that the Bank is currently subject to with the Consent Order containing, among other provisions, capital maintenance ratio requirements similar to those currently contained in the informal commitment described in the immediately preceding paragraph requiring the Bank to achieve and maintain a minimum Tier 1 to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. Once the Consent Order is effective, the Bank will be deemed to be “adequately capitalized” even if the Bank’s capital ratios exceed those minimum amounts necessary to be considered “well capitalized” under federal banking regulations as well as the minimum ratios set forth in the Consent Order.

Liquidity is the ability of a company to convert assets into cash or cash equivalents without significant loss. Our liquidity management involves maintaining our ability to meet the day-to-day cash flow requirements of our customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, we would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the production and growth needs of the communities we serve.

The Company’s primary source of liquidity is dividends paid to it by the Bank and cash that has not been injected into the Bank. The Bank is required by federal law to obtain the prior approval of the OCC for payments of dividends if the total of all dividends declared by its board of directors in any year will exceed (1) the total of its net profits for that year, plus (2) its retained net profits of the preceding two years, less any required transfers to surplus. Given the losses experienced by the Bank during 2009 and 2010, the Bank may not, without the prior approval of the OCC, pay any dividends to the Company until such time that current year profits exceed the net losses and dividends of the prior two years. Generally, federal regulatory policy discourages payment of holding company or bank dividends if the holding company or its subsidiaries are experiencing losses. Accordingly, until such time as it may receive dividends from the Bank, the Company must service its interest payment on its subordinated indebtedness from its available cash balances, if any.

On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. Management cannot currently project the length of time it will be necessary to extend the deferral of these payments and therefore anticipates deferring payment indefinitely. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. At March 31, 2011, total interest accrued for these deferred payments was approximately $170,000.

Supervisory guidance from the Federal Reserve Board indicates that bank holding companies that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries. The Company has informally committed to the Federal Reserve Board that it will not (1) declare or pay dividends on the Company’s common or preferred stock, or (2) incur any additional indebtedness without in each case, the prior written approval of the Federal Reserve Board.

The primary function of asset and liability management is not only to assure adequate liquidity in order for us to meet the needs of our customer base, but also to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that we can also meet the investment objectives of our shareholders. Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both the needs of our customers and the objectives of our shareholders. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are therefore monitored on a daily basis.

Off-Balance Sheet Arrangements

Our only material off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit issued in the ordinary course of business to facilitate customers’ funding needs or risk management objectives.

Commitments and Lines of Credit

In the ordinary course of business, the Bank has granted commitments to extend credit and standby letters of credit to approved customers. Generally, these commitments to extend credit have been granted on a temporary basis for seasonal or inventory requirements and have been approved by the loan committee. These commitments are recorded in the financial statements as they are funded. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitment amounts expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Following is a summary of the commitments outstanding at March 31, 2011 and December 31, 2010.


	March 31,		December 31,
	2011		2010
	(in thousands)

Commitments to extend credit	$	35,847	$	41,155
Standby letters of credit		4,271		5,288

TOTALS	$	40,118	$	46,443

Commitments to extend credit include unused commitments for open-end lines secured by 1-4 family residential properties, commitments to fund loans secured by commercial real estate, construction loans, land development loans, and other unused commitments. Reflecting current economic conditions in our market, commitments to fund commercial real estate, construction, and land development loans decreased by approximately $2,424,000 to approximately $5,280,000 at March 31, 2011, compared to commitments of approximately $7,704,000 at December 31, 2010.

Income Statement Analysis

The following tables set forth the amount of our average balances, interest income or interest expense for each category of interest-earning assets and interest-bearing liabilities and the average interest rate for total interest-earning assets and total interest-bearing liabilities, net interest spread and net interest margin for the three months ended March 31, 2011 and 2010 (dollars in thousands):

Net Interest Income Analysis
For the Three Months Ended March 31, 2011 and 2010
(in thousands, except rates)


	Average Balance				Income/Expense				Yield/Rate
	2011		2010		2011		2010		2011			2010
*Interest-earning assets:*
Loans	$	371,429	$	406,902	$	4,609	$	5,148		5.03	%		5.13	%
Investment Securities:
Available for sale		87,509		147,227		548		808		2.54	%		2.23	%
Held to maturity		1,323		1,571		15		16		4.60	%		4.13	%
Equity securities		3,843		3,818		48		48		5.07	%		5.10	%

Total securities		92,675		152,616		611		872		2.67	%		2.32	%
Federal funds sold and other		7,209		23,265		6		11		0.34	%		0.19	%

Total interest-earning assets		471,313		582,783		5,226		6,031		4.50	%		4.20	%
*Nonearning assets*		66,596		72,878

Total Assets	$	537,909	$	655,661


*Interest-bearing liabilities:*
Interest bearing deposits:
Interest bearing demand deposits		105,513		155,728		262		446		1.01	%		1.16	%
Savings deposits		23,154		22,001		42		73		0.74	%		1.35	%
Time deposits		258,007		308,452		1,149		1,660		1.81	%		2.18	%

Total interest bearing deposits		386,674		486,181		1,453		2,179		1.52	%		1.82	%
Securities sold under agreements to repurchase		622		1,570		3		6		1.96	%		1.55	%
Federal Home Loan Bank advances and other borrowings		55,200		62,900		554		638		4.07	%		4.11	%
Subordinated debt		13,403		13,403		77		80		2.33	%		2.42	%

Total interest-bearing liabilities		455,899		564,054		2,087		2,903		1.86	%		2.09	%
*Noninterest-bearing deposits*		44,700		42,454		—		—

Total deposits and interest-bearings liabilities		500,599		606,508		2,087		2,903		1.69	%		1.94	%

Other liabilities		2,416		1,651
*Shareholders’ equity*		34,894		47,502

	$	537,909	$	655,661

*Net interest income*					$	3,139	$	3,128

Net interest spread (1)										2.64	%		2.11	%
Net interest margin (2)										2.70	%		2.18	%


(1)		Yields realized on interest-earning assets less the rates paid on interest-bearing liabilities.

(2)		Net interest margin is the result of annualized net interest income divided by average interest-earning assets for the period.

The following tables set forth the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) change in volume (change in volume multiplied by previous year rate); (2) change in rate (change in rate multiplied by current year volume); and (3) a combination of change in rate and change in volume. The changes in interest income and interest expense attributable to both volume and rate have been allocated proportionately to the change due to volume and the change due to rate.

ANALYSIS OF CHANGES IN NET INTEREST INCOME


	2011 Compared to 2010
	Increase (decrease)
	due to change in
	Rate			Volume			Total
	*(dollars in thousands)*
Three months ended March 31, 2011 and 2010
Income from interest-earning assets:
Interest and fees on loans	$	(92	)	$	(447	)	$	(539	)
Interest on securities		80			(341	)		(261	)
Interest on Federal funds sold and other		3			(8	)		(5	)

Total interest income		(9	)		(796	)		(805	)

Expense from interest-bearing liabilities:
Interest on interest-bearing deposits		(72	)		(143	)		(215	)
Interest on time deposits		(237	)		(274	)		(511	)
Interest on other borrowings		(10	)		(80	)		(90	)

Total interest expense		(319	)		(497	)		(816	)


Net interest income	$	310		$	(299	)	$	11

The following is a summary of our results of operations (dollars in thousands except per share amounts):


	Three months ended
	3/31/11			3/31/10			$ change			% change
Interest income:
Loans	$	4,609		$	5,148			(539	)		-10.47	%
Securities		611			872			(261	)		-29.93	%
Fed funds sold/other		6			11			(5	)		-45.45	%

Total Interest income		5,226			6,031			(805	)		-13.35	%
Interest Expense:
Deposits		1,453			2,179			(726	)		-33.32	%
Other borrowed funds		634			724			(90	)		-12.43	%

Total interest expense		2,087			2,903			(816	)		-28.11	%


Net interest income		3,139			3,128			11			0.35	%
Provision for loan losses		3,000			212			2,788			1315.09	%

Net interest income after provision for loan losses		139			2,916			(2,777	)		-95.23	%
Noninterest income		887			1,975			(1,088	)		-55.09	%
Noninterest expense		4,306			4,584			(278	)		-6.06	%

Net income (loss) before income tax benefit		(3,280	)		307			(3,587	)		-1168.40	%
Income tax benefit		99			(22	)		121			550.00	%

Net income (loss)	$	(3,379	)	$	329		$	(3,708	)		-1127.05	%

Net Interest Income and Net Interest Margin

Interest Income

The interest income and fees earned on loans are the largest contributing element of interest income. The decrease in this component of interest income for the three months ended March 31, 2011 as compared to the same period in 2010 was primarily the result of a decrease in the volume of average loans as well as a decrease in the average rate earned on loans. Average loans outstanding decreased approximately $35,473,000, or 8.7%, from March 31, 2010 to March 31, 2011. The decrease in the average yield on loans was the result of several factors including the increase in TDRs involving interest rate concessions and the increase in average non-accrual loans. Interest income on securities decreased during the three-month period ended March 31, 2011 as compared to the same period in 2010 due to the approximately $59,941,000, or 39.3%, decrease in the volume of average securities from March 31, 2010 to March 31, 2011. Partially offsetting the reduction in volume, the yield earned on securities increased 35 basis points during the first quarter of 2011 as compared to the same period in 2010 reflecting a redistribution of the portfolio from lower to higher yielding investments at March 31, 2011 when compared to March 31, 2010. Additionally, interest income on federal funds sold/other decreased due to a decrease in the average balance outstanding.

Interest Expense

The decrease in interest expense for the three months ended March 31, 2011 as compared to the same period in 2010 was attributable to the reduction in both the volume and the average cost of the Bank’s interest-bearing liabilities, predominantly the volume and cost of time and interest bearing demand deposits. The average balance of total interest bearing deposits, the largest component of interest-bearing liabilities, decreased approximately $99,507,000, or 20.5%, for the first three months of 2011 compared to the first three months of 2010. Additionally, the average rate paid on total interest bearing deposits decreased 30 basis points between the two periods contributing to the net decrease in deposit interest expense. Interest expense on FHLB advances and other borrowings decreased during the three-month period ended March 31, 2011 compared to the same period in 2010 due to a decrease in the average borrowed funds balance of approximately $7,700,000, or 12.2%, during the periods compared. The average rate paid on these liabilities decreased 4 basis points, contributing to the reduction in interest expense. The average balance of subordinated debentures did not change from March 31, 2010 to March 31, 2011. Therefore, the 9 basis point decrease in the rate paid on this debt for the three-month period ended March 31, 2011 compared to the same period in 2010 resulted in an overall decrease in the related interest expense.

Interest bearing deposits consist of interest bearing demand deposits, savings and time deposits. As stated above, the cost of our interest bearing deposits decreased for the first three months of 2011 compared to the first three months of 2010. The largest factor contributing to the overall reduction in expense was a reduction in the average balance of time deposits from the first quarter of 2010 to the first quarter of 2011 of approximately $50,445,000, or 16.4%, followed by a reduction in the average rate paid on these time deposits of 37 basis points between the periods compared. Additionally, the average balance of interest bearing demand deposits decreased approximately $50,215,000, or 32.3%, during the first three months of 2011 when compared to the first three months of 2010, primarily due to a decrease in average public funds deposits resulting from Management’s 2009 strategic initiative that involved not bidding to retain the deposits of certain municipal entities. The rate paid on these deposits decreased 15 basis points during the same time period.

Net Interest Income

The increase in net interest income before the provision for loan losses for the three-month period ended March 31, 2011 when compared to the same period in 2010 was primarily the result of the decrease in interest expense on deposits and FHLB advances. Decreases in interest income, mostly related to loans and investment securities, largely offset the decreased interest expenses. Net interest income for the two periods was also influenced by decreases in the volume of interest-earning assets and interest-bearing liabilities as well as decreases in rates earned and paid on these interest-sensitive balances.

Net Interest Margin

Our net interest margin, the difference between the yield on earning assets, including loan fees, and the rate paid on funds to support those assets, increased 52 basis points for the first three months of 2011 compared to the same period in 2010. The increase in our net interest margin reflects an increase in the average spread during the first three months of 2011 between the rates we earned on our interest-earning assets, which had an increase in overall yield of 30 basis points to 4.50% at March 31, 2011, as compared to 4.20% at March 31, 2010, and the rates we paid on interest-bearing liabilities, which had a decrease of 23 basis points in the overall rate to 1.86% at March 31, 2011, versus 2.09% at March 31, 2010. Our net interest margin continues to be negatively impacted by the high level of nonaccrual loans as well as TDRs involving interest rate concessions. For the three-month period ended March 31, 2011, when compared to the same period in 2010, average nonaccrual loans increased approximately $2,469,000, or 4.8%, from approximately $51,609,000 at March 31, 2010 to $54,078,000 at March 31, 2011. The average balance of TDRs, certain of which involve interest rate concessions that cause the effective interest rate to be below the current market rate for similar debt, increased approximately $40,074,000, or 95.6%, from the first three months of 2010 to the first three months of 2011. Additionally, the net interest margin was positively affected by an increase in the average balance of noninterest-bearing deposits of approximately $2,246,000, or 5.29%, from the first quarter of 2010 to the first quarter of 2011. The effects of these changes will continue as long as and to the extent that the average balances of nonaccrual loans, TDRs and noninterest-bearing deposits remains elevated.

Provision For Loan Losses

The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses and is based on management’s evaluation of economic conditions, volume and composition of the loan portfolio, historical charge-off experience, the level of non-performing and past due loans, and other indicators derived from reviewing the loan portfolio. Management performs such reviews quarterly and makes appropriate adjustments to the level of the allowance for loan losses as a result of these reviews.

As mentioned above in the section titled Allowance for Loan Losses, management determines the necessary amount, if any, to increase the allowance account through the provision for loan losses. Although total loans decreased approximately $9 million during the first three months of 2011, the continuing increased level of provision for loan loss expense during the first quarter of 2011 was due to increased charge-offs and delinquencies, related primarily to deterioration in the real estate segment of the Company’s loan portfolio, particularly construction and land development, as well as increased probable losses as the result of the slowdown in economic conditions. Continuing reductions in property values and the reduced volume of sales of developed and undeveloped land has led to an increase of impaired loans determined to be collateral dependent. As the collateral value for these land loans has declined significantly during 2010 and into 2011, related charge-offs and provision expense have been incurred. Management has continued its ongoing review of the loan portfolio with particular emphasis on construction and land development loans and while we believe we have identified and adequately provided for losses present in the loan portfolio, due to the necessarily approximate and imprecise nature of the allowance for loan loss estimate, certain projected scenarios may not occur as anticipated. Additionally, further deterioration of factors relating to the loan portfolio, such as conditions in the local and national economy and the local real estate market, could have an added adverse impact and require additional provision expense and higher allowance levels.

The following table summarizes our loan loss experience and provision for loan losses for the three months ended March 31, 2011 and 2010.


	Three Months Ended March 31,
	2011			2010
	(dollars in thousands)
Charge-offs:
Construction and land development	$	839		$	290
Equity Lines of Credit		9			54
Residential 1-4 family		2,789			113
Second mortgages		26			—
Residential multifamily		2			—
Commercial real estate		225			48
Consumer loans		70			104
Recoveries:
Equity Lines of Credit		(1	)		(1	)
Commercial real estate		(48	)		—
Consumer loans		(6	)		(18	)


Net charge-offs		3,905			590

Average balance of loans outstanding		371,429			406,902
Annualized net charge-offs as % of average loans		4.26	%		0.59	%
Provision for loan losses		3,000			212

As noted in the table above, the majority of net charge-offs during the first quarter of 2011 were related to residential 1-4 family real estate loans followed by construction and land development loans. Six relationships involving charge-offs of approximately $3.4 million represent 87.5% of net charge-offs during the first quarter of 2011. Of this total, approximately $2.5 million, $741,000 and $189,000 were related to the residential 1-4 family, construction and land development and commercial real estate categories, respectively.

Non-Interest Income

Non-interest income represents the total of all sources of income, other than interest-related income, which are derived from various service charges, fees and commissions charged for bank services. The decrease in non-interest income for the three months ended March 31, 2011, was primarily attributable to the decrease in gain on investment securities. The gains recognized during the first quarter of 2010 were related to management’s strategy to manage liquidity and pledging requirements discussed in more detail above under Investment Securities. The decrease in non-interest income was also affected by a reduction in net ORE gains as well as a decrease in other noninterest income which was largely the result of a decrease in income generated by the Bank’s investment in Appalachian Fund for Growth II, LLC. Additionally, there was a decrease in gain on sale of mortgage loans and deposit service charges during the first three months of 2011, primarily non-sufficient fee income from overdrafts of demand deposit accounts.

The following table presents the main components that make up the changes in non-interest income:


	Three months ended
	3/31/11		3/31/10		$ change			% change
	(dollars in thousands)
Investment gains and losses, net	$	—	$	954		(954	)		-100.00	%
Other noninterest income		142		192		(50	)		-26.04	%
Net gain (loss) on other real estate		14		59		(45	)		-76.27	%
Gain on sale of mortgage loans		23		45		(22	)		-48.89	%
Service charges on deposit accounts		378		398		(20	)		-5.03	%
Other fees and commissions		331		326		5			1.53	%

Non-Interest Expense

The Company’s net loss during the three months ended March 31, 2011, as compared to the same period in 2010, was positively impacted by the decrease in non-interest expense. Total non-interest expense represents the total costs of operating overhead, such as salaries, employee benefits, building and equipment costs, telephone costs and marketing costs. The decrease in non-interest expense from the first quarter 2010 to the first quarter of 2011 relates primarily to a decrease in salary and employee benefit expenses which is the result of several cost cutting measures implemented during the first quarter of 2010 including staff reductions as well as reductions in remaining employees’ salaries, health insurance costs, 401(k) match expenses and fees paid to members of the board of directors, among other things. The decrease in non-interest expense was also attributable to a decrease in ORE expense related to maintenance and upkeep of our foreclosed properties. The decrease in non-interest expense was negatively impacted during the three months ended March 31, 2011 by an increase in FDIC assessment expense as well as increases in other general areas, primarily professional fees and credit/debit card related expenses.

The following table presents the main components that make up the changes in non-interest expense:


	Three months ended
	3/31/11		3/31/10		$ change			% change
	(dollars in thousands)
Salaries and employee benefits	$	1,995	$	2,342		(347	)		-14.82	%
Other real estate expense		153		206		(53	)		-25.73	%
FDIC assessment expense		352		312		40			12.82	%
Occupancy expenses		454		449		5			1.11	%

Income Taxes

The Company’s income tax expense (benefit) for the three months ended March 31, 2011 and 2010 is presented in the following table:

Provision for Income Taxes and Effective Tax Rates
(dollars in thousands)


	Three months ended
	3/31/11			3/31/10
Provision expense (benefit)		99			(22	)
Pre-tax income (loss)		(3,280	)		307
Effective tax rate		-3.02	%		-7.17	%

During the first quarter of 2011, the Bank’s effective income tax expense rate was primarily the result of increasing the deferred tax asset valuation allowance. Recording a valuation allowance requires recognition of tax expense which, when applied to a pretax loss, causes a negative effective tax rate. Additionally, tax exempt income has the effect of increasing a taxable loss, therefore increasing effective tax rates as a percentage of pretax income. This is the opposite effect on tax rates when a company has pretax income. During the first quarter of 2010, the Bank’s tax exempt income was enough to offset its taxable income resulting in a net tax benefit during the period and a negative effective tax rate. Tax exempt income effectively reduces the statutory tax rate and, as was the case during the first quarter of 2010, can potentially reduce the rate below zero.

For each period presented above, the effective tax rate was positively impacted by the continuing tax benefits generated from MNB Real Estate, Inc., which is a real estate investment trust subsidiary formed during the second quarter of 2005. The income generated from tax-exempt municipal bonds and bank owned life insurance also continues to improve our effective tax rate. Additionally, during 2006, the Bank became a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership has invested in a program that is expected to generate a federal tax credit in the amount of approximately $200,000 during 2011. The program is also expected to generate a one-time state tax credit in the amount of $200,000 to be utilized over a maximum of 20 years to offset state tax liabilities.

The Company had net deferred tax assets of approximately $104,000 as of March 31, 2011. A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion of the entire deferred tax or asset will not be realized. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of increased credit losses, the Company entered into a three-year cumulative pre-tax loss position in 2010. A cumulative loss position is considered significant negative evidence in assessing the reliability deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on future reversals of existing taxable temporary differences and taxable income in prior carry back years. The Company did not consider future taxable income in determining the reliability of its deferred assets. During the first quarter of 2011, we recorded an additional valuation allowance of approximately $1,273,000. The timing of the reversal of the valuation allowance is dependent on our assessment of future events and will be based on the circumstances that exist as of that future date.


ITEM 4.		CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports and other information filed with the Commission, under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to the management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

The Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon the foregoing, the Chief Executive Officer along with the Chief Financial Officer concluded that certain deficiencies identified in internal controls and procedures created a material weakness and resulted in the Company’s disclosure controls and procedures not being effective to ensure that information required to be disclosed in the Company’s reports under the Exchange Act was recorded, summarized and reported within the time periods specified in the Commission’s rules and forms as of the end of the period covered by this report. Based on this determination of the existence of a material weakness, which began during the fourth quarter of 2010 and continued into the first quarter of 2011, management identified certain areas requiring internal control and procedure improvements.

Changes in Internal Control over Financial Reporting

During Management’s assessment of the Company’s internal control over financial reporting at December 31, 2010 and continuing into the first quarter of 2011, the following deficiencies were noted: 1) Loans determined to be collateral dependent were not properly identified in a timely manner which created a material internal control deficiency. Procedures have been put in place by the Bank’s Special Assets Department to ensure loans that are dependent upon the sale of the underlying collateral for repayment are properly identified and documented when the determination is made the loan is collateral dependent and this information is incorporated in the allowance for loan loss calculation. 2) Appraisals and appraisal reviews from an independent third-party appraiser or collateral valuations performed internally for loans determined to be collateral dependent were not ordered, received or reviewed prior to the reporting date which could result in overstatement of loans and income and understatement of the provision for loan losses, charge off and the allowance for loan losses. The Special Assets Department has created procedures and updated the Appraisal Policy to address this deficiency. The remediation plan for these internal control deficiencies is noted below. Other than the items noted above, during the first quarter of 2011 there were no other changes in the Company’s internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.

During the first quarter of 2011, management took the following remediation actions regarding the above referenced internal control deficiencies:

	1)		During the first quarter of 2011, the OCC, during their regular safety and soundness exam, determined several loans were not properly identified by the Bank as collateral dependent as of December 31, 2010. Collateral dependent loans require a charge off of the loan balance if the recorded investment in the loan exceeds the underlying collateral value net of cost to sell. To make the determination the proper recorded investment has been recorded, the current appraised value of the collateral must be obtained. The Special Assets Department, formed during 2009, is in charge of complying with these requirements. During the first quarter of 2011, procedures were put in place in the Special Assets Department to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of March 31, 2011.

	2)		As noted in item 1, collateral dependent loans require the Bank to obtain a current appraisal or collateral valuation performed internally to allow for the determination as to whether there is sufficient collateral securing the loan. In addition to the requirement of obtaining the appraisal, the appraisal must be reviewed by an independent third-party appraiser charged with determining the appraisal has been properly performed. After the review, the Bank determines if the appraisal is acceptable, then provides the documentation to the Accounting Department to incorporate the results into the calculation of the allowance for loan losses. Failure to comply with any of these steps could result in the overstatement of both assets and income. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of March 31, 2011.

	3)		During the first quarter of 2011, Management sought to ensure proper controls are in place so that when either evidence of impairment of a loan exists or prior to the annual appraisal date, the Special Assets Department will order appraisals or collateral valuations in a timely manner to allow for proper review and incorporation of the results into the allowance for loan loss calculation. Additional controls have also been developed and incorporated into the process to assure a potential impairment is recorded when appraisal or valuation and review process is not complete as of a reporting date.

	4)		The Bank has revised its policy and procedures to require independent third-party appraisals or collateral valuations performed internally for all loans considered to be impaired, classified or worse. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of March 31, 2011.

The identified material weakness in our internal controls over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, tested, and concluded by management to be operating effectively.

PART II — OTHER INFORMATION


ITEM 1A.		RISK FACTORS

Except as set forth below, there were no material changes to the risk factors previously disclosed in Part I, Item 1A, of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010:

The effectiveness of our asset management activities are critical to our ability to improve, resolve or liquidate nonperforming loans and other real estate and thereby reduce loan losses and other real estate expense.

Over the past two years, we have undertaken various initiatives to enhance our credit review, loan administration and special asset management and administration procedures, and we believe that these enhancements should begin to reduce the levels of our problem and potential problem assets. However, continued improvement is dependent to a degree on market conditions and other factors beyond our control and if we are unable to successfully manage our problem and potential problem assets in a timely matter, we could experience materially increased loan losses and other real estate expenses.


ITEM 6.		EXHIBITS

Exhibits

The following exhibits are filed as a part of or incorporated by reference in this report:


Exhibit No.		Description

	3.1	Charter of the Company (1)

	3.2	Amended and Restated Bylaws of the Company, as amended (2)

	31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended

	31.2	Certification of the Senior Vice President and Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended

	32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification of the Senior Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


(1)		Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (333-168281) as filed with the Securities and Exchange Commission on July 22, 2010.

(2)		Incorporated by reference to the Registrants Form 8-K as filed with the Securities and Exchange Commission March 31, 2010.

SIGNATURES

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


	MOUNTAIN NATIONAL BANCSHARES, INC.
Date: May 16, 2011	/s/ Dwight B. Grizzell
	Dwight B. Grizzell
	President and Chief Executive Officer

Date: May 16, 2011	/s/ Richard A. Hubbs
	Richard A. Hubbs
	Senior Vice President and Chief Financial Officer

EXHIBIT INDEX


Exhibit No.		Description

	3.1	Charter of the Company (1)

	3.2	Amended and Restated Bylaws of the Company, as amended (2)

	31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended

	31.2	Certification of the Senior Vice President and Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended

	32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

	32.2	Certification of the Senior Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


(1)		Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (333-168281) as filed with the Securities and Exchange Commission on July 22, 2010.

(2)		Incorporated by reference to the Registrant’s Form 8-K as filed with the Securities and Exchange Commission on March 31, 2010.

MOUNTAIN NATIONAL BANCSHARES INC - FORM 10-Q - May 16, 2011

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