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EX-32.1 - EXHIBIT 32.1 - BAY BANCORP, INC.ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - BAY BANCORP, INC.ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - BAY BANCORP, INC.ex31-1.htm
EX-32.2 - EXHIBIT 32.2 - BAY BANCORP, INC.ex32-2.htm
United States Securities and Exchange Commission
Washington, D.C. 20549
 
FORM 10-Q
 
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2012

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURIIES EXCHANGE ACT OF 1934
 
For the transition period from           to           
 
Commission file number     0-23090
 
CARROLLTON BANCORP
(Exact name of registrant as specified in its charter)
 
MARYLAND
 
52-1660951
(State or other jurisdiction
of incorporation or organization)
 
(IRS Employer
Identification No.)
 
7151 Columbia Gateway Drive, Suite A, Columbia, Maryland 21046
(Address of principal executive offices)                (Zip Code)

(410) 312-5400
(Registrant’s telephone number, including area code)
 
 (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 for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý  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 (§223.405 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 ý   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  (Do not check if a smaller reporting company)       Smaller reporting company x  
 
 
                                                                                                                              
                                                                                                                                       
 
 
 

 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes  o    No  x
 
Indicate the number shares outstanding of each of the issuer’s classes of
common stock, as of the latest practicable date:
2,579,388 common shares outstanding at May 14, 2012
 
 





































 
 

 






CARROLLTON BANCORP
CONTENTS
 
PART I - FINANCIAL INFORMATION
PAGE
     
 
Item 1. Financial Statements:
 
 
Consolidated Balance Sheets as of March 31, 2012 (unaudited) and December 31, 2011
 
Consolidated Statements of Income for the Three Months Ended March 31, 2012 and 2011 (unaudited)
 
Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2012 and 2011 (unaudited)
 
Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2012 and 2011 (unaudited)
 
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011 (unaudited)
 
Notes to Consolidated Financial Statements
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk
 
Item 4. Controls and Procedures
 
PART II - OTHER INFORMATION
 
 
Item 1. Legal Proceedings
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
Item 3. Defaults Upon Senior Securities
 
Item 4. Mine Safety Disclosures
 
Item 5. Other Information
 
Item 6. Exhibits
 
 
 

 
 
PART I
 
ITEM 1.    FINANCIAL STATEMENTS
 
CONSOLIDATED BALANCE SHEETS

   
March 31
   
December 31,
 
   
2012
   
2011
 
   
(unaudited)
       
ASSETS
           
Cash and due from banks
  $ 3,337,446     $ 2,411,319  
Federal funds sold and other interest-bearing deposits
    27,420,179       13,185,809  
Total cash and equivalents
    30,757,625       15,597,128  
Federal Home Loan Bank stock, at cost
    2,111,300       2,111,300  
Investment securities:
               
Available for sale
    24,447,771       25,470,207  
Held to maturity (fair value of $2,874,377 and $3,024,217)
    2,713,174       2,848,594  
Loans held for sale
    35,170,486       28,420,897  
Loans, less allowance for loan losses of $5,038,876 and $4,858,551
    250,973,789       264,190,295  
Premises and equipment
    6,662,694       6,660,574  
Accrued interest receivable
    1,162,217       1,215,060  
Bank owned life insurance
    5,117,396       5,081,539  
Deferred income taxes
    5,553,605       6,087,400  
Foreclosed real estate
    4,878,849       4,822,417  
Other assets
    2,868,036       2,854,806  
    $ 372,416,942     $ 365,360,217  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Deposits
               
Noninterest-bearing
  $ 83,838,349     $ 75,020,489  
Interest-bearing
    248,319,747       239,972,347  
Total deposits
    332,158,096       314,992,836  
Advances from the Federal Home Loan Bank
    2,210,000       11,210,000  
Accrued interest payable
    35,201       50,689  
Accrued pension plan
    3,017,997       3,579,496  
Other liabilities
    2,276,930       2,883,623  
      339,698,224       332,716,644  
                 
STOCKHOLDERS’ EQUITY
               
Preferred stock, par value $1.00 per share (liquidation preference of $1,000 per share) authorized
    9,035,503       9,013,436  
shares; issued and outstanding 9,201 as of March 31, 2012 and December 31, 2011 (discount of
               
$165,497 as of March 31, 2012 and $187,564 as of December 31, 2011)
               
Common stock, par $1.00 per share; authorized 10,000,000 shares; issued and outstanding 2,576,388
    2,576,388       2,576,388  
as of March 31, 2012 and December 31, 2011
               
Additional paid-in capital
    15,725,454       15,725,454  
Retained earnings
    9,497,003       9,886,546  
Accumulated other comprehensive income
    (4,115,630 )     (4,558,251 )
      32,718,718       32,643,573  
    $ 372,416,942     $ 365,360,217  
 
See accompanying notes to consolidated financial statements.


 
4

 


CONSOLIDATED STATEMENTS OF INCOME


   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(unaudited)
   
(unaudited)
 
Interest income:
           
Loans
  $ 3,859,938     $ 4,065,366  
Investment securities:
               
Taxable
    233,264       293,954  
Nontaxable
    76,493       76,707  
Dividends
    7,514       7,261  
Federal funds sold and other interest-bearing deposits
    9,642       1,100  
                 
Total interest income
    4,186,851       4,444,388  
                 
Interest expense:
               
Deposits
    742,994       806,744  
Borrowings
    83,722       212,124  
                 
Total interest expense
    826,716       1,018,868  
                 
Net interest income
    3,360,135       3,425,520  
                 
Provision for loan losses
    245,514       114,217  
                 
Net interest income after provision for loan losses
    3,114,621       3,311,303  
                 
Noninterest income:
               
Electronic banking fees
    697,437       608,564  
Mortgage-banking fees and gains
    1,130,832       775,594  
Brokerage commissions
    149,222       200,247  
Service charges on deposit accounts
    98,735       123,736  
Other fees and commissions
    85,366       79,246  
Write down of impaired securities
    (819,054 )     (167,467 )
Security (losses) gains, net
    498       (2,603 )
                 
Total noninterest income
    1,343,036       1,617,317  
                 
Noninterest expenses:
               
Salaries
    1,991,600       1,889,913  
Employee benefits
    528,091       635,484  
Occupancy
    583,268       597,718  
Professional services
    364,585       191,925  
Furniture and equipment
    147,631       147,884  
Foreclosed real estate losses, write downs and costs
    176,320       74,715  
Other operating expenses
    1,122,306       1,166,219  
                 
Total noninterest expenses
    4,913,801       4,703,858  
                 
(Loss) Income before income taxes
    (456,144 )     224,762  
                 
Income tax (benefit) expense
    (203,680 )     53,467  
                 
Net (loss) income
    (252,464 )     171,295  
Preferred stock dividends and discount accretion
    137,079       137,078  
Net (loss) income available to common stockholders
  $ (389,543 )   $ 34,217  
                 
Basic net (loss) income per common share
  $ (0.15 )   $ 0.01  
                 
Diluted net (loss) income per common share
  $ (0.15 )   $ 0.01  
 
See accompanying notes to consolidated financial statements.




 
5

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Three Months Ended March 31, 2012 and 2011 (unaudited)


   
Three months Ended
 
   
March 31,
 
   
2012
   
2011
 
Net (Loss) Income
  $ (252,464 )   $ 171,295  
                 
Other comprehensive income
               
   Unrealized gain/(loss) on securities available for sale
    (87,615 )     (208,315 )
Reclassification adjustment for net (gains) losses included in net income
    818,556       170,070  
      730,941       (38,245 )
Income Tax relating to items above
    (288,320 )     15,085  
    Other comprehensive income
    442,621       (23,160 )
Total comprehensive income
  $ 190,157     $ 148,135  
                 
 
 
See accompanying notes are an integral part of these consolidated financial statements.
 
 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Three Months Ended March 31, 2012 and 2011 (unaudited)
 
                           
Accumulated
 
               
Additional
         
Other
 
   
Preferred
   
Common
   
Paid-in
   
Retained
   
Comprehensive
 
   
Stock
   
Stock
   
Capital
   
Earnings
   
Income
 
Balance December 31, 2010
  $ 8,925,171     $ 2,573,088     $ 15,713,782     $ 9,888,133     $ (3,705,196 )
Net income
    -       -       -       171,295       -  
Changes in unrealized gains (losses) on available for sale securities & paid pension, net of tax
    -       -       -       -       (23,160 )
Comprehensive income
                                       
Accretion of discount associated with U.S. Treasury preferred stock
    22,066       -       -       (22,066 )     -  
Issuance of Common Stock under 2007 Equity Plan
    -       -       -       -       -  
Preferred stock dividend accrued
    -       -       -       -          
Preferred stock cash dividend
    -       -       -       (115,012 )     -  
Balance March 31, 2011
  $ 8,947,237     $ 2,573,088     $ 15,713,782     $ 9,922,350     $ (3,728,356 )
                                         
                                         
                                   
Accumulated
 
                   
Additional
           
Other
 
   
Preferred
   
Common
   
Paid-in
   
Retained
   
Comprehensive
 
   
Stock
   
Stock
   
Capital
   
Earnings
   
Income
 
Balance December 31, 2011
  $ 9,013,436     $ 2,576,388     $ 15,725,454     $ 9,886,546     $ (4,558,251 )
Net loss
    -       -       -       (252,464 )     -  
Changes in unrealized gains (losses) on available for sale securities & paid pension, net of tax
    -       -       -       -       442,621  
Comprehensive income
                                       
Accretion of discount associated with U.S. Treasury preferred stock
    22,067       -       -       (22,067 )     -  
Issuance of Common Stock under 2007 Equity Plan
    -       -       -       -       -  
Preferred stock dividend accrued
    -       -       -       (115,012 )      -  
Preferred stock cash dividend
    -       -       -       -       -  
Balance March 31, 2012
  $ 9,035,503     $ 2,576,388     $ 15,725,454     $ 9,497,003     $ (4,115,630 )
 
See accompanying notes to consolidated financial statements.
 
 
 
6

 
 
 CARROLLTON BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended March 31, 2012 and 2011

   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(unaudited)
   
(unaudited)
 
Cash flows from operating activities:
           
Net income (loss)
  $ (252,464 )   $ 171,295  
Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities:
               
Provision for loan losses
    245,514       114,217  
Depreciation and amortization
    184,536       181,660  
Amortization of premiums and discounts
    (9,202 )     (11,970 )
Write down of impaired securities
    819,054       167,467  
Loss (gain) on sale of securities
    (498 )     2,603  
Loans held for sale made, net of principal sold
    (6,749,589 )     8,396,712  
Loss (gain) on sale of foreclosed real estate
    -       29,021  
Loss (gain) on disposal of premises and equipment
    -       1,101  
Decrease (increase) in:
               
Accrued interest receivable
    52,843       70,506  
Prepaid income taxes
    (667,344 )     44,068  
Deferred income taxes
    245,476       24,253  
Cash surrender value of bank owned life insurance
    (35,857 )     (37,971 )
Other assets
    639,710       (535,466 )
Increase (decrease) in:
               
Accrued interest payable
    (15,488 )     (18,486 )
Deferred loan origination fees
    (56,019 )     (25,316 )
Accrued Pension Plan
    (561,499 )     -  
Other liabilities
    (721,707 )     (241,903 )
Net cash (used) provided by operating activities
    (6,882,534 )     8,331,791  
                 
Cash flows from investing activities:
               
Proceeds from maturities of securities available for sale
    940,246       1,227,026  
Proceeds from maturities of securities held to maturity
    135,982       411,950  
Proceeds from sale of equity securities
    3,216       1,800  
Purchase of securities available for sale
    -       (1,121,457 )
Loans made, net of principal collected
    12,885,911       7,985,746  
Purchase of premises and equipment
    (172,252 )     (259,147 )
Proceeds from sale of foreclosed real estate
    -       224,561  
Partial recovery of costs on foreclosed real estate
    84,668       -  
Proceeds from sale of premises and equipment
    -       -  
                  Net cash provided by investing activities
    13,877,771       8,470,479  
Cash flows from financing activities:
               
Net increase (decrease)  in time deposits
    4,832,074       2,835,639  
Net increase (decrease) in other deposits
    12,333,186       4,173,966  
Payments of Federal Home Loan Bank advances
    (9,000,000 )     (23,350,000 )
Dividends paid
    -       (115,012 )
Net cash provided (used) by financing activities
    8,165,260       (16,455,407 )
Net increase in cash and cash equivalents
    15,160,497       346,863  
Cash and cash equivalents at beginning of period
    15,597,128       6,662,853  
Cash and cash equivalents at end of period
  $ 30,757,625     $ 7,009,716  
                 
Supplemental information:
               
Interest paid on deposits and borrowings
  $ 842,204     $ 1,037,354  
Income taxes paid
  $ 874,300     $ 9,399  
Transfer of loan to foreclosed real estate
  $ 141,100     $ -  
 
See accompanying notes to consolidated financial statements

 
 
7

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of and for the three months ended March 31, 2012 and 2011 is unaudited)
 
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The accompanying consolidated financial statements for Carrollton Bancorp (“the Company”) have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and notes necessary for a full presentation of financial condition, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America.  The consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto, included in the Company’s 2011 Annual Report on Form 10-K (“2011 Form 10-K”) filed with the Securities and Exchange Commission (“SEC”).
 
The consolidated financial statements include the accounts of the Company’s subsidiary, Carrollton Bank, Carrollton Bank’s wholly-owned subsidiaries, Carrollton Mortgage Services, Inc. (“CMSI”), Carrollton Financial Services, Inc. (“CFS”), Mulberry Street, LLC (“MSLLC”), 13 Beaver Run LLC (“BRLLC”), Mulberry Street A LLC (“MSALLC”) and Carrollton Bank’s 96.4% owned subsidiary, Carrollton Community Development Corporation (“CCDC”) (collectively, the “Bank”).  All significant intercompany balances and transactions have been eliminated.
 
The consolidated financial statements as of March 31, 2012 and for the three months ended March 31, 2012 and 2011 are unaudited but include all adjustments, consisting only of normal recurring adjustments, which the Company considers necessary for a fair presentation of financial position and results of operations for those periods.  The results of operations for the three months ended March 31, 2012, are not necessarily indicative of the results that will be achieved for the entire year.
 
Management has evaluated all significant events and transactions that occurred after March 31, 2012 through the date these financial statements were issued for potential recognition or disclosure in these financial statements.
 
Subsequent events

On April 8, 2012, the Company, Jefferson Bancorp, Inc. (“Jefferson”) and Financial Service Partners Fund I, LLC (“FSPF”) entered into an Agreement and Plan of Merger (the “Merger Agreement”), which sets forth the terms and conditions upon which Jefferson will merge with and into the Company (the “Merger”).  The Company will be the surviving entity.  Pursuant to the Merger Agreement, the subsidiary banks of Jefferson and the Company will also merge, with Bay Bank, FSB (the subsidiary bank of Jefferson)  being the surviving entity and a wholly-owned subsidiary of the Company.
 
In exchange for 100% of the outstanding shares of Jefferson, the stockholders of Jefferson will receive newly issued shares of the Company’s common stock (“Carrollton Common Stock”) representing approximately 85.92% of the total outstanding shares of Carrollton Common Stock as of the closing of the Merger, assuming the current Company stockholders elect to exchange for cash 50%, in the aggregate, of the current outstanding Carrollton Common Stock.  Stockholders of Jefferson will receive 2.2217 shares of Carrollton Common Stock for each share of Jefferson common stock owned at the time of the Merger. Any outstanding options to purchase Jefferson common stock will be converted into options to purchase Carrollton Common Stock at the same exchange ratio described above.
 
At the effective date of the Merger, stockholders of Carrollton may elect to retain their shares of Carrollton Common Stock or to receive $6.20 in cash per share, subject to proration in the event the aggregate cash elections exceed 50% of the shares of Carrollton Common Stock outstanding as of the closing of the Merger. In no event will cash be paid for more than 50% of the total number of shares of Carrollton Common Stock outstanding as of the closing. Outstanding options to purchase Carrollton Common Stock will remain outstanding.
 
The completion of the Merger is subject to various closing conditions, including obtaining the approval of the Company’s stockholders and receiving certain regulatory approvals.
 
 
Reclassifications
 
Certain items in prior financial statements have been reclassified to conform to the current presentation.



 
8

 


NOTE 2 – NET INCOME PER COMMON SHARE

The calculation of net income per common share is as follows:

   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
Basic:
           
Net (loss) income
  $ (252,464 )   $ 171,295  
Net (loss) income available to common stockholders
    (389,543 )     34,217  
Average common shares outstanding
    2,576,388       2,573,088  
Basic net (loss) income per common share
  $ (0.15 )   $ 0.01  
Diluted:
               
Net (loss) income
  $ (252,464 )   $ 171,295  
Net (loss) income available to common stockholders
    (389,543 )     34,317  
Average common shares outstanding
    2,576,388       2,573,088  
Stock option adjustment
    -       -  
Average common shares outstanding - diluted
    2,576,388       2,573,088  
Diluted net (loss) income per common share
  $ (0.15 )   $ 0.01  

NOTE 3 – INVESTMENT SECURITIES

Investment securities are summarized as follows:
 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
cost
   
gains
   
losses
   
value
 
March 31, 2012
                       
Available for sale
                       
U.S. government agency
  $ 2,038,623     $ 76,223     $ -     $ 2,114,845  
Mortgage‑backed securities
    11,309,124       899,631       2,021       12,206,735  
State and municipal
    7,106,003       469,054       -       7,575,057  
Corporate bonds
    7,025,818       51,889       4,798,394       2,279,313  
      27,479,568       1,496,797       4,800,415       24,175,950  
Equity securities
    126,587       148,634       3,400       271,821  
    $ 27,606,155     $ 1,645,431     $ 4,803,815     $ 24,447,771  
Held to maturity
                               
Mortgage‑backed securities
  $ 1,488,174     $ 105,833     $ -     $ 1,594,007  
State and municipal
    1,225,000       55,370       -       1,280,370  
    $ 2,713,174     $ 161,203     $ -     $ 2,874,377  
                                 
                                 
                                 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
cost
   
gains
   
losses
   
value
 
December 31, 2011
                               
Available for sale
                               
U.S. government agency
  $ 2,105,188     $ 107,468     $ -     $ 2,212,656  
Mortgage‑backed securities
    12,180,280       974,839       29,195       13,125,924  
State and municipal
    7,113,029       513,695       -       7,626,724  
Corporate bonds
    7,793,220       45,791       5,577,761       2,261,250  
      29,191,717       1,641,793       5,606,956       25,226,554  
Equity securities
    167,816       147,370       71,533       243,653  
    $ 29,359,533     $ 1,789,163     $ 5,678,489     $ 25,470,207  
Held to maturity
                               
Mortgage‑backed securities
  $ 1,623,594     $ 110,955     $ -     $ 1,734,549  
State and municipal
    1,225,000       64,668       -       1,289,668  
    $ 2,848,594     $ 175,623     $ -     $ 3,024,217  
                                 


 
9

 


As of March 31, 2012 securities with unrealized losses segregated by length of impairment were as follows:

   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
 Mortgage‑backed securities
  $ 368,324     $ 2,021     $ -     $ -     $ 368,324     $ 2,021  
 State and municipals
    -       -       -       -       -       -  
 Corporate bonds
    -       -       280,293       4,798,394       280,293       4,798,394  
 Equity securities
    -       -       12,100       3,400       12,100       3,400  
    $ 368,324     $ 2,021     $ 292,393     $ 4,801,794     $ 660,717     $ 4,803,815  

 
Contractual maturities of debt securities at March 31, 2012 are shown below. Actual maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

Maturing
 
Amortized
   
Fair
   
Amortized
   
Fair
 
   
Cost
   
Value
   
Cost
   
Value
 
Within one year
  $ -     $ -     $ -     $ -  
Over one to five years
    4,569,276       4,734,421       -       -  
Over five to ten years
    3,747,185       4,019,663       1,225,000       1,280,370  
Over ten years
    7,853,983       3,215,132       -       -  
Mortgage‑backed securities
    11,309,124       12,206,734       1,488,174       1,594,007  
    $ 27,479,568     $ 24,175,950     $ 2,713,174     $ 2,874,377  

 
Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.  The amount of the impairment related to other factors is recognized in other comprehensive income.  Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
 
Management has the ability and intent to hold the securities classified as held to maturity in the table above until they mature, at which time, the Company will receive full value for the securities. Management and the Investment Committee of the Board of Directors continuously evaluate securities for possible sale due to credit quality. Any sale and reinvestment decisions will be approved by the Investment Committee.  Excluding the trust preferred securities, unrealized losses exist on two available-for-sale securities and total $5,421 at March 31, 2012. One additional equity security was deemed to be impaired and we wrote the investment in this security down $38,510 through earnings during the three months ended March 31, 2012 to the market value as of  March 31, 2012, to properly reflect impairment associated with this security. The fair value of the remaining two securities with unrealized losses is expected to recover as the investments approach their maturity date or repricing date or if market yields for such investments decline.  Management does not believe either of these securities is impaired due to reasons of credit quality.  Accordingly, as of March 31, 2012 management believes the impairments detailed in the table above, except for the trust preferred securities described below, are temporary and no impairment loss has been realized in the Company’s consolidated income statement.
 
At March 31, 2012 and December 31, 2011, the Company owned six collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (“PreTSLs”).  The market for these securities at March 31, 2012 and December 31, 2011 was not active and markets for similar securities were also not active.  The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which PreTSLs trade and then by a significant decrease in the volume of trades relative to historical levels.  The new issue market is also inactive as no new PreTSLs have been issued since 2007.  Currently very few market participants are willing or able to transact for these securities.
 
The market values for these securities (and any securities other than those issued or guaranteed by the U.S. Treasury) are very depressed relative to historical levels.   Thus, in today’s market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general versus being an indicator of credit problems with a particular issuer.
 

 
 
10

 

 
Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:
 
·  
The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at March 31, 2012 and December 31, 2011;
 
·  
An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and
 
·  
Our PreTSLs will be classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required to determine fair value at the measurement date.
 
The following tables (deferral and default amounts are in thousands) lists the class, credit rating, deferrals, defaults and carrying value of the six trust preferred securities (PreTSL):
 
March 31, 2012
   
Moody
Deferrals
 
Defaults
         
 
PreTSL
 
Class
Credit
Rating
Amount
Percent
 
Amount
Percent
 
Amortized
Cost
 
Fair
Value
IV
Mezzanine
Ca
6,000
9.02%
 
12,000
18.05%
 
 $     182,991
 
 $     78,162
XVIII
C
Ca
95,140
14.27%
 
109,000
16.35%
 
1,617,936
 
                -
XIX
B
C
135,150
20.79%
 
93,500
13.84%
 
1,006,667
 
31,787
XIX
C
Ca
135,150
20.79%
 
93,500
13.84%
 
546,696
 
                -
XXII
B-1
Caa2
175,500
13.48%
 
215,000
16.52%
 
1,724,399
 
170,344
XXIV
C-1
Ca
130,500
12.94%
 
215,800
21.40%
 
-
 
-
                 
 $ 5,078,689
 
 $ 280,293
                       
December 31, 2011
   
Moody
Deferrals
 
Defaults
         
 
PreTSL
 
Class
Credit
Rating
Amount
Percent
 
Amount
Percent
 
Amortized
Cost
 
Fair
Value
IV
Mezzanine
Ca
 $    6,000
9.02%
 
 $    12,000
18.05%
 
 $     182,991
 
 $     57,850
XVIII
C
Ca
63,140
9.47%
 
101,000
15.15%
 
1,914,659
 
16,195
XIX
B
C
102,900
15.83%
 
93,500
13.84%
 
1,006,347
 
78,007
XIX
C
Ca
102,900
15.83%
 
93,500
13.84%
 
1,030,516
 
6,501
XXII
B-1
Caa2
186,500
14.32%
 
215,000
16.52%
 
1,724,399
 
122,597
XXIV
C-1
Ca
145,500
14.43%
 
215,800
21.40%
 
-
 
-
                 
 $  5,858,912
 
 $   281,150

 
Based on qualitative considerations such as a down-grade in credit rating, defaults of underlying issuers and an analysis of expected cash flows, we determined in prior periods that three PreTSLs included in corporate bonds were other-than-temporarily impaired (OTTI). Those PreTSLs were written down in the periods in which the impairments were identified. Two of the three securities required additional adjustments and we wrote our investments in these PreTSLs down $780,544 through earnings during the three months ended March 31, 2012 to the present value of expected cash flows at March 31, 2012, to properly reflect credit losses associated with these PreTSLs. The remaining fair value of these three securities was $0 at March 31, 2012. The amortized cost of these three securities as of March 31, 2012 was $2.2 million.  The issuers of these securities are primarily banks, but some of the pools do include a limited number of insurance companies.  The Company uses the OTTI evaluation model prepared by an independent third party to compare the present value of expected cash flows to the previous estimate to ensure there are no adverse changes in cash flows during the quarter.  The OTTI model considers the structure and term of the PreTSLs and the financial condition of the underlying issuers.  Specifically, the model details interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes.  Cash flows are projected using a forward rate LIBOR curve, as these PreTSLs are variable rate instruments.  The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying trust preferred securities usually resulting from the closure of the issuer by its primary regulator.  Assumptions used in the model include expected future default rates and prepayments.
 
 
 
11

 

 

NOTE 4 – LOANS

Major classifications of loans are as follows:
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Commercial loans:
           
   Commercial mortgages - investor
  $ 88,018,723     $ 95,463,294  
   Commercial mortgages – owner occupied
    34,255,976       36,174,471  
   Construction and development
    15,032,756       13,309,235  
   Commercial and industrial loans
    34,382,994       38,988,466  
       Total commercial loans
    171,690,449       183,935,466  
Consumer loans:
               
   Residential mortgages
    47,887,289       48,345,794  
   Home equity lines of credit
    35,768,239       36,151,239  
   Other
    592,133       597,811  
      Total consumer loans
    84,247,661       85,094,844  
      255,938,110       269,030,310  
Deferred costs, net
    74,555       18,536  
Allowance for loan losses
    (5,038,876 )     (4,858,551 )
      Net loans
  $ 250,973,789     $ 264,190,295  
 
The maturity and rate repricing distribution of the loan portfolio is as follows:
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Repricing or maturing within one year
  $ 113,034,146     $ 124,807,449  
Maturing over one to five years
    95,061,992       95,940,468  
Maturing over five years
    47,841,972       48,282,393  
    $ 255,938,110     $ 269,030,310  
 
Loan balances have been adjusted by the following deferred amounts:
 
             
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Deferred origination costs and premiums
  $ 730,856     $ 756,830  
Deferred origination fees and unearned discounts
    (656,301 )     (738,294 )
      Net deferred costs (fees)
  $ 74,555     $ 18,536  
 
Loan Origination/Risk Management. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower's ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower's management possesses sound ethics and solid business acumen, the Company's management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
 
 
 
12

 
 
 
Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company's commercial real estate portfolio are diverse in terms of type. This diversity helps reduce the Company's exposure to adverse economic events that affect any industry. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. As a general rule, the Company avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. The Company also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.
 
With respect to loans to developers and builders that are secured by non-owner occupied properties that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
 
The Company originates consumer loans utilizing credit score analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by credit policies, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.
 
The Company utilizes external consultants to conduct independent loan reviews. These consultants review and validate the credit risk program on a periodic basis. Results of these reviews are presented to management and the Board of Directors. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company's policies and procedures.
 
Concentrations of Credit. The Company makes loans to customers located in Maryland, Virginia, Pennsylvania and Delaware. Although the loan portfolio is diversified, its performance will be influenced by the regional economy.
 
Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management's opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
 

 
13

 
 
Non-accrual loans, segregated by class of loans, were as follows:
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Commercial loans:
           
   Commercial mortgages - investor
  $ 1,112,002     $ 1,137,226  
   Commercial mortgages – owner occupied
    -       -  
   Construction and development
    -       -  
   Commercial and industrial loans
    1,726,776       1,726,776  
Consumer loans:
               
   Residential mortgages
    493,145       606,533  
   Home equity lines of credit
    335,308       489,961  
   Other
    -       -  
      Total
  $ 3,667,231     $ 3,960,496  
Unrecorded interest on nonaccrual loans
  $ 162,870     $ 141,267  
Interest income recognized on nonaccrual loans
  $ 7,897     $ 162,015  

Past due loans, segregated by age and class of loans, as of March 31, 2012 were as follows:

         
Loans
                     
Accruing
 
   
Loans
   
90 or More
                     
Loans 90 or
 
   
30-89 Days
   
Days
   
Total Past
   
Current
         
More Days
 
   
Past Due
   
Past Due
   
Due Loans
   
Loans
   
Total Loans
   
Past Due
 
Commercial loans:
                                   
   Commercial mortgages – investor
  $ 754,396     $ 1,011,848     $ 1,766,244     $ 86,252,479     $ 88,018,723     $ -  
   Commercial mortgages – owner occupied
    164,699       -       164,699       34,091,277       34,255,976       -  
   Construction and development
    -       -       -       15,032,756       15,032,756       -  
   Commercial and industrial loans
    -       1,726,776       1,726,776       32,656,218       34,382,994       -  
Consumer loans:
                                               
   Residential mortgages
    2,104,359       493,145       2,597,504       45,289,785       47,887,289       -  
   Home equity lines of credit
    111,991       197,675       309,666       35,458,573       35,768,239       -  
   Other
    -       -       -       592,133       592,133       -  
       Total
  $ 3,135,445     $ 3,429,444     $ 6,564,889     $ 249,373,221     $ 255,938,110     $ -  
                                                 

Three nonaccrual loans with balances totaling $237,787 are less than 90 days past due as of March 31, 2012. $39,754 of this total is included in “Loans 30 – 89 Days Past Due” and the remainder is current.

 
 
14

 
 
Past due loans, segregated by age and class of loans, as of December 31, 2011 were as follows:
 
         
Loans
                     
Accruing
 
   
Loans
   
90 or More
                     
Loans 90 or
 
   
30-89 Days
   
Days
   
Total Past
   
Current
         
More Days
 
   
Past Due
   
Past Due
   
Due Loans
   
Loans
   
Total Loans
   
Past Due
 
Commercial loans:
                                   
   Commercial mortgages – investor
  $ -     $ 1,020,766     $ 1,020,766     $ 94,442,528     $ 95,463,294     $ -  
   Commercial mortgages – owner occupied
    -       -       -       36,174,471       36,174,471       -  
   Construction and development
    -       -       -       13,309,235       13,309,235       -  
   Commercial and industrial loans
    -       1,726,776       1,726,776       37,261,690       38,988,466       -  
Consumer loans:
                                               
   Residential mortgages
    1,698,602       606,533       2,305,135       46,040,659       48,345,794       -  
   Home equity lines of credit
    203,503       268,809       472,312       35,678,927       36,151,239       -  
   Other
    -       -       -       597,811       597,811       -  
       Total
  $ 1,902,105     $ 3,622,884     $ 5,524,989     $ 263,505,321     $ 269,030,310     $ -  

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated on an individual loan basis for all such loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on the cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
 
Impaired loans are defined as loans that have been assessed for impairment and have been determined to either need a write down or specific reserve.
 
Impaired loans as of March 31, 2012, are set forth in the following table:
 
   
Unpaid
   
Recorded
   
Recorded
                   
   
Contractual
   
Investment
   
Investment
   
Total
         
Average
 
   
Principal
   
With No
   
With
   
Recorded
   
Related
   
Recorded
 
   
Balance
   
Allowance
   
Allowance
   
Investment
   
Allowance
   
Investment
 
Commercial loans:
                                   
   Commercial mortgages – investor
  $ 1,024,036       -     $ 1,024,036     $ 1,024,036     $ 125,535     $ 1,024,457  
   Commercial mortgages – owner occupied
    2,340,705       -       2,340,705       2,340,705       619,955       2,342,537  
   Construction and development
    1,576,818       -       1,576,818       1,576,818       269,000       1,576,818  
   Commercial and industrial loans
    149,957       -       149,957       149,957       74,957       149,957  
Consumer loans:
                                               
   Residential mortgages
    375,647       -       375,647       375,647       122,447       376,110  
   Home equity lines of credit
    383,677       -       383,677       383,677       227,524       381,408  
   Other
    -       -       -       -       -       -  
       Total
  $ 5,850,840     $ -     $ 5,850,840     $ 5,850,840     $ 1,439,418     $ 5,851,287  
 
 
At March 31, 2012, the Company had thirteen impaired loans totaling approximately $5.9 million.  Seven impaired loans totaling $2.8 million were not past due on March 31, 2012; $2.5 million of the impaired loans were classified as non-accrual loans. During the quarter ended March 31, 2012, the Company received  interest payments on impaired loans of $591, all of which was applied to reduce principal. 
 
 
 
15

 
 
 
Impaired loans as of December 31, 2011, are set forth in the following table.
 
  
 
Unpaid
   
Recorded
   
Recorded
                   
   
Contractual
   
Investment
   
Investment
   
Total
         
Average
 
   
Principal
   
With No
   
With
   
Recorded
   
Related
   
Recorded
 
   
Balance
   
Allowance
   
Allowance
   
Investment
   
Allowance
   
Investment
 
Commercial loans:
                                   
   Commercial mortgages – investor
  $ 1,025,168     $ -     $ 1,025,168     $ 1,025,168     $ 135,668     $ 1,031,792  
   Commercial mortgages – owner occupied
    2,343,293       -       2,343,293       2,343,293       606,543       2,348,107  
   Construction and development
    -       -       -       -       -       -  
   Commercial and industrial loans
    1,726,776       -       1,726,776       1,726,776       329,957       1,730,124  
Consumer loans:
                            -                  
   Residential mortgages
    504,138       -       504,138       504,138       119,418       506,529  
   Home equity lines of credit
    284,574       -       284,574       284,574       179,574       285,211  
   Other
    -       -       -       -       -       -  
       Total
  $ 5,883,949     $ -     $ 5,883,949     $ 5,883,949     $ 1,371,160     $ 5,901,763  
 
At December 31, 2011, the Company had twelve impaired loans totaling approximately $5.9 million.  Seven impaired loans totaling $3.2 million were not past due on December 31, 2011; the remainder of the loans were classified as non-accrual loans. During the year ended December 31, 2011, the Company received total interest payments on impaired loans of $209,204, all of which was applied to reduce principal. 
 
Nonperforming assets and loans past due 90 days or more but accruing interest were as follows:
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Nonaccrual loans
  $ 3,667,231     $ 3,960,496  
Restructured loans
    9,387,867       8,460,654  
Foreclosed real estate
    4,878,849       4,822,417  
   Total nonperforming assets
  $ 17,933,947     $ 17,243,567  

 
As of March 31, 2012, four restructured notes totaling $679,356 are included in nonaccrual loans. All other restructured notes are paying in accordance with the terms of the agreement and remain on accrual status.
 
Troubled Debt Restructurings. The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. These concessions typically result from the Company’s loss mitigation activities and may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules, forbearance and other actions intended to minimize potential losses and to avoid foreclosure or repossession of collateral. Effective July 1, 2011, the Company adopted the provisions of Accounting Standards Update (“ASU”) No. 2011-02, Receivables (Topic 310) - A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. As such, the Company reassessed all loan modifications occurring since January 1, 2011 for identification as troubled debt restructurings.
 

 
16

 

 
Troubled debt restructurings as of March 31, 2012 and December 31, 2011 are set forth in the following table:
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
Commercial loans:
           
   Commercial mortgages – investor
  $ 2,921,214     $ 2,950,361  
   Commercial mortgages – owner occupied
    1,786,805       1,786,805  
   Construction and development
    -       -  
   Commercial and industrial loans
    -       -  
Consumer loans:
               
   Residential mortgages
    4,890,722       4,038,982  
   Home equity lines of credit
    468,482       467,482  
   Other
    -       -  
Deferred costs, net
    -       -  
       Total
  $ 10,067,223     $ 9,243,630  
                 

Loans restructured for the three month periods ended March 31, 2012 and March 31, 2011 were as follows:
 
   
Period Ended
 
   
03/31/12
   
03/31/11
 
Commercial loans:
           
   Commercial mortgages – investor
  $ -     $ -  
   Commercial mortgages – owner occupied
    -       -  
   Construction and development
    -       -  
   Commercial and industrial loans
    -       -  
Consumer loans:
               
   Residential mortgages
    863,031       186,530  
   Home equity lines of credit
    -       -  
   Other
    -       -  
       Total
  $ 863,031     $ 186,530  
 
Management strives to identify borrowers in financial difficulty early and work with them to modify to more affordable terms before their loans reach non-accrual status.  In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans.  Certain troubled debt restructurings are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.  As of March 31, 2012, there are 7 restructured loans totaling $1.5 million that are more than 30 days past due. Three of the past due loans totaling $579,202 are classified as non-accrual loans. There is one loan totaling $100,154 that is current but is classified as a non-accrual loan.
 
Credit Quality Indicators

As part of the on-going monitoring of the credit quality of the Company's loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans (see details above) and (v) the general economic conditions in the Company’s market.
 
The Company utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the 9 risk grades is as follows:
 
Risk Rating 1:  Prime
 
Loans with a 1 risk rating are assets of high liquidity and minimal or very low risk.  They are well structured loans to entities of unquestioned financial stature and credit strength.  Borrowers possess a record of performance on past obligations which is long and unblemished.  Loans so rated also include credit to a reasonably strong borrower fully and appropriately secured by liquid collateral of unquestioned value, such as bank CDs or savings accounts.
 
 
 
17

 
 
Risk Rating 2:  Good
 
Loans with a 2 risk rating are assets of good liquidity and low risk.  They are well-structured, self-liquidating loans to very sound borrowers who exhibit excellent liquidity and debt service ability.  Borrowers possess a strong capital position attributable to a long history of strong and stable earnings, significant unpledged assets, proven access to alternative financing, and a better than average payment history.  They have a well-defined market and the potential for growth within that market.
 
Risk Rating 3:  Standard
 
Loans with a 3 risk rating are assets of acceptable liquidity and low risk.  Borrowers exhibit average credit strength, with no meaningful apparent financial, management or market weaknesses.  Leverage and liquidity indicators are better than average, recent earnings and cash flow are positive and stable, and access to alternative financing sources is apparent.  Borrowers are individuals/business enterprises who are financially sound, but whose liquidity, leverage or debt service ability are not quite the optimum exhibited by borrowers with a risk rating 2.  If secured, these loans are supported by assets at better than adequate margins.
 
Commercial real estate loans with a 3 risk rating possess debt service coverage (“DSC”) and loan to value (“LTV”) ratios which significantly exceed lending policy standards.  Such loans exceed conventional market terms for third party take-outs, and borrowers/guarantors exhibit substantial capacity for providing support if necessary.
 
Risk Rating 4:  Acceptable
 
Loans with a 4 risk rating are assets of acceptable liquidity and acceptable risk.  Borrowers demonstrate adequate earnings and debt service ability and exhibit normal leverage and liquidity indicators.  Borrowers differ from low risk (risk rating 3) clients due to weaknesses in an area such as newness of company, marginal liquidity or leverage indicators, recent volatility in earnings, inability to sustain a major setback, or similar issues.  Hence, these loans are supported by identified, independent and assured secondary repayment sources (e.g., collateral and/or guarantors).  Loans may be unsecured but are likely secured by assets at margins appropriate for the collateral type, with realizable liquidation values.  Guarantors, known to the Bank, demonstrate adequate capacity and proven responsibility.
 
Commercial real estate loans with a 4 risk rating possess DSC and LTV ratios which meet or are slightly better than loan policy standards.  Such loans meet conventional market terms for third party take-outs, and feature borrowers/guarantors who are capable of providing support if necessary.
 
Risk Rating 5:  Watch
 
Loans with a 5 risk rating are generally acceptable assets which reflect above average risk. Loans rated 5 warrant closer scrutiny by management than is routine, due to circumstances affecting the borrower, the borrower’s industry or the overall economic environment.  Borrowers may reflect weaknesses such as inconsistent or weak earnings, break even or moderately deficit cash flow, thin liquidity, minimal capacity to increase leverage, or volatile market fundamentals or other industry risks.  Such loans are typically secured by acceptable collateral, at or near appropriate margins, with realizable liquidation values.
 
Commercial real estate loans with a 5 risk rating may possess a DSC ratio which is positive but still short of lending policy standards, or an LTV ratio which exceeds lending policy but is less than 90%.  Such loans may not meet conventional market terms and could require a higher risk lender for third party take-outs, and borrower’s/guarantor’s capacity to provide support, if necessary, could be marginal.
 
Risk Rating 6:  Special Mention
 
Loans with a 6 risk rating are classified special mention. A special mention asset has potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date.  Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
 
Borrowers may exhibit poor liquidity and leverage positions resulting from generally negative cash flow and/or negative trends in earnings.  LTV ratio substantially exceeds normal standards, and access to alternative financing may be limited to finance companies for business borrowers and may be unavailable for commercial real estate borrowers.
 
Risk Rating 7:  Substandard
 
Loans with a 7 risk rating are classified substandard.  A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any.  Assets so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Loss potential, while existing in the aggregate amount of substandard assets does not have to exist in individual assets classified as substandard.
 
 
 
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Borrowers may exhibit recent or unexpected unprofitable operations, an inadequate DSC ratio, or marginal liquidity and capitalization.  For commercial real estate loans with a 7 risk rating, the orderly liquidation of the debt is jeopardized due to lack of timely project completion, deficiency of project marketability, inadequate cash flow or collateral support, or failure of the project to meet economic expectations.  Repayment of such loans may depend upon liquidation of collateral, or upon other credit risk mitigating factors.  These loans require more intensive supervision by Bank management.
 
Risk Rating 8:  Doubtful
 
Loans with an 8 risk rating are classified doubtful.  An asset classified doubtful has all the weaknesses inherent in one that is classified substandard but with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors which may work to the advantage and strengthening of the asset, and which are expected to be completed within a relatively short period of time, its classification as an estimated loss is deferred until its more exact status may be determined.  Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans.  All assets classified as doubtful require a specific reserve of no less than 50%, are on non-accrual status, and necessitate a plan for liquidation.
 
Risk Rating 9: Loss
 
Loans with a 9 risk rating are classified loss.  Assets classified losses are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.  Long term recoveries should not be allowed while the asset remains booked.  Losses should be taken in the period in which they surface as uncollectible.  The bankruptcy of a borrower with an unsecured credit requires that the loss be taken immediately.
 
The following table presents the balances of classified loans by class of commercial loan as of March 31, 2012 and December 31, 2011. Classified loans include loans in Risk Grades 5, 6 and 7. The Company has no loans with a risk rating of 8 or 9.
 
   

 
March 31, 2012
 
   
Risk Rating
 
      5       6       7    
Total
 
Commercial mortgages - investor
  $ 4,533,662     $ -     $ 3,007,689     $ 7,541,351  
Commercial mortgages – owner occupied
    553,901       616,560       1,786,805       2,957,266  
Construction and development
    3,402,457       -       -       3,402,457  
Commercial and industrial loans
    1,428,149       1,973,295       1,812,867       5,214,311  
 Total
  $ 9,918,169     $ 2,589,855     $ 6,607,361     $ 19,115,385  
                                 
                                 
                                 
   

 
December 31, 2011
 
   
Risk Rating
 
      5       6       7    
Total
 
Commercial mortgages - investor
  $ 5,427,985     $ -     $ 2,904,638     $ 8,332,623  
Commercial mortgages – owner occupied
    556,488       620,280       1,786,805       2,963,573  
Construction and development
    3,402,457       -       -       3,402,457  
Commercial and industrial loans
    1,397,684       2,223,748       1,814,750       5,436,182  
 Total
  $ 10,784,614     $ 2,844,028     $ 6,506,193     $ 20,134,835  

Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company's allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, Receivables and allowance allocations calculated in accordance with ASC Topic 450, Contingencies. Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company's process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. The amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.
 
 
 
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The level of the allowance reflects management's continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management's judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company's control, including, among other things, the performance of the Company's loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
 
The Company's allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other qualitative risk factors both internal and external to the Company.
 
The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor's ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan has a calculated grade of 5 or higher, a special assets committee analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower's ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower's industry, among other things.
 
Historical valuation allowances are calculated based on the historical loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool over the prior twelve quarters. The historical loss ratios are updated quarterly based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Company's pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer real estate loans and consumer and other loans.
 
General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) the experience, ability and effectiveness of the Bank's lending management and staff; (ii) the effectiveness of the Bank's loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on portfolio risks; and (ix) the impact of rising interest rates on portfolio risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a general allocation matrix to determine an appropriate general valuation allowance.
 
Included in the general valuation allowances are allocations for groups of similar loans with risk characteristics that exceed certain concentration limits established by management. Concentration risk limits have been established for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy exceptions that exceed specified risk grades.
 
Loans identified as losses by management, internal loan review and/or bank examiners are charged-off. Furthermore, consumer loan accounts are charged-off automatically based on regulatory requirements.
 
The following table details charge-offs, recoveries and the provision for loan losses for the three month periods ended March 31, 2012 and 2011 and the allocation of the allowance for loan losses by portfolio as of March 31, 2012 and 2011 and December 31, 2011 and 2010. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.
 

 
 
20

 

   
Allowance
                     
Allowance
 
   
12/31/2011
   
Charge-offs
   
Recoveries
   
Provision
   
3/31/2012
 
Commercial loans:
                             
   Commercial mortgages – investor
  $ 967,668     $ -     $ -     $ (46,835 )   $ 920,833  
   Commercial mortgages – owner occupied
    772,429       -       4,051       2,793       779,273  
   Construction and development
    1,366,014       -       -       63,386       1,429,400  
   Commercial and industrial loans
    613,792       -       1,000       66,566       681,358  
Consumer loans:
                                       
   Residential mortgages
    661,408       35,672       -       83,603       709,339  
   Home equity lines of credit
    455,276       39,135       4,467       80,106       500,714  
   Other
    21,964       -       100       (4,105 )     17,959  
       Total
  $ 4,858,551     $ 74,807     $ 9,618     $ 245,514     $ 5,038,876  

   
Allowance
                     
Allowance
 
   
12/31/2010
   
Charge-offs
   
Recoveries
   
Provision
   
3/31/2011
 
Commercial loans:
                             
   Commercial mortgages – investor
  $ 1,073,448     $ -     $ -     $ 12,071     $ 1,085,519  
   Commercial mortgages – owner occupied
    460,914       -       -       36,871       497,785  
   Construction and development
    1,112,103       -       -       64,470       1,176,573  
   Commercial and industrial loans
    754,770       (1,414 )     6,901       28,804       789,061  
Consumer loans:
                                    -  
   Residential mortgages
    821,197       (64,200 )     -       32,341       789,338  
   Home equity lines of credit
    243,119       -       76,865       (61,456 )     258,528  
   Other
    15,685       -       -       1,116       16,801  
       Total
  $ 4,481,236     $ (65,614 )   $ 83,766     $ 114,217     $ 4,613,605  
 
Loans with a balance of approximately $109.3 million and $112.6 million were pledged as collateral to the Federal Home Loan Bank of Atlanta as of March 31, 2012 and December 31, 2011, respectively.
 
NOTE 5 – STOCK BASED COMPENSATION
 
At the Company’s annual stockholders’ meeting on May 15, 2007, the 2007 Equity Plan was approved.  Under this plan, 500,000 shares of the Common Stock of the Company were reserved for issuance. Also, in accordance with the 2007 Equity Plan, 300 shares of unrestricted Company Stock are issued to each non-employee director in May of each year. One director receives cash in lieu of stock due to restrictions by his/her employer on receiving stock of a company.  Also, in accordance with the 2007 Equity Plan, 300 shares were awarded to each new director as of the effective date of their acceptance onto the board.  No new grants will be made under the 1998 Long Term Incentive Plan.  However, incentive stock options issued under this plan will remain outstanding until exercised or until the tenth anniversary of the grant date of such options.
 
There was no stock based compensation expense recognized during the first three months of 2012 or 2011. As of March 31, 2012, there was no unrecognized stock option expense related to nonvested stock options.
 
Stock option compensation expense is the estimated fair value of options granted amortized on a straight-line basis over the vesting period of the award (3 years) or the fair value of common stock on the date of issuance.

NOTE 6 – DEFINED BENEFIT PENSION PLAN

Effective December 31, 2004, the Company froze the Defined Benefit Pension Plan. Participant benefits stopped accruing as of the date of the freeze. No new participants entered the Plan after December 31, 2004. During the three months ended March 31, 2012 and 2011, the Company recognized net periodic costs for this plan of $60,825 and $34,254, respectively.  The Company contributed $622,324 and $10,000  respectively, to the plan during the first quarters of 2012 and 2011.
 
 
 
21

 
 
 
NOTE 7 - COMMITMENTS AND CONTINGENT LIABILITIES
 
The Company enters into off-balance sheet arrangements in the normal course of business.  These arrangements consist primarily of commitments to extend credit, lines of credit and letters of credit. The Company applies the same credit policies to these off-balance sheet arrangements as it does for on-balance-sheet instruments. 
 
Additionally, the Company enters into commitments to originate residential mortgage loans to be sold in the secondary market, where the interest rate is determined prior to funding the loan. The commitments on mortgage loans to be sold are considered derivatives. The intent is that the borrower has assumed the interest rate risk on the loan. As a result, the Company is not exposed to losses due to interest rate changes. As of March 31, 2012 the difference between the market value and the carrying amount of these commitments is immaterial and therefore, no gain or loss has been recognized in the financial statements.
 
Outstanding loan commitments, unused lines of credit, and letters of credit were as follows:
 
  
 
March 31,
   
December 31,
   
March 31,
 
   
2012
   
2011
   
2011
 
Loan commitments
  $ 15,423,516     $ 11,861,878     $ 18,316,911  
Unused lines of credit
    42,173,966       40,822,933       44,381,406  
Letters of credit
    624,919       624,919       3,248,106  
 
NOTE 8 – TARP CAPITAL PURCHASE PROGRAM
 
On February 13, 2009, as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program, the Company entered into a Letter Agreement, and the related Securities Purchase Agreement — Standard Terms (collectively, the ‘‘Purchase Agreement’’), with the United States Department of the Treasury (‘‘Treasury’’), pursuant to which the Company issued (i) 9,201 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation preference $1,000 per share (‘‘Series A Preferred Stock’’), and (ii) a warrant to purchase 205,379 shares of the Company’s common stock, par value $1.00 per share. The Company raised $9,201,000 through the sale of the Series A Preferred Stock that qualifies as Tier 1 capital. The Series A Preferred Stock pays cumulative dividends at a rate of 5% per annum until February 15, 2014. Beginning February 16, 2014, the dividend rate will increase to 9% per annum. Dividends are payable quarterly.  The redemption of the Series A Preferred Stock requires prior regulatory approval.
 
The warrant is exercisable in whole or in part at $6.72 per share at any time on or before February 13, 2019. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant.
 
The Series A Preferred Stock and the warrant were issued in a transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. The Company registered for resale the warrant and the shares of common stock underlying the warrant on February 13, 2009. Neither the Series A Preferred Stock nor the warrant is subject to any contractual restrictions on transfer.
 
The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (the ‘‘EESA’’) and the American Recovery and Reinvestment Act of 2009. As a condition to the closing of the transaction, the Company’s Senior Executive Officers, as defined in the Purchase Agreement each: (i) voluntarily waived any claim against the Treasury or the Company for any changes to such Senior Executive Officer’s compensation or benefits that are required to comply with the regulation issued by the Treasury under the TARP Capital Purchase Program as published in the Federal Register on October 20, 2008, and acknowledging that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements (including so called ‘‘golden parachute’’ agreements) as they relate to the period the Treasury holds any equity or debt securities of the Company acquired through the TARP Capital Purchase Program; and (ii) entered into an amendment to Messrs Altieri and Jewell and Mrs. Stokes’ employment agreements that provide that any severance payments made to such officers will be reduced, as necessary, so as to comply with the requirements of the TARP Capital Purchase Program.
 
The Treasury’s current consent shall be required for any increase in the common dividends per share until February 13, 2012, unless prior to such date, the Series A preferred stock is redeemed in whole or the Treasury has transferred all of the Series A Preferred Stock to third parties.
 
The Company previously notified Treasury that it would not make the quarterly dividend payments on the Series A Preferred Stock issued to Treasury under the TARP Capital Purchase Program due after February 15, 2011. Under the terms of the Series A Preferred Stock, dividend payments are cumulative and failure to pay dividends for six dividend periods would trigger board appointment rights for the holder of the TARP preferred stock. The Company has deferred four quarterly dividend payments since February 15, 2011. As a result, as of March 31, 2012, the Company is $460,050 in arrears on dividend payments on the Series A Preferred Stock. The dividend has been accrued and reflected as a reduction in retained earnings.
 

 
22

 
 
NOTE 9 – FAIR VALUE
 
The fair value of an asset or liability is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability.
 
The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact.
 
In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, accounting guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
 
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, and other inputs that are observable or can be corroborated by observable market data.
 
Level 3:  Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
 
The Company uses the following methods and significant assumptions to estimate fair value for financial assets and financial liabilities:
 
Securities available for sale:  The fair value of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges.  If quoted market prices are not available, fair value is determined using quoted market prices for similar securities. When the market for securities is indeterminable due to inactive trading or when the few observable transactions and market quotations that are available are not reliable for determining fair value, an income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs provides an equally or more representative fair value than the market approach valuation used at prior measurement dates. Equity securities are reported at fair value using Level 1 inputs.
 
Loans held for sale:  The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices.  If no such quoted pricing exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan, including the current interest rate of similar loans.
 
Impaired loans and foreclosed real estate:  Nonrecurring fair value adjustments to loans and foreclosed real estate reflect full or partial write-downs that are based on the loan’s or foreclosed real estate’s observable market price or current appraised value of the collateral in accordance with “Accounting by Creditors for Impairment of a Loan”. Since the market for impaired loans and foreclosed real estate is not active, loans or foreclosed real estate subjected to nonrecurring fair value adjustments based on the current appraised value of the collateral may be classified as Level 2 or Level 3 depending on the type of asset and the inputs to the valuation.  When appraisals are used to determine impairment and these appraisals are based on a market approach incorporating a dollar-per-square-foot multiple, the related loans or foreclosed real estate are classified as Level 2.  If the appraisals require significant adjustments to market-based valuation inputs or apply an income approach based on unobservable cash flows to measure fair value, the related loans or foreclosed real estate subjected to nonrecurring fair value adjustments are typically classified as Level 3 because Level 3 inputs are significant to the fair value measurement.
 

 
 
23

 
 
The following table represents the Company’s financial assets measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011:
 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair
 
   
Inputs
   
Inputs
   
Inputs
   
value
 
March 31, 2012
                       
Available for sale
                       
U.S. government agency
  $ -     $ 2,114,846     $ -     $ 2,114,846  
Mortgage‑backed securities
    -       12,206,734       -       12,206,734  
State and municipal
    -       7,575,057       -       7,575,057  
Corporate bonds
    -       1,999,020       280,293       2,279,313  
      -       23,895,657       280,293       24,175,950  
Equity securities
    271,821       -       -       271,821  
    $ 271,821     $ 23,895,657     $ 280,293     $ 24,447,771  
                                 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair
 
   
Inputs
   
Inputs
   
Inputs
   
value
 
December 31, 2011
                               
Available for sale
                               
U.S. government agency
  $ -     $ 2,212,656     $ -     $ 2,212,656  
Mortgage‑backed securities
    -       13,125,924       -       13,125,924  
State and municipal
    -       7,626,724       -       7,626,724  
Corporate bonds
    -       1,980,100       281,150       2,261,250  
      -       24,945,404       281,150       25,226,554  
Equity securities
    243,653       -       -       243,653  
    $ 243,653     $ 24,945,404     $ 281,150     $ 25,470,207  
 
During the first three months of 2012, the Company recognized $819,054 of other-than-temporary impairment charges related to two debt securities and one equity security issued by financial institutions.  The following table reconciles the beginning and ending balances of available for sale securities measured at fair value on a recurring basis using significant unobservable (Level 3) inputs during the three months ended March 31, 2012 and 2011.

   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
 Balance, beginning of period
  $ 281,150     $ 373,542  
  Total gains (losses) realized and unrealized:
               
    Included in earnings
    (780,544 )     (167,467 )
    Included in other comprehensive income
    779,687       111,168  
  Transfer to (from) Level 3
    -       -  
 Balance, end of period
  $ 280,293     $ 317,243  

 
24

 
 
Certain other assets are measured at fair value on a nonrecurring basis.  Adjustments to fair value usually result from application of lower of cost or fair value accounting or write-downs of individual assets due to impairment.  For assets measured at fair value on a nonrecurring basis during the first three months of 2012 that were still held in the balance sheet at period end, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets at period end.
 
   
Carrying Value at March 31, 2012
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Loans held for sale
  $ 35,170,486     $ -     $ 35,170,486     $ -  
Impaired loans
    4,411,422       -       4,411,422       -  
Foreclosed  real estate
    4,878,849       -       4,878,849       -  
 
 
  During the first three months of 2012, the Company recognized losses related to certain assets that are measured at fair value on a nonrecurring basis (i.e. loans and loans held for sale).  Losses related to loans of $74,807 were recognized as charge-offs for loan losses. There were no losses on the sale of foreclosed real estate properties; in addition, there were no write-downs on properties that remain in foreclosed real estate. During the first three months of 2012, there were losses of $2,810 related to loans held for sale accounted for at the lower of cost or fair value. These losses occur as a result of interest rate movement prior to the sale of the loans to secondary market investors.
 
The following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets as of December 31, 2011.
 
   
Carrying Value at December 31, 2011
 
   
Total
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Loans held for sale
  $ 28,420,897     $ -     $ 28,420,897     $ -  
Impaired loans
    4,512,789       -       4,512,789       -  
Foreclosed  real estate
    4,822,417       -       4,822,417       -  
 
FASB ASC Topic 825 requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. A detailed description of the valuation methodologies used in estimating the fair value of financial instruments is set forth in the 2011 Form 10-K.
 

 
 
25

 
 
The estimated fair values of financial instruments that are reported at amortized cost in the Company’s consolidated balance sheets, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value, were as follows:
 
   
March 31, 2012
   
December 31, 2011
 
   
Carrying
   
Estimated fair
   
Carrying
   
Estimated fair
 
   
amount
   
value
   
amount
   
value
 
Financial assets
                       
Level 2 inputs:
                       
Cash and cash equivalents
  $ 30,757,625     $ 30,757,625     $ 15,597,128     $ 15,597,128  
Investment securities held to maturity
    2,713,174       2,874,377       2,848,594       3,024,217  
Loans held for sale
    35,170,486       35,170,486       28,420,897       28,466,856  
Accrued interest receivable
    1,162,217       1,162,217       1,215,060       1,215,060  
Bank owned life insurance
    5,117,396       5,117,396       5,081,539       5,081,539  
Level 3 inputs:
                               
Federal Home Loan Bank stock
    2,111,300       2,111,300       2,111,300       2,111,300  
Loans, net
    250,973,789       256,257,000       264,190,295       271,476,390  
Financial liabilities
                               
Level 2 inputs:
                               
Noninterest‑bearing deposits
  $ 83,838,349     $ 83,838,349     $ 75,020,489     $ 75,020,489  
Interest‑bearing deposits
    248,319,747       251,126,651       239,972,347       243,699,338  
Advances from the Federal Home Loan Bank
    2,210,000       2,271,000       11,210,000       11,383,000  
Accrued interest payable
    35,201       35,201       50,689       50,689  
 
NOTE 10 – NEW AUTHORITATIVE ACCOUNTING GUIDANCE
 
In June 2011, FASB issued ASU No. 2011-05, "Comprehensive Income (Topic 220)-Presentation of Comprehensive Income" which amended disclosure guidance related to comprehensive income. The amendment requires that all nonowner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment also requires entities to present, on the face of the financial statements, reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement or statements where components of net income and the components of other comprehensive income are presented. The option to present components of other comprehensive income as part of the consolidated statement of changes in stockholders' equity was eliminated. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Adoption of this guidance did not have a material impact on our consolidated results of operations or financial condition.
 
In May 2011, the FASB issued ASU 2011-04, "Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs." ASU 2011- 04 amends Topic 820, "Fair Value Measurements and Disclosures," to converge the fair value measurement guidance in U.S. generally accepted accounting principles and International Financial Reporting Standards. ASU 2011-04 clarifies the application of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value disclosures. This guidance was effective for annual periods beginning after December 15, 2011, and did not have a material impact on our consolidated results of operations or financial condition.
 
In December 2011, the FASB issued ASU 2011-12 “Comprehensive Income (Topic 220) - Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” ASU 2011-12 defers changes in ASU No. 2011-05 that relate to the presentation of reclassification adjustments to allow the FASB time to redeliberate whether to require presentation of such adjustments on the face of the financial statements to show the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income. ASU 2011-12 allows entities to continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU No. 2011-05. All other requirements in ASU No. 2011-05 are not affected by ASU No. 2011-12. ASU 2011-12 became effective for the Company on January 1, 2012 and did not have a significant impact on the Company’s financial statements.
 

 
26

 


ITEM 2.                    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF     OPERATIONS
 
THE COMPANY
 
  Carrollton Bancorp was formed on January 11, 1990 and is a Maryland chartered bank holding company.  The Company holds all of the outstanding shares of common stock of Carrollton Bank.  The Bank, formed on April 10, 1900, is a commercial bank that provides a full range of financial services to individuals, businesses and organizations through its branch and loan origination offices and its automated teller machines.  Deposits in the Bank are insured by the Federal Deposit Insurance Corporation.  The Bank considers its core market area to be the Baltimore metropolitan area.
 
FORWARD-LOOKING STATEMENTS
 
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements included or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements that are purely historical, are forward-looking statements.  Statements that include the use of terminology such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “estimates,” and similar expressions also identify forward-looking statements.  The statements in this report with respect to, among other things, our plans, strategies, objectives and intentions and the anticipated results thereof, the anticipated merger with Jefferson Bancorp and our belief that the merged entity will be larger, better capitalized and better equipped to compete, increased professional service fees while the merger is pending, potential losses from off-balance sheet arrangements, opportunities emerging as the business environment clarifies and improves, improving operating results, increased loan demand in the future, increased asset sales and the implied impact on brokerage commissions during the remainder of the year, the recovery of fair value of available-for sale securities, the allowance for loan losses, anticipated increases in the value of trust preferred securities held in our investment portfolio as the economy improves, liquidity sources and the impact of the outcome of pending legal proceedings,  are forward-looking.  These forward-looking statements are based on our current intentions, beliefs, and expectations. 
 
These statements are not guarantees of future performance and are subject to certain risks and uncertainties that are difficult to predict.  Actual results may differ materially from these forward-looking statements because of, among other things:
 
(i) the risk that necessary stockholder and regulatory approvals for the merger will not be obtained; (ii) our businesses may not be integrated into Jefferson Bancorp successfully or such integration may be more difficult, time-consuming or costly than expected; (iii) expected revenue synergies and cost savings from the merger may not be fully realized, or realized within the expected timeframe; (iv) disruption in our and Jefferson Bancorp’s businesses and operations as a result of the announcement and pendency of the merger; (v) revenues following the merger may be lower than expected; (vi) customer and employee relationships and business operations may be disrupted by the merger; (vii) the ability to complete the merger may be more difficult, time-consuming or costly than expected, or the merger may not be completed at all; (viii) unexpected changes or further deterioration in the housing market or in general economic conditions in our market area and Jefferson Bancorp’s market area, or a slowing economic recovery; (ix) unexpected changes in market interest rates or monetary policy; (x) the impact of new governmental regulations that might require changes in our and Jefferson Bancorp’s business model; (xi) changes in laws, regulations, policies and guidelines impacting our ability to collect on outstanding loans or otherwise negatively impacting our and Jefferson Bancorp’s business; (xiii) higher than anticipated loan losses or the insufficiency of the allowance for loan losses; (xiv) changes in competitive, governmental, regulatory, accounting, technological and other factors that may affect us or Jefferson Bancorp specifically or the banking industry generally, including as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 20120 (the “Dodd-Frank Act”); and (xv) other risks described in this report, in the Company’s 2011 Form 10-K and in our other filings with the SEC. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q.  We undertake no obligation to update or revise the information contained in this report whether as a result of new information, future events or circumstances, or otherwise.  Past results of operations may not be indicative of future results. Readers should carefully review the risk factors described in other documents that we file from time to time with the SEC.
 
BUSINESS AND OVERVIEW
 
 The Company is a bank holding company headquartered in Columbia, Maryland, with one wholly-owned subsidiary, Carrollton Bank.  The Bank has six subsidiaries, CMSI, CFS, and three limited liability companies that are wholly owned, as well as CCDC, which is 96.4% owned.
 
The Bank is engaged in a general commercial and retail banking business, with ten branch locations. The Bank attracts deposit customers from the general public and uses such funds, together with other borrowed funds, to make loans. Our results of operations are primarily determined by the difference between interest income earned on our interest-earning assets, primarily interest and fee income on loans, and interest paid on our interest-bearing liabilities, including deposits and borrowings.
 
During 2004, the Bank opened a mortgage subsidiary, Carrollton Mortgage Services, Inc. (“CMSI”). CMSI became inactive in January 2012 and its operations are now conducted as a division of the Bank.  The Bank’s mortgage division is in the business of originating residential mortgage loans to be sold. The mortgage-banking business is structured to provide a source of fee income largely from the process of originating residential mortgage loans for sale on the secondary market, as well as the origination of loans to be held in our loan portfolio. Mortgage-banking products include Federal Housing Administration and Federal Veterans Administration loans, conventional and nonconforming first and second mortgages, and construction and permanent financing. Loans originated by the mortgage division are generally sold into the secondary market but may be considered for retention by the Bank as part of our balance sheet strategy.
 
 
 
27

 
 
 
CFS provides brokerage services and a variety of financial planning and investment options to customers through INVEST Financial Corp. pursuant to a service agreement with INVEST and recognizes commission income as these services are provided. The investment options CFS offers through this arrangement include mutual funds, U.S. government bonds, tax-free municipals, individual retirement account rollovers, long-term care, and health care insurance services. INVEST is a full-service broker/dealer, registered with the Financial Industry Regulatory Authority (“FINRA”) and the SEC, a member of Securities Investor Protection Corporation (“SIPC”), and licensed with state insurance agencies in all 50 states. CFS refers clients to an INVEST representative for investment counseling prior to purchase of securities.
 
The three limited liability companies  manage and dispose of real estate acquired through foreclosure.
 
CCDC promotes, develops, and improves the housing and economic conditions of people in Maryland. We coordinate our efforts to identify opportunities with a local non-profit ministry whose mission and vision is to eliminate poverty housing in the region by building decent houses for affordable homeownership throughout Anne Arundel County and the Baltimore metropolitan region. CCDC generates revenue through the origination of loans for the purchase of these homes.
 
 We reported a net loss of $252,464 for the three months ended March 31, 2012, compared to net income of $171,295 for the comparable period in 2011.  Net loss attributable to common stockholders was $389,543 ($0.15 loss per diluted share) for the three months ended March 31, 2012, compared to net income available to common stockholders of $34,217 ($0.01 per diluted share) for the prior year period.
 
Return on average assets and return on average equity are key measures of our performance.  Return on average assets, the quotient of net (loss) income divided by total average assets, measures how effectively the Company utilizes its assets to produce income.  The Company’s loss on average assets for the three month period ended March 31, 2012 was (0.28)% compared to return on average assets of 0.19% for the three month period ended March 31, 2011. Loss on average equity, the quotient of net (loss) income divided by average equity, measures how effectively the Company invests its capital to produce income.  Loss on average equity for the three month period ended March 31, 2012 was (3.09)% compared to return on average equity of 2.08% for the corresponding period in 2011.
 
Net interest income decreased $65,385, or 1.91%, for the three month period ended March 31, 2012, compared to the same period in 2011, while our net interest margin held steady at 3.93% for the three months ended both March 31, 2012 and 2011. Net interest margin, a profitability measure, is the dollar difference between interest income from earning assets, including loans and investments, and interest expense paid on deposits and other borrowings, expressed as a percentage of average earning assets. The decline in net interest income in the quarter is a result of the decline in average interest earning assets.
 
The decline in operating results for the quarter ended March 31, 2012, as compared to the same period in 2011, is primarily a result of a $131,297 increase in the provision for loan losses, as well as a $651,587 increase in impaired securities write downs and a $172,660 increase in professional services expenses.  During the three month period ended March 31, 2012, the Company recorded a provision for loan losses of $245,514 compared to $114,217 during the same period in 2011. Expenses and losses associated with foreclosed real estate were $176,320 for the three month period ended March 31, 2012 as compared to $74,715 for the same period in 2011.
 
No dividends were declared or paid to common stockholders during the first three months of 2012 or 2011 as we continue the suspension of dividends in recognition of our limited earnings during recent periods.

CURRENT STRATEGY
 
Our Board of Directors and senior management continue to employ a strategy designed to strengthen the balance sheet and improve operating results by improving asset quality, reducing higher cost funding sources, and pursuing operating efficiencies through the use of technology and strategic partners. The objective is to strengthen our overall foundation during these difficult and uncertain economic times in order to take advantage of opportunities that we expect will emerge as the business environment clarifies and improves.
 
The financial regulatory reform measures enacted and to be enacted pursuant to the Dodd-Frank Act, along with the ongoing instability in the residential and commercial real estate markets, have created a great deal of uncertainty within the community banking industry. In addition, uncertainty about future tax policy and the cost of employment associated with healthcare reform add uncertainty to planning for operational costs. We have chosen to carefully evaluate all growth opportunities with this uncertainty in mind, carefully limiting decisions that could be impacted by circumstances beyond our control.
 
We have narrowed our focus for targeted growth on the following customer groups:
 
·  
Small and mid-sized businesses, including service firms, manufacturing companies and distributors;
 
 
 
28

 
 
 
·  
Executives and professionals, including attorneys, accountants, medical professionals, consultants, corporate executives and their firms;
 
·  
Non-profit associations, including charities, foundations, professional/trade associations, homeowner/condo associations, and faith based organizations; and
 
·  
High net worth individuals and affluent families.
 
The Bank will continue to serve its customers by utilizing its existing branch network as well as by providing internet based services, remote deposit capture, courier service, and loan production business offices.
 
Going forward, our business strategy will include:
 
·  
Increasing awareness and consideration in the business marketplace through directed marketing and direct sales efforts;
 
·  
Leading with deposit and cash management products;
 
·  
Retaining and growing existing customer relationships;
 
·  
Growing our Small Business Administration loan portfolio; and
 
· Increasing adoption and usage of online products.
 
Note, however, that this is our business strategy as it stands today, and our strategy may change after closing of the merger.
 
Our effort to improve net interest margin by reducing balance sheet liquidity and high cost funding sources has leveled off with a net interest margin of 3.93% for the three months ended March 31, 2012 and 2011.
 
Our efforts to reduce non-performing assets and improve operating efficiencies will take longer to appear in operating results. The reduction of non-performing assets is subject to the market conditions associated with the commercial real estate market, while operating efficiencies will be geared towards prudently reducing operating expenses while growing the business within the constraints of our capital base.
 
As we indicated in previous reports, we believed that we would need to raise additional capital to redeem our outstanding preferred stock issued to the Treasury under the TARP Capital Purchase Program and support balance sheet growth. We have remained “well capitalized” for regulatory purposes, which allowed us to carefully assess various capital alternatives and determine which alternative was best for the Company and our stockholders. These considerations ultimately resulted in the execution of a definitive agreement to merge with Jefferson Bancorp, Inc. on April 8, 2012. Under the terms of this agreement, the Company will remain the holding company upon completion of the merger, and the preferred stock issued to Treasury under the TARP Capital Purchase Program will be redeemed This merger will result in a larger and better capitalized institution that we believe will be better equipped to compete in a changing environment.
 
CRITICAL ACCOUNTING POLICIES
 
The Company’s financial condition and results of operations are sensitive to accounting measurements and estimates of matters that are inherently uncertain.  When applying accounting policies in areas that are subjective in nature, management must use its best judgment to arrive at the carrying value of certain assets.  One of the most critical accounting policies applied is related to the valuation of the loan portfolio.
 
 A variety of estimates impact the carrying value of the loan portfolio including the calculation of the allowance for loan losses, valuation of underlying collateral and the timing of loan charge-offs. The allowance for loan losses is one of the most difficult and subjective judgments that we make.  The allowance is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payments on loans.  Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio.  Current trends in delinquencies and charge-offs, the views of bank regulators, changes in the size and composition of the loan portfolio and peer comparisons are also factors.  The analysis also requires consideration of the economic climate and direction, and change in the interest rate environment, which may affect a borrower’s ability to pay, legislation influencing the banking industry, and economic conditions specific to the Bank’s service areas.  Because the calculation of the allowance for loan losses relies on estimates and judgments relating to inherently uncertain events, results may differ from our estimates.
 
Another critical accounting policy is related to the securities we own.  Securities are evaluated periodically to determine whether a decline in their value is other than temporary.  The term “other than temporary” is not intended to indicate a permanent decline in value.  Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of an investment.  Management reviews other criteria such as magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary.  Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. 
 
 
 
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FINANCIAL CONDITION
 
Investment Securities
 
The investment portfolio consists primarily of securities available for sale.  Securities available for sale are those securities that we intend to hold for an indefinite period of time but not necessarily until maturity.  These securities are carried at fair value and may be sold as part of an asset/liability management strategy, liquidity management, interest rate risk management, regulatory capital management or other similar factors.  Investment securities we anticipate holding until the investment’s maturity date are recorded at amortized cost.
 
The investment portfolio consists primarily of U.S. Government agency securities, mortgage-backed securities, corporate bonds, state and municipal obligations, and equity securities.  The income from state and municipal obligations is exempt from federal income tax.  Certain agency securities are exempt from state income taxes.  We use the investment portfolio as a source of both liquidity and earnings.
 
Investment securities decreased $1.2 million, or 4.09%, to $27.2 million at March 31, 2012, from $28.3 million at December 31, 2011. The decrease is primarily the result of principal paydowns on debt securities. Management continues to look for opportunities to use liquidity from maturing investments to reduce our use of high cost certificates of deposit and borrowed funds. Management continues to evaluate investment options that will produce income without assuming significant credit or interest rate risk. 
 
Loans Held for Sale
 
Loans held for sale increased by $6.7 million, or 23.75%, from $28.4 million at December 31, 2011, to $35.2 million at March 31, 2012. Generally, loans originated with the intention of being sold to a third party remain on our balance sheet for approximately 45 days, meaning that this figure is impacted by the number of loans originated in such period. In this regard, during March 2012, loans originated with the intention of being sold totaled $27.5 million compared to $23.3 million during December 2011. Loans held for sale are carried at the lower of cost or the committed sale price, determined on an individual loan basis.
 
Loans
 
Gross loans, excluding loans held for sale, decreased 4.85% to $256.0 million at March 31, 2012 compared to $269.0 million at December 31, 2011, resulting from weak loan demand as businesses continue to limit borrowing to expand their operations during the continued sluggish and uncertain economy.  
 
Loans are placed on nonaccrual status when they are past-due 90 days as to either principal or interest or when, in the opinion of management, the collection of all interest and/or principal is in doubt.  Placing a loan on nonaccrual status means that we no longer accrue interest on such loan and reverse any interest previously accrued but not collected.  Management may grant a waiver from nonaccrual status for a 90-day past-due loan that is both well secured and in the process of collection.  A loan remains on nonaccrual status until the loan is current as to payment of both principal and interest and the borrower demonstrates the ability to pay and remain current.
 
A loan is considered to be impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Impaired loans are measured based on the fair value of the collateral for collateral dependent loans and at the present value of expected future cash flows using the loans’ effective interest rates for loans that are not collateral dependent.
 
At March 31, 2012, we had 13 impaired loans totaling approximately $5.9 million, seven of which have been classified as nonaccrual.  The valuation allowance for impaired loans was $1.4 million as of March 31, 2012.
 
The following table provides information concerning non-performing assets and past due loans at the dates indicated:
 
   
March 31,
   
December 31,
   
March 31,
 
   
2012
   
2011
   
2011
 
                   
Nonaccrual loans
  $ 3,667,231     $ 3,960,496     $ 10,691,682  
Restructured loans
    9,387,867       8,460,654       8,337,368  
Foreclosed real estate
    4,878,849       4,822,417       4,255,969  
    Total non-performing assets
  $ 17,933,947     $ 17,243,567     $ 23,285,019  
                         
 Accruing loans past-due 90 days or more
  $ -     $ -     $ -  
 
 
 
 
30

 
 
Four restructured notes totaling $679,356 are more than 90 days past due and are included in nonaccrual loans. All other restructured notes are paying in accordance with the terms of the agreement, and remain on accrual status.
 
The level of non-performing assets continues to have a negative impact on earnings as the economy is showing little improvement and real estate values continue to decline. Management has worked diligently to identify borrowers that may be facing difficulties in order to restructure terms where appropriate, secure additional collateral or pursue foreclosure and other secondary sources of repayment. The successful reduction of non-performing assets will ultimately be dependent on continued management diligence and improvement in the economy and the real estate market.
 
Allowance for Loan Losses
 
The allowance for loan losses represents management’s best estimate of probable losses in the existing loan portfolio.  We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of the consolidated financial statements.  The allowance for loan losses is a material estimate that is particularly susceptible to significant changes in the near term and is established through a provision for loan losses.
 
 We base the evaluation of the adequacy of the allowance for loan losses upon loan categories. We categorize loans as commercial loans or consumer loans. We further divide commercial and consumer loans by collateral type and whether the loan is an installment loan or a revolving credit facility. We apply historic loss ratios to each subcategory of loans within the commercial and consumer loan categories. Loss ratios are determined based upon the most recent three years of history for each loan subcategory.
 
We further divide commercial loans by risk rating and apply loss ratios by risk rating to determine estimated loss amounts. We evaluate delinquent loans and loans for which management has knowledge about possible credit problems of the borrower or knowledge of problems with loan collateral separately and assign loss amounts based upon the evaluation.
 
With respect to commercial loans, management assigns a risk rating of one through nine to each loan at inception, with a risk rating of one having the least amount of risk and a risk rating of nine having the greatest amount of risk. The risk rating is reviewed at least annually based on, among other things, the borrower’s financial condition, cash flow and ongoing financial viability; the collateral securing the loan; the borrower’s industry; and payment history. We evaluate loans with a risk rating of five or greater separately and allocate a portion of the allowance for loan losses based upon the evaluation, if necessary.
 
 We consider delinquency rates and other qualitative or environmental factors that may cause estimated credit losses associated with our existing portfolio to differ from historical loss experience. These factors include, but are not limited to, changes in lending policies and procedures, changes in the nature and volume of the loan portfolio, changes in the experience, ability and depth of lending management and the effect of other external factors such as economic factors, competition and legal and regulatory requirements on the level of estimated credit losses in our existing portfolio.
 
Our policies require an independent review of assets on a regular basis and we believe that we appropriately reclassify loans as warranted. We believe that we use the best information available to make a determination with respect to the allowance for loan losses, recognizing that the determination is inherently subjective and that future adjustments may be necessary depending upon, among other factors, a change in economic conditions of specific borrowers or generally in the economy and new information that becomes available to us. However, there are no assurances that the allowance for loan losses will be sufficient to absorb losses on non-performing assets, or that the allowance will be sufficient to cover losses on non-performing assets in the future.
 
The allowance for loan losses was $5.0 million at March 31, 2012, which was 1.97% of loans compared to $4.9 million at December 31, 2011, which was 1.81% of loans.  During the first three months of 2012, we experienced net chargeoffs of $65,189 compared to net recoveries of $18,152 during the same period of 2011.  The annualized ratio of net loan losses to average loans outstanding was 0.09% for the three months ended March 31, 2012 compared to the net loan loss ratio of (0.02)% for the first three months of 2011. The ratio of nonperforming assets, including accruing loans past-due 90 days or more, as a percentage of period-end loans, excluding loans held for sale, and foreclosed real estate increased to 6.87% at March 31, 2012, compared to 6.30% at December 31, 2011. The increase in the allowance for loan losses was necessary to recognize the increase in historical loss rates used to calculate the allowance as well as the completion of new appraisals that indicated that collateral values have continued to decline during 2012. These declines result from the extended economic stagnation and the limited market activity in commercial and residential real estate. 

 
 
31

 
 
 
The following table shows the activity in the allowance for loan losses:
 
   
Three Months Ended
   
Year Ended
 
   
March 31,
   
December 31,
 
   
2012
   
2011
   
2011
 
                   
Allowance for loan losses - beginning of period
  $ 4,858,551     $ 4,481,236     $ 4,481,236  
   Provision for loan losses
    245,514       114,217       2,156,626  
   Charge-offs
    (74,807 )     (65,614 )     (1,892,084 )
   Recoveries
    9,618       83,766       112,773  
Allowance for loan losses - end of period
  $ 5,038,876     $ 4,613,605     $ 4,858,551  
 
Funding Sources
 
Deposits
 
Total deposits increased by $17.2 million, or 5.5%, to $332.2 million as of March 31, 2012, from $315.0 million as of December 31, 2011.  Our successful efforts to attract additional deposits, particularly from the small and mid-sized business segments, are evidenced by growth in demand deposits which increased by $8.8 million, or 11.8%, to $83.8 million as of March 31, 2012 compared to $75.0 million at December 31, 2011. Interest-bearing accounts, excluding certificate of deposit accounts, increased by $3.5 million to $110.8 million at March 31, 2012, compared to $107.2 million at December 31, 2011. Certificate of deposit accounts increased by 3.6% from $132.7 million at December 31, 2011 to $137.5 million at March 31, 2012.
 
Included in our certificate of deposit portfolio are brokered certificates of deposit through the Promontory Interfinancial Network. Through this deposit matching network and its certificate of deposit account registry service (CDARS), we obtained the ability to offer our customers access to Federal Deposit Insurance Corporation (“FDIC”) insured deposit products in aggregate amounts exceeding current insurance limits. When we place funds through CDARS on behalf of a customer, we receive matching deposits through the network’s reciprocal deposit program. We can also place deposits through this network without receiving matching deposits. At March 31, 2012, we had $25.0 million in CDARS through the reciprocal deposit program compared to $18.2 million at December 31, 2011. We did not have any non-reciprocal deposits in the CDARS program as of March 31, 2012, or as of December 31, 2011.
 
Borrowings
 
Total borrowings decreased $9.0 million, or 80.3%, to $2.2 million at March 31, 2012 compared to $11.2 million at the end of 2011. The decrease in borrowings is a result of repaying Federal Home Loan Bank (“FHLB”) advances.  We were able to reduce these borrowings as a result of the increase in total deposits of $17.2 million during the period, which resulted in our requiring fewer borrowings as of March 31, 2012.
 
All borrowings at March 31, 2012 and December 31, 2011 consisted of advances from the FHLB. As of March 31, 2012, outstanding advances included two fixed rate credit loans totaling $2.2 million with maturities of greater than 30 days. The latest maturity date is June 2013. These advances carry interest rates ranging from 3.26% to 4.33%.  At December 31, 2011, outstanding advances included four fixed rate credit loans totaling $11.2 million with the latest maturity date of June 2013.
 
CAPITAL RESOURCES
 
Bank holding companies and banks are required by the Board of Governors of the Federal Reserve (the “Federal Reserve”) and the FDIC to maintain levels of Tier 1 (or Core) and Tier 2 capital measured as a percentage of assets on a risk-weighted basis.  Capital is primarily represented by stockholders’ equity, adjusted for the allowance for loan losses and certain issues of preferred stock, convertible securities, and subordinated debt, depending on the capital level being measured.  Assets and certain off-balance sheet transactions are assigned to one of five different risk-weighting factors for purposes of determining the risk-adjusted asset base.  The minimum levels of Tier 1 and Total capital to risk-adjusted assets are 4% and 8%, respectively, under the regulations.
 
In addition, the Federal Reserve and the FDIC require that bank holding companies and banks maintain a minimum level of Tier 1 (or Core) capital to average total assets excluding intangibles for the current quarter.  This measure is known as the leverage ratio.  The current regulatory minimum for the leverage ratio for institutions to be considered adequately capitalized is 4%, but an individual institution could be required to be maintained at a higher level based on its regulator’s assessment of its risk profile. As of March 31, 2012 and December 31, 2011, the Company is considered well capitalized.  The Bank also exceeded the FDIC required minimum capital levels to be considered well capitalized at those dates.  Management knows of no conditions or events that would change this classification.
 
 

 
 
32

 
 
The following table summarizes the Company’s capital ratios:

         
Minimum
   
 
March 31,
 
December 31,
 
Regulatory
 
To Be
 
2012
 
2011
 
Requirements
 
Well Capitalized
Risk-based capital ratios:
             
Tier 1 capital
11.17%
 
10.59%
 
4.00%
 
6.00%
Total capital
12.45%
 
11.87%
 
8.00%
 
10.00%
Tier 1 leverage ratio
9.65%
 
9.75%
 
4.00%
 
5.00%
 
Total stockholders’ equity increased 0.2%, or $75,145, during the three months ended March 31, 2012 compared to December 31, 2011, increasing to $32.7 million at March 31, 2012. The increase was due to a reduction in the unrealized loss on available for sale securities, net of tax, of $442,621, offset by our net loss of $252,464 and dividends accrued on preferred stock of $115,012.
 
RESULTS OF OPERATIONS
 
Net Interest Income
 
 Net interest income, the amount by which interest income on interest-earning assets exceeds interest expense on interest-bearing liabilities, is the most significant component of the Company’s earnings. Net interest income is a function of several factors, including changes in the volume and mix of interest-earning assets and funding sources, and market interest rates. While management policies influence these factors, external forces, including customer needs and demands, competition, the economic policies of the federal government and the monetary policies of the Federal Reserve are also important.
 
Net interest income decreased by $65,385, or 1.9%, for the three months ended March 31, 2012. Net interest margin, which represents the annualized percentage of net interest income as compared to average interest earning assets, remained flat at 3.93% for the three month periods ended both March 31, 2012 and 2011.
 
Total interest income decreased $257,537, or 5.8%, for the three month period ended March 31, 2012 compared to the same period in 2011. Interest and fee income on loans decreased $205,428, or 5.1%, for the three month period ended March 31, 2012 compared to the same period in 2011. The decrease for the three month period is a result of a decline in average loans outstanding from $307.7 million for the 2011 quarter to $286.9 million for the same period in 2012. The decrease in average balances is a result of management’s decision to manage capital ratios through the careful reduction of assets.
 
 Interest income from investment securities, overnight investments, and interest-bearing deposits was $326,913 for the three month period ended March 31, 2012, compared to $379,022 for the same period in 2011.  The average investment portfolio decreased 13.9%, or $5.1 million, for the three month period ended March 31, 2012 as compared to the same period in 2011. The overall yield on investments decreased from 4.08% for the three month period ended March 31, 2011 to 3.93% for the comparable period in 2012.  The decline in the investment portfolio resulted from management’s decision to shrink the balance sheet by using cash flow from investments to reduce high-cost borrowings. The decrease in yields resulted from maturities and calls of securities that carried higher yields than the securities remaining in our portfolio. The yield on Federal funds sold and other interest-bearing deposits increased to 0.17% for the first three months of 2012 compared to 0.09% for the same period in 2011.  The increase in the yield on Federal funds sold and other interest-bearing deposits is primarily related to the increase in excess reserves held with the Federal Reserve, which paid a higher rate than other correspondent banks during both periods.
 
Interest expense decreased $192,152, or 18.9%, for the three month period ended March 31, 2012 compared to the same period in 2011.  The primary reasons for the decrease are a reduction in the cost of interest-bearing liabilities and a reduction in the overall level of interest bearing liabilities. The cost of interest-bearing liabilities decreased to 1.31% for the three month period ended March 31, 2012 compared to 1.53% for the same period in 2011.  The decrease in the cost of interest-bearing liabilities was primarily related to management’s continuing focus on reducing high-cost certificates of deposit and borrowings. The cost of average interest-bearing deposits for the three month period ended March 31, 2012 declined to 1.22% from 1.37% for the comparable period in 2011. Also contributing to the decrease in interest expense during the 2012 period was a decrease in average borrowed funds to $9.7 million for the three months ended March 31, 2012, from $29.8 million for the same period in 2011.



 
33

 


The following tables set forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities, the amount of interest income and interest expense and the resulting yields on average interest-earning assets and rates paid on average interest-bearing liabilities.

   
Three Months Ended March 31, 2012
   
Three Months Ended March 31, 2011
 
   
Average
               
Average
             
   
Balance
   
Interest
   
Yield
   
Balance
   
Interest
   
Yield
 
                                     
ASSETS
                                   
Interest-earning assets:
                                   
Federal funds sold, Federal Reserve Bank and Federal Home Loan Bank deposit
    23,026,677       9,642       0.17 %     5,137,155       1,100       0.09 %
Federal Home Loan Bank stock
    2,111,300       7,508       1.43 %     3,463,000       7,027       0.82 %
Investment securities:
                                               
U.S. government agency
    2,073,179       22,637       4.39 %     1,907,566       24,642       5.24 %
State and municipal
    8,335,616       76,639       3.70 %     8,362,740       76,846       3.73 %
Mortgage backed securities
    13,384,927       185,545       5.58 %     17,968,664       245,997       5.55 %
Corporate bonds
    7,460,945       24,935       1.34 %     8,042,196       23,176       1.17 %
Other
    486,011       7       0.01 %     582,992       234       0.16 %
      31,740,678       309,763       3.93 %     36,864,158       370,895       4.08 %
Loans:
                                               
Commercial and industrial
    36,537,322       480,526       5.29 %     37,704,638       458,014       4.93 %
Residential mortgage (a)
    108,294,486       1,276,153       4.74 %     113,476,327       1,386,310       4.95 %
Commercial mortgage and construction
    141,476,567       2,086,922       5.93 %     155,854,015       2,205,595       5.74 %
Installment
    618,076       16,337       10.63 %     615,347       15,447       10.18 %
      286,926,451       3,859,938       5.41 %     307,650,327       4,065,366       5.36 %
Total interest earning assets
    343,805,106       4,186,851       4.90 %     353,114,640       4,444,388       5.10 %
Noninterest bearing cash
    3,216,351                       3,058,825                  
Premises and equipment
    6,644,915                       7,062,415                  
Other assets
    19,657,547                       19,354,995                  
Allowance for loan losses
    (4,915,219 )                     (4,559,041 )                
Unrealized gains (losses) on available for sale securities, net
    (3,851,355 )                     (4,687,116 )                
      364,557,345                       373,344,718                  
LIABILITIES AND STOCKHOLDERS' EQUITY
                                               
Interest bearing deposits:
                                               
Savings and NOW
    58,049,528       25,292       0.18 %     53,963,643       33,346       0.25 %
Money market
    48,545,580       59,550       0.49 %     43,448,581       71,965       0.67 %
Certificates of deposit
    137,748,322       658,152       1.92 %     142,040,143       701,433       2.00 %
      244,343,430       742,994       1.22 %     239,452,367       806,744       1.37 %
Borrowed funds
    9,748,060       83,722       3.45 %     29,752,666       212,124       2.89 %
Total interest bearing liabilities
    254,091,490       826,716       1.31 %     269,205,033       1,018,868       1.53 %
Noninterest bearing deposits
    72,612,251                       68,270,623                  
Other liabilities
    5,465,027                       2,512,514                  
Stockholders' equity
    32,388,577                       33,356,548                  
Total liabilities and stockholders' equity
    364,557,345                       373,344,718                  
Net interest margin (b)
    343,805,106       3,360,135       3.93 %     353,114,640       3,425,520       3.93 %
                                                 
 (a) Includes loans held for sale.
         
(b) Net interest margin is the ratio of net interest income to total average interest-earning assets.
         
 
Provision for Loan Losses 
 
The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable losses within the existing loan portfolio. On a monthly basis, management reviews all loan portfolios to determine trends and monitor asset quality. For consumer loan portfolios, this review generally consists of reviewing delinquency levels on an aggregate basis with timely follow-up on accounts that become delinquent. In commercial loan portfolios, delinquency information is monitored and periodic reviews of business and property leasing operations are performed on an individual loan basis to determine potential collection and repayment problems. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion for further analysis of the provision for loan losses.
 
We recorded a provision for loan losses of $245,514 for the three month period ended March 31, 2012 compared to $114,217 for the same period in 2011.  Nonaccrual loans, foreclosed real estate and delinquent loans over 90 days still accruing interest to total loans, excluding loans held for sale, and foreclosed real estate increased to 3.28% at March 31, 2012 from 3.21% at December 31, 2011. The increase in the provision for the three month period is a result of an increase in historical loss rates used to calculate the allowance and loans with new appraisals in the 2012 period showing a decline in the value of collateral securing certain loans.
 
 
 
34

 
 
Noninterest Income
 
Noninterest income for the three months ended March 31, 2012 was $1.3 million compared to $1.6 million for the same period in 2011, representing a decrease of $274,281, or 17.0% for the period. The decrease for the three month period is almost entirely a result of a $651,587, or 389.1%, increase in write downs on impaired securities. The write downs related to two PreTSLs and one equity security. These write downs were partially offset by an $88,873, or 14.6%, increase in electronic banking revenue and a $355,238, or 45.8%, increase in mortgage banking income. Also contributing to the overall decrease were declines in service charge income on deposit accounts and a decline in brokerage commissions during the three months ended March 31, 2012 compared to the same period in 2011.
 
The higher electronic banking fee income during the 2012 period is a result of an increased point of sale (“POS”) client base which generates a larger volume of fee-based transactions.  Electronic banking income is comprised of three sources: national POS sponsorships, ATM fees, and check card fees.  The Company sponsors merchants who accept ATM cards for purchases within various networks (i.e. STAR, PULSE, NYCE). This national POS sponsorship income represents approximately 90% of total electronic banking revenue. Fees from ATMs represent approximately 3% of total electronic banking revenue.  Fees from check cards and other service charges represent approximately 7% of electronic banking revenue. Mortgage banking revenue, net of commissions paid to mortgage lenders, was $1.1 million for the three months ended March 31, 2012 as compared to $775,594 for the same period in 2011.   Origination volume increased by $18.1 million, or 32.3%, for the three month period ended March 31, 2012 as compared to same period in 2011.  The ability to grow revenue levels at a faster pace than volume growth for the three month period is a result of a change in the commission structure of loan officers under which loan officers are now paid based on volume instead of pricing. This change was phased in during the second quarter of 2011 and resulted in lower commissions than would have been paid under the prior structure.
 
With interest rates at historic lows and concern about future rising rates, consumer demand for mortgage loans has increased in the first three months of 2012 as compared to the same period in 2011. When the economy strengthens, we would anticipate increased consumer demand for financing of owner-occupied, residential properties.
 
Brokerage commissions from services provided by CFS decreased by $51,025, or 25.5%, for the three month period ended March 31, 2012, compared to the same period in 2011.  The uncertainty in the equity markets caused a slowdown in sales that has carried over from late 2011. There is a tremendous amount of liquidity in most asset classes which could translate into increased sales as the year progresses. 
 
Services charges on deposit accounts decreased by 20.2% to $98,735 for the first quarter of 2012 compared to $123,736 during the same period in 2011. A decline in overdraft fee income during 2012 compared to 2011 was the primary reason for the overall decrease in service charges on deposit accounts income.
 
Other fees and commissions were $85,366 for the three month period ended March 31, 2012 compared to $79,246 for the same period in 2011. These fees have increased as a result of increased wire transfer fees and other miscellaneous fees.
 
We incurred a loss on securities write downs of $819,054 for the three period ended March 31, 2012, compared to a loss of $167,467 for the same period in 2011. The write down in the three months ended March 31, 2012 was related to the write-down of two PreTSLs and one equity holding in a bank stock. The equity holding was deemed impaired as a result of the issuer’s ongoing asset quality issues and declines in its capital strength. The PreTSLs have been written down through the income statement as the quarterly impairment analysis dictates. Impairments on trust preferred securities result from the deferral of dividends by financial institutions or complete failure of the institutions that hold the underlying debt obligations on these securities. It is possible that continuation of the current economic environment will result in additional write-downs resulting from future deferrals or failures. While this creates volatility in our earnings, the write-downs have very little effect on the Bank’s regulatory capital position since the regulatory capital calculations allocate enough capital to cover the unrealized losses. Management is hopeful that these investments will increase in value as the economy improves and management will continuously evaluate all strategies to maximize the ultimate value realized from these investments.
 
Noninterest Expense
 
Noninterest expenses increased $209,943, or 4.5%, for the three months ended March 31, 2012 compared to the same period in 2011. The increase for the three month period is primarily a result of increases in salaries, professional fees and costs associated with foreclosed real estate. These increases were partially offset by reductions in employee benefits, occupancy costs and other operating expenses.
 
Salaries increased by $101,687, or 5.4%, as a result of additional mortgage volume related compensation paid to mortgage production managers and mortgage operations staff. The new mortgage compensation program implemented in the second quarter of 2011 pays based upon volume instead of profitability and pricing. This change was mandated by rules related to the Dodd-Frank Act.
 
Employee benefits decreased $107,393, or 16.9%, to $528,091 during the first quarter of 2012 compared to $635,484 during the first quarter of 2011. The decrease was a result of elimination of certain employee benefits at the end of the second quarter of 2011.
 
 
 
35

 
 
 Occupancy expense decreased by $14,450 to $583,268 for the three months ended March 31, 2012, compared to $597,718 for the same three month period in 2011. The decrease was associated with lower utility costs resulting from a mild winter in 2012.
 
Professional services were $364,585 for the three month period ended March 31, 2012 compared to $191,925 for the same period in 2011, an increase of $172,660, or 90.0%, for the quarter. The increase is a result of legal fees and investment banker fees paid in conjunction with the merger announced on April 8, 2012. It is expected that these fees will remain elevated as the Company works toward stockholder and regulatory approval of the transaction which is projected to be completed in the third quarter of 2012.
 
Furniture and equipment expense decreased marginally by $253, or 0.2%, for the three month period ended March 31, 2012.
 
Foreclosed real estate losses, write downs and costs increased by $101,605 for the three month period ended March 31, 2012 as compared to the same period in 2011. The increase for the three month period is a result of increased costs to maintain properties and to market them for sale.
 
Other operating expenses decreased $43,913, or 3.8%, for the three months ended March 31, 2012 as compared to the same periods in 2011. The quarterly decrease was due to a decrease in FDIC assessments of $64,864 partially offset by increases in various other items.
 
Income Taxes
 
For the three months ended March 31, 2012, we recorded an income tax benefit of $203,680 compared to an income tax expense of $53,467 for the three months ended March 31, 2011. The effective tax rates, which may fluctuate from year to year due to changes in the mix of tax-exempt loans, investments and operating losses, were (44.7)% for the 2012 period as compared to 23.8% for the 2011 period.
 
LIQUIDITY AND CAPITAL EXPENDITURES
 
Liquidity
 
Liquidity describes our ability to meet financial obligations, including lending commitments and contingencies, which arise during the normal course of business.  Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers, as well as to meet current and planned expenditures.
 
Our liquidity is derived primarily from our deposit base and equity capital. Additionally, liquidity is provided through our portfolios of cash and interest-bearing deposits in other banks, federal funds sold, loans held for sale, and securities available for sale.  Such assets totaled $90.4 million, or 24.3% of total assets, at March 31, 2012.
 
The borrowing requirements of customers include commitments to extend credit and the unused portion of lines of credit, which totaled $57.6 million at March 31, 2012.  Of this total, management places a high probability of required funding within one year of approximately $15.4 million. The amount remaining is unused home equity lines and other consumer lines on which management places a low probability of funding.
 
We also have external sources of funds through the Federal Reserve Bank (“FRB”) and FHLB, which we can draw upon when required. We have a line of credit totaling approximately $49.0 million with the FHLB based on qualifying loans pledged as collateral.  In addition, we can pledge securities at the FRB and FHLB and borrow approximately 97% of the fair market value of the securities. We had $9.8 million of securities pledged at the FHLB under which the Bank could have borrowed approximately $9.5 million. Also, the Bank has $2.3 million of securities pledged at FRB under which it could have borrowed approximately $2.2 million.  Outstanding borrowings at the FHLB were $2.2 million at March 31, 2012. Fixed rate borrowings from FHLB include $340,000 maturing in 2012 and $1.9 million maturing during 2013. The interest rates on these borrowings range from 3.26% to 4.33%. Additionally, we have an unsecured federal funds line of credit of $5.0 million and a $10.0 million secured federal funds line of credit with other institutions. The secured federal funds line of credit with another institution would require the Bank to transfer securities pledged at the FHLB or FRB to this institution before it could borrow against this line. There was no balance outstanding under these lines at March 31, 2012. These lines bear interest at the current federal funds rate of the correspondent bank.
 
MARKET RISK AND INTEREST RATE SENSITIVITY
 
The Company’s interest rate risk represents the level of exposure it has to fluctuations in interest rates and is primarily measured as the change in earnings and the theoretical market value of equity that results from changes in interest rates.  The Asset/Liability Management Committee of the Bank’s Board of Directors (the “ALCO”) oversees our management of interest rate risk.  The objective of the management of interest rate risk is to optimize net interest income during periods of volatility as well as stable interest rates while maintaining a balance between the maturity and repricing characteristics of assets and liabilities that is consistent with our liquidity, asset and earnings growth, and capital adequacy goals.
 
Due to changes in interest rates, the level of income for a financial institution can be affected by the repricing characteristics of its assets and liabilities. At March 31, 2012, we are in an asset sensitive position.  Management continuously takes steps to reduce higher costing fixed rate funding instruments, while increasing assets that are more fluid in their repricing. An asset sensitive position, theoretically, is favorable in a rising rate environment since more assets than liabilities will reprice in a given time frame as interest rates rise. Management works to maintain a consistent spread between yields on assets and costs of deposits and borrowings, regardless of the direction of interest rates.
 
 
 
36

 
 
 
INFLATION
 
Inflation may be expected to have an impact on the Company’s operating costs and thus on net income. A prolonged period of inflation could cause interest rates, wages, and other costs to increase and could adversely affect the Company’s results of operations unless the fees charged by the Company could be increased correspondingly. However, the Company believes that the impact of inflation was not material for the first three months of 2012 or 2011. 
 
OFF-BALANCE SHEET ARRANGEMENTS
 
We enter into off-balance sheet arrangements in the normal course of business. These arrangements consist primarily of commitments to extend credit, lines of credit, and letters of credit. In addition, we have certain operating lease obligations.
 
Credit commitments are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates fixed at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party.
 
Our exposure to credit loss in the event of nonperformance by the borrower is the contract amount of the commitment. Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. We are not aware of any accounting loss we would incur by funding our commitments.

 
 
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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Not applicable.
 
ITEM 4.    CONTROLS AND PROCEDURES
 
We maintain disclosure controls and procedures (as that term is defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) that are designed to provide material information about the Company to the chief executive officer, the chief financial officer, and others within the Company so that information may be recorded, processed, summarized, and reported as required under the SEC’s rules and forms. The Company’s chief executive officer and chief financial officer have evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report and, based on that evaluation, have each concluded that such disclosure controls and procedures are effective as of March 31, 2012.
 
There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15 under the Exchange Act) during the quarter ended March 31, 2012, that have materially affected or are reasonably likely to materially affect, the internal control over financial reporting.

 
PART II – OTHER INFORMATION
 
ITEM 1.    LEGAL PROCEEDINGS
 
The Company is involved in various legal actions arising from normal business activities.  In management’s opinion, the outcome of these matters, individually or in the aggregate, will not have a material adverse impact on our results of operation or financial condition.
 
ITEM 1A.    RISK FACTORS
 
There have been no material changes in the risk factors from those disclosed in our 2011 Form 10-K.
 
ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 
ITEM 3.    DEFAULTS UPON SENIOR SECURITIES
 
None.
 
ITEM 4.    MINE SAFETY DISCLOSURES
 
Not applicable.
 
ITEM 5.    OTHER INFORMATION
 
None.
 
 
 
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ITEM 6.  EXHIBITS
 

 
*Pursuant to Rule 406T of Regulation S-T, the interactive data files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
 
 
 
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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.
 
       
CARROLLTON BANCORP
         
       
PRINCIPAL EXECUTIVE OFFICER:
         
Date
May 14, 2012
   
/s/Robert A. Altieri
         
       
Robert A. Altieri
       
President and Chief Executive Officer
         
       
PRINCIPAL FINANCIAL OFFICER:
         
Date
May 14, 2012
   
/s/Mark A. Semanie
         
       
Mark A. Semanie
       
Chief Financial Officer
 
 
 
 
 
 
 
 
 

 
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