Southeastern Bank Financial CORP - FORM 10-Q

Attached files

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EX-31.2 - EXHIBIT 31.2 - Southeastern Bank Financial CORP	ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - Southeastern Bank Financial CORP	ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - Southeastern Bank Financial CORP	ex32-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2012.

o	Transition Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _______________ to ________________.

Commission File No. 0-24172

	Southeastern Bank Financial Corporation
(Exact name of registrant as specified in its charter)

	Georgia			58-2005097
(State of Incorporation)			(I.R.S. Employer Identification No.)

	3530 Wheeler Road, Augusta, Georgia 30909
(Address of principal executive offices)

	(706) 738-6990
(Issuer’s telephone number, including area code)

	Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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

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

Indicate by check mark whether the issuer 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		Non-accelerated filer o
			(do not check if a smaller reporting company)

	Accelerated filer o		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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

6,680,225 shares of common stock, $3.00 par value per share, outstanding as of July 25, 2012.

SOUTHEASTERN BANK FINANCIAL CORPORATION

FORM 10-Q

INDEX

			Page
Part I
	Item 1.	Financial Statements (Unaudited)

		Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011	3

		Consolidated Statements of Income and Comprehensive Income for the Three and Six Months ended June 30, 2012 and 2011	4

		Consolidated Statements of Cash Flows for the Six Months ended June 30, 2012 and 2011	6

		Notes to Consolidated Financial Statements	8

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	49

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	72

	Item 4.	Controls and Procedures	73

Part II Other Information
	Item 1.	Legal Proceedings	74
	Item 1A.	Risk Factors	74
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	74
	Item 3.	Defaults Upon Senior Securities	74
	Item 4.	Mine Safety Disclosures	74
	Item 5.	Other Information	74
	Item 6.	Exhibits	75

Signature			76

* No information submitted under this caption

PART I

FINANCIAL INFORMATION

SOUTHEASTERN BANK FINANCIAL CORPORATION
Consolidated Balance Sheets
(Dollars in thousands, except share data)

	June 30,
	2012		December 31,
	(Unaudited)		2011
Assets
Cash and due from banks	$	53,500	$	51,080
Interest-bearing deposits in other banks		5,820		18,761
Cash and cash equivalents		59,320		69,841

Available-for-sale securities		665,369		603,759
Loans held for sale		27,197		29,615
Loans		847,759		846,010
Less allowance for loan losses		29,552		29,046
Loans, net		818,207		816,964

Premises and equipment, net		26,787		27,608
Accrued interest receivable		6,508		6,247
Bank-owned life insurance		31,239		30,713
Restricted equity securities		5,399		5,086
Other real estate owned		7,773		6,209
Prepaid FDIC assessment		2,733		3,420
Deferred tax asset		11,523		12,723
Other assets		4,072		2,588
	$	1,666,127	$	1,614,773
Liabilities and Stockholders’ Equity
Deposits
Noninterest-bearing	$	154,047	$	147,196
Interest-bearing:
NOW accounts		348,628		346,236
Savings		483,101		471,728
Money management accounts		38,980		42,977
Time deposits over $100		284,014		286,319
Other time deposits		126,245		124,766
		1,435,015		1,419,222

Securities sold under repurchase agreements		664		701
Advances from Federal Home Loan Bank		66,000		39,000
Accrued interest payable and other liabilities		16,784		15,874
Subordinated debentures		21,547		22,947
Total liabilities		1,540,010		1,497,744

Stockholders’ equity:
Preferred stock, no par value; 10,000,000 shares authorized; 0 shares outstanding in 2012 and 2011, respectively		-		-
Common stock, $3.00 par value; 10,000,000 shares authorized; 6,679,381 and 6,677,667 shares issued and outstanding in 2012 and 2011, respectively		20,038		20,033
Additional paid-in capital		62,804		62,767
Retained earnings		37,256		30,593
Accumulated other comprehensive income, net		6,019		3,636
Total stockholders’ equity		126,117		117,029
	$	1,666,127	$	1,614,773

See accompanying notes to consolidated financial statements.

SOUTHEASTERN BANK FINANCIAL CORPORATION

Consolidated Statements of Income and Comprehensive Income

(Dollars in thousands, except share data)

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
Interest income:
Loans, including fees	$	11,558		$	12,827		$	23,218		$	25,455
Investment securities		4,422			4,510			8,667			8,830
Interest-bearing deposits in other banks		22			35			47			70
Total interest income		16,002			17,372			31,932			34,355
Interest expense:
Deposits		2,377			3,839			5,091			7,907
Securities sold under repurchase agreements		8			1			9			3
Other borrowings		631			663			1,227			1,377
Total interest expense		3,016			4,503			6,327			9,287

Net interest income		12,986			12,869			25,605			25,068
Provision for loan losses		1,950			3,424			4,166			6,664
Net interest income after provision for loan losses		11,036			9,445			21,439			18,404

Noninterest income:
Service charges and fees on deposits		1,685			1,750			3,296			3,328
Gain on sales of loans		2,003			1,720			4,022			2,927
Gain on sale of fixed assets, net		8			-			6			17
Investment securities gains (losses), net		101			(30	)		478			118
Other-than-temporary loss
Total impairment loss		(13	)		-			(13	)		(127	)
Less loss recognized in other comprehensive income		(4	)		-			(4	)		(65	)
Net impairment loss recognized in earnings		(9	)		-			(9	)		(62	)
Retail investment income		505			507			1,027			964
Trust service fees		288			292			577			565
Earnings from cash surrender value of bank-owned life insurance		265			248			526			466
Miscellaneous income		176			191			366			404
Total noninterest income		5,022			4,678			10,289			8,727
Noninterest expense:
Salaries and other personnel expense		6,543			5,654			12,740			11,218
Occupancy expenses		1,043			1,112			2,097			2,227
Other real estate losses, net		688			366			1,349			461
Other operating expenses		2,971			2,931			5,982			5,932
Total noninterest expense		11,245			10,063			22,168			19,838

Income before income taxes		4,813			4,060			9,560			7,293
Income tax expense		1,452			1,255			2,897			2,186
Net income	$	3,361		$	2,805		$	6,663		$	5,107

Other comprehensive income:
Unrealized loss on derivatives		(839	)		(106	)		(358	)		(106	)
Unrealized gain on securities available-for-sale		4,879			9,128			4,727			7,656
Reclassification adjustment for realized (gain) loss on securities, net of OTTI		(92	)		30			(469	)		(56	)
Tax effect		(1,535	)		(3,521	)		(1,517	)		(2,915	)
Total other comprehensive income		2,413			5,531			2,383			4,579
Comprehensive income	$	5,774		$	8,336		$	9,046		$	9,686

SOUTHEASTERN BANK FINANCIAL CORPORATION

Consolidated Statements of Income and Comprehensive Income

(Dollars in thousands, except share data)

(Unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011

Basic net income per share	$	0.50	$	0.42	$	1.00	$	0.76

Diluted net income per share		0.50		0.42		1.00		0.76

Weighted average common shares outstanding		6,679,371		6,676,467		6,678,927		6,676,161

Weighted average number of common and common equivalent shares outstanding		6,679,371		6,676,467		6,678,927		6,676,161

See accompanying notes to consolidated financial statements.

SOUTHEASTERN BANK FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Dollars in thousands)

(Unaudited)


	Six Months Ended
	June 30,
	2012			2011
Cash flows from operating activities:
Net income	$	6,663		$	5,107
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation		1,104			1,254
Deferred income tax benefit		(317	)		(1,238	)
Provision for loan losses		4,166			6,664
Net investment securities gains		(478	)		(118	)
Other-than-temporary impairment losses		9			62
Net amortization of premiums on investment securities		2,300			1,609
Earnings from CSV of bank-owned life insurance		(526	)		(466	)
Stock options compensation cost		22			63
Gain on disposal of premises and equipment		(6	)		(17	)
Loss on the sale of other real estate		852			213
Provision for other real estate valuation allowance		497			248
Gain on sales of loans		(4,022	)		(2,927	)
Real estate loans originated for sale		(139,226	)		(102,402	)
Proceeds from sales of real estate loans		145,666			102,191
(Increase) decrease in accrued interest receivable		(261	)		92
Increase in other assets	(797		)		(387	)
Increase (decrease) in accrued interest payable and other liabilities		552			(110	)
Net cash provided by operating activities		16,198			9,838

Cash flows from investing activities:
Proceeds from sales of securities		62,320			59,984
Proceeds from maturities and calls of available-for-sale securities		118,661			77,875
Purchase of available-for-sale securities		(240,164	)		(114,700	)
Purchase of restricted equity securities		(500	)		(38	)
Proceeds from redemption of FHLB stock		187			291
Net increase in loans		(12,031	)		(7,970	)
Purchase of bank-owned life insurance		-			(5,500	)
Additions to premises and equipment		(285	)		(403	)
Proceeds from sale of other real estate		3,710			2,085
Proceeds from sale of premises and equipment		8			36
Net cash (used in) provided by investing activities		(68,094	)		11,660

SOUTHEASTERN BANK FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Dollars in thousands)

(Unaudited)




	Six Months Ended
	June 30,
	2012			2011

Cash flows from financing activities:
Net increase (decrease) in deposits		15,793			(8,737	)
Net decrease in securities sold under repurchase agreements		(37	)		(207	)
Payments of Federal Home Loan Bank advances		-			(8,000	)
Advances from Federal Home Loan Bank		27,000			-
Payments on subordinated debentures		(1,400	)		-
Proceeds from Directors’ stock purchase plan		19			15
Net cash provided by (used in) financing activities		41,375			(16,929	)

Net (decrease) increase in cash and cash equivalents		(10,521	)		4,569
Cash and cash equivalents at beginning of period		69,841			65,115
Cash and cash equivalents at end of period	$	59,320		$	69,684

Supplemental disclosures of cash paid during the period for:
Interest	$	6,273		$	9,918
Income taxes		3,683			3,054

Supplemental information on noncash investing activities:
Loans transferred to other real estate	$	6,623		$	3,353

See accompanying notes to consolidated financial statements.

SOUTHEASTERN BANK FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

(Dollar amounts are expressed in thousands unless otherwise noted)

June 30, 2012

Note 1 – Summary of Significant Accounting Policies

(a) Basis of Presentation

The accompanying consolidated financial statements include the accounts of Southeastern Bank Financial Corporation (the “Company”), and its wholly-owned subsidiary, Georgia Bank & Trust Company of Augusta (“GB&T”). Significant intercompany transactions and accounts are eliminated in consolidation. Dollar amounts are rounded to thousands except share and per share data.

The financial statements for the three and six months ended June 30, 2012 and 2011 are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2011.

In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations and cash flows for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations for the three and six months ended June 30, 2012 are not necessarily indicative of the results of operations which the Company may achieve for the entire year.

Some items in the prior period financial statements were reclassified to conform to the current presentation.

(b) Loans and Allowance for Loan Losses

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Non-Accrual Loan Procedures:

Interest income on loans of all segments and classes are generally discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer loans are typically charged off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment as measured from the loan’s contractual due date.

All interest, accrued but not received, for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Subsequent payments of interest are recognized on the cash basis as income when full collection of principal is expected. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured and there is a period of at least 6 months of repayment performance (1 year for loans providing for quarterly or semi-annual payments) by the borrower in accordance with contractual terms.

Concentration of Credit Risk:

Most of the Company’s business activity is with customers located within the Augusta-Richmond County, GA-SC metropolitan statistical area. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in this area. The Company also has a significant concentration of loans with real estate developers.

Certain Purchased Loans:

The Company purchases individual loans; some of which have shown evidence of credit deterioration since origination. These purchased loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses.

Such purchased loans are accounted for individually based on common risk characteristics such as, credit score, loan type, and date of origination. The Company estimates the amount and timing of expected cash flows for each purchased loan, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

Over the life of the loan, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

Allowance for Loan Losses:

The allowance for loan losses (ALLL) is a valuation allowance for probable incurred credit losses. The allowance for loan losses is established through a provision for loan losses charged to expense. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

Impaired Loans and Troubled Debt Restructurings:

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

All lending relationships over $500 are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated 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. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The following portfolio segments have been identified:

●

Acquisition Development and Construction (“ADC”) – CSRA

●

ADC – Other

●

Commercial Real Estate – Non owner occupied

●

Commercial Real Estate – Owner occupied

●

1-4 Family

●

Consumer

The following is a discussion of the risks characteristics of these portfolio segments.

Acquisition, Development & Construction (ADC) – CSRA (Primary Market) – ADC lending carries all of the normal risks involved in lending including the changing nature of borrower and guarantor financial conditions and the knowledge that the sale of the completed lots and/or structures is likely the sole source of repayment as opposed to other forms of borrower cash flow. In addition, this type of lending carries several additional risk factors including: (1) timely project completion (contractor financial condition, commodity prices, weather delays, prospective tenant financial condition); (2) market factors (changing economic conditions, unemployment rates, end-user financing availability, interest rates); (3) competition (similar product availability, bank foreclosed properties); and (4) end-product price stability.

ADC – Other – ADC lending in all other markets carries all of the ADC risks outlined for the CSRA plus the additional risk of lending outside of the Company’s traditional market area where our knowledge of these markets may not be as well developed.

Commercial Real Estate – Non Owner Occupied – This lending category includes loans for multi-family, office, warehouse, retail, hotel/motel and other non-owner occupied properties. Loans in this category carry more risk than owner-occupied properties because the property’s cash flow is not derived from the owner of the property’s business, but from unrelated tenants. These outside tenants are each subject to their own set of business risks depending upon their own financial situation, competitors, industry segment and general economic conditions. Therefore, the cash flow from the property in the form of rent may not be as stable as a one-user, owner-occupied property.

Commercial Real Estate – Owner Occupied – This portfolio segment includes loans to finance office buildings, retail establishments, warehouses, convenience stores, churches, schools, daycare facilities, restaurants, health care facilities, golf courses and other owner-occupied properties. Loans in this category generally carry less risk than non-owner occupied properties because the cash flow to service the property’s debt is derived from the owner of the property’s business as opposed to unrelated third-party tenants. The cash flows and property values for one-user, owner-occupied properties tend to be more stable because they are based upon the operation of the owner’s business as opposed to rent from a variety of smaller tenants (each of which carries its own set of business and market risks).

1-4 Family – This lending category includes loans secured by improved residential real estate. Loans in this category are affected by local real estate markets, local & national economic factors affecting borrowers’ employment prospects & income levels, and levels & movement of interest rates and the general availability of mortgage financing.

Consumer – This portfolio segment includes loans secured by consumer goods (e.g. vehicles, recreational products, equipment, etc.), but also may be unsecured. Similar to the 1-4 family category, this segment of the loan portfolio depends on a variety of local & national economic factors affecting borrowers’ employment prospects, income levels and overall economic sentiment.

The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans that become uncollectible, based on evaluations of the collectability of loans. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, historical loss rates, overall portfolio quality, review of specific problem loans, and current economic conditions and trends that may affect a borrower’s ability to pay. The allowance is evaluated on a regular basis utilizing estimated loss factors for specific types of loans. Such loss factors are periodically reviewed and adjusted as necessary based on actual losses.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may advise the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

The process of assessing the adequacy of the allowance is necessarily subjective. Further, and particularly in terms of economic downturns, it is reasonably possible that future credit losses may exceed historical loss levels and may also exceed management’s current estimates of probable incurred credit losses inherent within the loan portfolio. As such, there can be no assurance that future loan charge-offs will not exceed management’s current estimate of the allowance for loan losses.

ALLL Methodology:

The Company’s approach to ALLL reserve calculation uses two distinct perspectives, the guidelines of using Financial Accounting Standards ASC 450 (Accounting for Contingencies) and ASC 310 (Accounting by Creditors for Impairment of a Loan, for individual loans). The process is generally as follows and methodology applies to all classes of loans within the portfolio segments:

●

Loans are grouped according in categories of similar risk characteristics (Portfolio segments)

●

For each loan category, a four year average rolling historical net loss rate is calculated, with the loss rate more heavily weighted to the most recent two years loss history. The historical loss ratios are adjusted for internal and external qualitative factors within each loan category. The qualitative factor adjustment may be further increased for loan classifications of watch rated and substandard within each category. Factors include:

levels and trends in delinquencies and impaired/classified/graded loans;

changes in the quality of the loan review system;

trends in volume and terms of loans;

effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;

experience, ability, and depth of lending management and other relevant staff;

national and local economic trends and conditions;

changes in the value of underlying collateral;

other external factors-competition, legal and regulatory requirements;

effects of changes in credit concentrations

●

The resultant loss factor is applied to each respective loan pool to calculate the ALLL for each loan pool.

●

The total of each loan pool is then added to the ALLL determined for individual loans evaluated for impairment in accordance with ASC 310.

In 2011, certain changes were made in the methodology for calculating the allowance for loan losses. In particular, due to declining balances and merger of the two subsidiary banks, the company elected to combine all non-CSRA ADC segments into one ADC-Other portfolio segment for determining historical loss factors and disclosure purposes. In conjunction with that change, the company determined that the aggregate historical loss factor for the ADC-Other segment was appropriate to use for the new segment. Previously, certain individual ADC segments had judgmentally determined loss factors due to the declining sizes of those portfolios. Because these segments were generally smaller at the time of combination, none of the changes resulted in material adjustments to the aggregate allowance for loan losses, or to the ADC-Other loan segment, nor did they have a material impact on prior years presented.

Loans Held for Sale:

Mortgage loans held for sale are generally sold with servicing rights released. The Company originates mortgages to be held for sale only for loans that have been individually pre-approved by the investor. Mortgage loans originated and intended for sale in the secondary market are carried at fair value, as determined by outstanding commitments from investors.

Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

The Company bears minimal interest rate risk on these loans and only holds the loans temporarily until documentation can be completed to finalize the sale to the investor.

Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge the change in interest rates resulting from its commitments to fund the loans. Changes in the fair values of these derivatives are included in net gains on sales of loans. Fair values of these derivatives were $22 and $24 as of June 30, 2012 and December 31, 2011, respectively.

At the inception of a derivative contract, the Company designates the derivative as one of three types based on the Company’s intentions and belief as to likely effectiveness as a hedge. These three types are (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value hedge”), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”), or (3) an instrument with no hedging designation (“stand-alone derivative”). For a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item, are recognized in current earnings as fair values change. For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings. For both types of hedges, changes in the fair value of derivatives that are not highly effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as noninterest income.

Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged. Net cash settlements on derivatives that do not qualify for hedge accounting are reported in noninterest income. Cash flows on hedges are classified in the cash flow statement the same as the cash flows of the items being hedged.

The Company formally documents the relationship between derivatives and hedged items, as well as the risk-management objective and the strategy for undertaking hedge transactions at the inception of the hedging relationship. This documentation includes linking fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in fair values or cash flows of the hedged items. The Company discontinues hedge accounting when it determines that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative is settled or terminates, a hedged forecasted transaction is no longer probable, a hedged firm commitment is no longer firm, or treatment of the derivative as a hedge is no longer appropriate or intended.

When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded as noninterest income. When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a cash flow hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized into earnings over the same periods which the hedged transactions will affect earnings.

(d) Recent Accounting Pronouncements

In April 2011, the FASB amended existing guidance to assist creditors in determining whether a modification of the terms of a receivable meets the definition of a troubled debt restructuring (“TDR”). The guidance does not change previous standards that a restructuring of debt constitutes a TDR “if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider,” but provides clarification on determining whether a debtor is in financial difficulty and if a concession was granted. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and should be applied retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. The adoption of this guidance did not have a material effect on the Company’s results of operations or financial position, but did require expansion of the Company’s disclosures.

In May 2011, the FASB issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this guidance are effective for interim and annual reporting periods beginning after December 15, 2011. The adoption of this guidance did not have a material effect on the Company’s results of operations or financial position, but did require expansion of the Company’s disclosures.

In June 2011, the FASB amended existing guidance relating to presentation of other comprehensive income in a convergence effort with international accounting standards. This guidance eliminates the option to present the components of comprehensive income as a part of the statement of changes in stockholders’ equity and requires a consecutive presentation of net income and other comprehensive income, and a reconciliation of the components of other comprehensive income. Similar to the requirements of existing guidance, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from OCI to net income in the statements where the components of net income and OCI are presented. The amendments in this guidance should be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted and the amendments do not require any transition disclosures. The adoption of this guidance did not have an effect on the Company’s results of operations or financial position but did require expansion of the Company’s financial statement presentation.

Note 2 – Investment Securities

The following tables summarize the amortized cost and fair value of the available-for-sale investment securities portfolio at June 30, 2012 and December 31, 2011 and the corresponding amounts of unrealized gains and losses therein.

	June 30, 2012
			Gross		Gross
	Amortized		unrealized		unrealized			Estimated
	cost		gains		losses			fair value
			(Dollars in thousands)
Available-for-sale
Obligations of U.S. Government agencies	$	169,995		990		(105	)		170,880
Obligations of states and political subdivisions		112,420		6,828		(138	)		119,110
Mortgage backed securities
U.S. GSE’s* MBS - residential		145,407		4,189		(19	)		149,577
U.S. GSE’s CMO		143,906		1,938		(538	)		145,306
Other CMO		2,172		26		(220	)		1,978
Corporate bonds		78,999		690		(1,171	)		78,518
	$	652,899		14,661		(2,191	)		665,369

* Government sponsored entities

	December 31, 2011
			Gross		Gross
	Amortized		unrealized		unrealized			Estimated
	cost		gains		losses			fair value
			(Dollars in thousands)
Available-for-sale
Obligations of U.S. Government agencies	$	169,137		758		(143	)		169,752
Obligations of states and political subdivisions		98,305		4,641		(86	)		102,860
Mortgage backed securities
U.S. GSE’s MBS - residential		154,130		3,363		(27	)		157,466
U.S. GSE’s CMO		118,173		2,040		(211	)		120,002
Other CMO		2,462		9		(248	)		2,223
Corporate bonds		53,340		131		(2,015	)		51,456
	$	595,547		10,942		(2,730	)		603,759

At June 30, 2012, in addition to the U.S. Government agencies and government sponsored entities, there was one issuer who represented 10% or more of stockholders’ equity within the investment portfolio. The Company’s holdings of investment securities issued by SunTrust Banks totaled $14,585, or 11.56% of stockholders’ equity at June 30, 2012. At December 31, 2011, except for the U.S. Government agencies and government sponsored entities, there was no issuer who represented 10% or more of stockholders’ equity within the investment portfolio.

Proceeds from sales of securities available-for-sale and the associated gains (losses), excluding gains (losses) on called securities, for the three and six months ended June 30, 2012 and 2011 were as follows:

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Dollars in thousands)						(Dollars in thousands)

Proceeds	$	29,669		$	25,508		$	62,320		$	59,984
Gross Gains		144			132			588			439
Gross Losses		(56	)		(187	)		(123	)		(358	)

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

	June 30, 2012
	Amortized		Estimated
	cost		fair value
	(Dollars in thousands)
Available-for-sale:
One year or less	$	1,001		987
After one year through five years		46,315		46,579
After five years through ten years		83,789		85,908
After ten years		521,794		531,895
	$	652,899		665,369

The following tables summarize the investment securities with unrealized losses at June 30, 2012 and December 31, 2011, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position.

	June 30, 2012
	Less than 12 months				12 months or longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	fair value		loss		fair value		loss		fair value		loss
Temporarily impaired	(Dollars in thousands)
Obligations of U.S. Government agencies	$	18,616		89		3,995		16		22,611		105
Obligations of states and political subdivisions		7,137		138		—		—		7,137		138
Mortgage backed securities
U.S. GSE’s MBS - residential		10,176		19		—		—		10,176		19
U.S. GSE’s CMO		43,382		538		295		—		43,677		538
Other CMO		222		6		1,206		210		1,428		216
Corporate bonds		29,890		381		12,572		790		42,462		1,171
	$	109,423		1,171		18,068		1,016		127,491		2,187

Other-than-temporarily impaired
Mortgage backed securities
Other CMO	$	—		—		446		4		446		4
	$	109,423		1,171		18,514		1,020		127,937		2,191

	December 31, 2011
	Less than 12 months				12 months or longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	fair value		loss		fair value		loss		fair value		loss
	(Dollars in thousands)
Temporarily impaired
Obligations of U.S. Government agencies	$	41,841		123		4,549		20		46,390		143
Obligations of states and political subdivisions		4,977		83		449		3		5,426		86
Mortgage backed securities
U.S. GSE’s MBS - residential		12,055		23		2,348		4		14,403		27
U.S. GSE’s CMO		27,998		176		5,005		35		33,003		211
Other CMO		250		10		1,305		221		1,555		231
Corporate bonds		25,814		833		17,817		1,182		43,631		2,015
	$	112,935		1,248		31,473		1,465		144,408		2,713

Other-than-temporarily impaired
Mortgage backed securities
Other CMO	$	—		—		478		17		478		17
	$	112,935		1,248		31,951		1,482		144,886		2,730

Other-Than-Temporary Impairment – June 30, 2012

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under the provisions of ASC 320-10, Investments – Debt and Equity Securities. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

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

As of June 30, 2012, the Company’s security portfolio consisted of 378 securities, 62 of which were in an unrealized loss position. Of these securities with unrealized losses, 88.91% were related to the Company’s mortgage-backed and corporate securities as discussed below.

Mortgage-backed Securities

At June 30, 2012, $294,883 or approximately 99.33% of the Company’s mortgage-backed securities were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Government National Mortgage Association (“Ginnie Mae”), institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at June 30, 2012.

The Company’s mortgage-backed securities portfolio also includes five non-agency collateralized mortgage obligations with a market value of $1,978, of which four had unrealized losses of approximately $220 at June 30, 2012. These non-agency securities were rated AAA at purchase.

At June 30, 2012, four of these non-agency securities were rated below investment grade and a cash flow analysis was performed to evaluate OTTI. The assumptions used in the model include expected future default rates, loss severity and prepayments. The model also takes into account the structure of the security including credit support. Based on these assumptions, the model calculates and projects the timing and amount of interest and principal payments expected for the security. In addition, the model was used to “stress” each security, or make assumptions more severe than expected activity, to determine the degree to which assumptions could deteriorate before the security could no longer fully support repayment. Upon completion of the June 30, 2012 analysis, our model indicated that one of these securities was other-than-temporarily impaired. This security had OTTI losses of $9 and remained classified as available-for-sale at June 30, 2012.

At June 30, 2012, the fair values of these four collateralized mortgage obligations totaling $1,673 were measured using Level 3 inputs because the market for them has become illiquid, as indicated by few, if any, trades during the period. The discount rates used in the valuation model were based on a yield of 10% that the market would require for collateralized mortgage obligations with maturities and risk characteristics similar to the securities being measured.

Corporate Securities

The Company holds thirty-three corporate securities totaling $78,518, of which nineteen had an unrealized loss of $1,171 at June 30, 2012. The Company’s unrealized losses on corporate securities relate primarily to its investment in single issuer corporate and corporate trust preferred securities. At June 30, 2012, five securities to two issuers were not rated. None of the issuers were in default, but in January of 2011 the Company was notified that two trust preferred securities totaling $1,250 to two issuers not rated had elected to defer interest payments. The issuers are both bank holding companies with operations in the Southeast. One of the issuers of $1,000 of such securities announced a successful capital raise which was completed in the first quarter of 2011 and during the third quarter of 2011 this issuer brought current all interest previously deferred. The Company considered several factors including the financial condition and near term prospects of the issuers and concluded that the decline in fair value was primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. Although one issuer continues to indicate they will defer payments going forward, the Company has considered the capital position of the subsidiary banks, the liquidity of the holding company, the existence and severity of publicly available regulatory agreements, and the fact that these deferrals are coming after the most severe impact of the national and regional recession. The prospect of capital formation in the current market, improving operating results of the industry overall have caused the Company to conclude that a return to normal subsidiary dividends and thus interest payments on the debt for this issuer is reasonably assured at this time. Because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at June 30, 2012.

At June 30, 2012, the fair value of one corporate security totaling $107 was measured using Level 3 inputs because the market for it has become illiquid, as indicated by few, if any, trades during the period. The discount rate used in the valuation model was based on a yield of 10% that the market would require for corporate debt obligations with maturities and risk characteristics similar to the subordinated debenture being measured.

The table below presents a rollforward of the credit losses recognized in earnings for the six month period ended June 30, 2012.

Beginning balance, January 1, 2012	$	673
Amounts related to credit loss for which an other-than-temporary impairment was not previously recognized		-
Additions/Subtractions
Amounts realized for securities sold during the period		-
Amounts related to securities for which the company intends to sell or that it will be more likely than not that the company will be required to sell prior to recovery of amortized cost basis		-
Reductions for increase in cash flows expected to be collected that are recognized over the remaining life of the security		-
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized		9

Ending balance, June 30, 2012	$	682

Total other-than-temporary impairment recognized in accumulated other comprehensive income was $4 for the sixth month period ended June 30, 2012.

Other-Than-Temporary Impairment – June 30, 2011

As of June 30, 2011, the Company’s security portfolio consisted of 339 securities, 89 of which were in an unrealized loss position. Of these securities with unrealized losses, 54.88% were related to the Company’s mortgage-backed and corporate securities as discussed below.

Mortgage-backed Securities

At June 30, 2011, $260,365 or approximately 99.09% of the Company’s mortgage-backed securities were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Government National Mortgage Association (“Ginnie Mae”), institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at June 30, 2011.

The Company’s mortgage-backed securities portfolio also includes five non-agency collateralized mortgage obligations with a market value of $2,378 which had unrealized losses of approximately $229 at June 30, 2011. These non-agency securities were rated AAA at purchase.

At June 30, 2011, four of these non-agency securities were rated below investment grade and a cash flow analysis was performed to evaluate OTTI. The assumptions used in the model include expected future default rates, loss severity and prepayments. The model also takes into account the structure of the security including credit support. Based on these assumptions the model calculates and projects the timing and amount of interest and principal payments expected for the security. In addition the model was used to “stress” each security, or make assumptions more severe than expected activity, to determine the degree to which assumptions could deteriorate before the security could no longer fully support repayment. Upon completion of the June 30, 2011 analysis, our model indicated that none of these securities were other-than-temporarily impaired. During the first quarter of 2011, one of these securities was considered to be other-than-temporarily impaired with an OTTI loss of $127, of which $62 was recognized in earnings. This security remains classified as available-for-sale at June 30, 2011.

At June 30, 2011, the fair values of three collateralized mortgage obligations totaling $1,950 were measured using Level 3 inputs because the market for them has become illiquid, as indicated by few, if any, trades during the period. The discount rates used in the valuation model were based on a yield of 10% that the market would require for collateralized mortgage obligations with maturities and risk characteristics similar to the securities being measured.

Corporate Securities

The Company holds nineteen corporate securities totaling $35,781, of which twelve had an unrealized loss of $865. The Company’s unrealized losses on corporate securities relate primarily to its investment in single issuer corporate and corporate trust preferred securities. At June 30, 2011, two of the corporate securities were rated below investment grade and seven securities to three issuers were not rated. None of the issuers were in default but in January of 2011 the Company was notified that two trust preferred securities totaling $1,250 to two issuers not rated had elected to defer interest payments. The issuers are both bank holding companies with operations in the Southeast. One of the issuers of $1,000 of such securities announced a successful capital raise which was completed in the first quarter of 2011. The Company considered several factors including the financial condition and near term prospects of the issuers and concluded that the decline in fair value was primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. Although these issuers have indicated they will defer payments going forward, the Company has considered the capital position of the subsidiary banks, the liquidity of the holding company, the existence and severity of publicly available regulatory agreements, and the fact that these deferrals are coming after the most severe impact of the national and regional recession. The prospect of capital formation in the current market, improving operating results of the industry overall have caused the Company to conclude that a return to normal subsidiary dividends and thus interest payments on the debt for these issuers is reasonably assured at this time. Because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at June 30, 2011.

At June 30, 2011, the fair values of four corporate securities totaling $2,335 were measured using Level 3 inputs because the market for them has become illiquid, as indicated by few, if any, trades during the period. The discount rates used in the valuation model were based on current spreads to U.S. Treasury rates of long-term corporate debt obligations with maturities and risk characteristics similar to the subordinated debentures being measured. An additional adjustment to the discount rate for illiquidity in the market for subordinated debentures was not considered necessary based on the illiquidity premium already present in the spreads used to estimate the discount rate.

The table below presents a roll forward of the credit losses recognized in earnings for the six month period ended June 30, 2011.

Beginning balance, January 1, 2011	$	571
Amounts related to credit loss for which an other-than-temporary impairment was not previously recognized		-
Additions/Subtractions
Amounts realized for securities sold during the period		-
Amounts related to securities for which the company intends to sell or that it will be more likely than not that the company will be required to sell prior to recovery of amortized cost basis		-
Reductions for increase in cash flows expected to be collected that are recognized over the remaining life of the security		-
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized		62

Ending balance, June 30, 2011	$	633

Total other-than-temporary impairment recognized in accumulated other comprehensive loss was $65 for the sixth month period ended June 30, 2011.

Note 3 – Loans

The following table summarizes loans at June 30, 2012 and December 31, 2011.

	June 30, 2012			December 31, 2011
	(Dollars in thousands)

Commercial, financial, and agricultural	$	179,794			171,750
Real estate:
Commercial		326,363			332,666
Residential		163,408			159,022
Acquisition, development and construction		163,334			168,050
Consumer installment		14,612			14,412
	$	847,511			845,900
Less allowance for loan losses		29,552			29,046
Less deferred loan origination fees (costs)		(248	)		(110	)
	$	818,207			816,964

The following tables present the activity in the allowance for loan losses by portfolio segment as of June 30, 2012 and June 30, 2011.

	June 30, 2012
	Commercial,
	Financial, and		CRE - Owner		CRE - Non Owner			Residential		ADC		ADC
	Agricultural		Occupied		Occupied			Real Estate		CSRA		Other		Consumer			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	4,183		6,285		4,476			5,607		4,236		3,819		440			29,046
Charge-offs		658		1,049		368			610		258		710		473			4,126
Recoveries		179		2		7			67		22		1		188			466
Provision		1,081		1,464		(248	)		757		118		526		468			4,166
Ending balance	$	4,785		6,702		3,867			5,821		4,118		3,636		623			29,552

	June 30, 2011
	Commercial,
	Financial, and		CRE - Owner		CRE - Non Owner			Residential		ADC		ADC
	Agricultural		Occupied		Occupied			Real Estate		CSRA		Other		Consumer			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	3,463		3,921		4,777			5,372		5,097		3,396		631			26,657
Charge-offs		1,304		115		512			764		760		1,784		73			5,312
Recoveries		304		—		—			8		—		6		83			401
Provision		1,581		2,026		235			683		1,290		893		(44	)		6,664
Ending balance	$	4,044		5,832		4,500			5,299		5,627		2,511		597			28,410

The following tables present the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of June 30, 2012 and December 31, 2011.

	June 30, 2012
	Commercial,
	Financial, and		CRE - Owner		CRE - Non Owner		Residential		ADC		ADC
	Agricultural		Occupied		Occupied		Real Estate		CSRA		Other		Consumer		Total
	(Dollars in thousands)
Allowance for loan losses:
Ending balance attributable to loans:
Individually evaluated for impairment	$	42		—		61		293		17		—		25		438
Collectively evaluated for impairment		4,743		6,702		3,806		5,528		4,101		3,636		598		29,114
	$	4,785		6,702		3,867		5,821		4,118		3,636		623		29,552

Loans:
Individually evaluated for impairment		1,077		2,461		12,828		5,991		8,424		2,745		145		33,671
Collectively evaluated for impairment		178,717		193,352		117,722		157,417		126,393		25,772		14,467		813,840
	$	179,794		195,813		130,550		163,408		134,817		28,517		14,612		847,511

	December 31, 2011
	Commercial,
	Financial, and		CRE - Owner		CRE - Non Owner		Residential		ADC		ADC
	Agricultural		Occupied		Occupied		Real Estate		CSRA		Other		Consumer		Total
	(Dollars in thousands)
Allowance for loan losses:
Ending balance attributable to loans:
Individually evaluated for impairment	$	—		—		—		96		—		171		—		267
Collectively evaluated for impairment		4,183		6,285		4,476		5,511		4,236		3,648		440		28,779
	$	4,183		6,285		4,476		5,607		4,236		3,819		440		29,046

Loans:
Individually evaluated for impairment		1,920		5,472		15,988		4,191		9,645		4,697		141		42,054
Collectively evaluated for impairment		169,830		188,548		122,658		154,831		130,233		23,475		14,271		803,846
	$	171,750		194,020		138,646		159,022		139,878		28,172		14,412		845,900

The following tables present loans individually evaluated for impairment by class of loans as of June 30, 2012 and December 31, 2011.

	June 30, 2012
	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest Income
	Balance		Investment (2)		Allocated		Investment		Recognized		Recognized
	(Dollars in thousands)
With no related allowance recorded: (1)
Commercial, financial, and agricultural:
Commerical	$	—		—		—		—		—		—
Financial		—		—		—		—		—		—
Agricultural		346		327		—		346		—		—
Equity lines		578		578		—		578		—		—
Other		—		—		—		—		—		—
Commercial real estate:
Owner occupied		3,206		2,461		—		2,727		5		5
Non Owner occupied		13,022		11,759		—		15,136		43		43
Residential real estate:
Secured by first liens		4,480		3,604		—		3,990		—		—
Secured by junior liens		296		233		—		256		2		2
Acquisition, development and construction:
Residential		208		208		—		201		—		—
Other		12,919		10,762		—		11,156		—		—
Consumer		78		36		—		75		—		—
		35,133		29,968		—		34,465		50		50

With an allowance recorded:
Commercial, financial, and agricultural:
Commerical		172		172		42		172		—		—
Financial		—		—		—		—		—		—
Agricultural		—		—		—		—		—		—
Equity lines		—		—		—		—		—		—
Other		—		—		—		—		—		—
Commercial real estate:
Owner occupied		—		—		—		—		—		—
Non Owner occupied		1,071		1,069		61		1,072		—		—
Residential real estate:
Secured by first liens		2,159		2,154		293		2,158		—		—
Secured by junior liens		—		—		—		—		—		—
Acquisition, development and construction:
Residential		—		—		—		—		—		—
Other		200		199		17		200		—		—
Consumer		109		109		25		109		—		—
		3,711		3,703		438		3,711		—		—

	$	38,844		33,671		438		38,176		50		50

(1) No specific allowance for credit losses is allocated to these loans since they are sufficiently collateralized or had charge-offs

(2) Excludes accrued interest receivable and loan origination fees, net due to immateriality

	December 31, 2011
	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest Income
	Balance		Investment (2)		Allocated		Investment		Recognized		Recognized
	(Dollars in thousands)

With no related allowance recorded: (1)
Commercial, financial, and agricultural:
Commerical	$	66		66		—		88		—		—
Financial		—		—		—		—		—		—
Agricultural		1,267		1,123		—		1,165		31		31
Equity lines		736		731		—		732		—		—
Other		—		—		—		—		—		—
Commercial real estate:
Owner occupied		5,965		5,472		—		6,902		16		16
Non Owner occupied		17,339		15,988		—		16,261		—		—
Residential real estate:
Secured by first liens		3,872		3,258		—		3,977		15		15
Secured by junior liens		103		103		—		103		7		7
Acquisition, development and construction:
Residential		—		—		—		—		—		—
Other		15,182		13,700		—		10,314		—		—
Consumer		141		141		—		221		—		—
		44,671		40,582		—		39,763		69		69

With an allowance recorded:
Commercial, financial, and agricultural:
Commerical		—		—		—		—		—		—
Financial		—		—		—		—		—		—
Agricultural		—		—		—		—		—		—
Equity lines		—		—		—		—		—		—
Other		—		—		—		—		—		—
Commercial real estate:
Owner occupied		—		—		—		—		—		—
Non Owner occupied		—		—		—		—		—		—
Residential real estate:
Secured by first liens		830		830		96		829		—		—
Secured by junior liens		—		—		—		—		—		—
Acquisition, development and construction:
Residential		201		201		7		200		—		—
Other		441		441		164		441		—		—
Consumer		—		—		—		—		—		—
		1,472		1,472		267		1,470		—		—

	$	46,143		42,054		267		41,233		69		69

(1) No specific allowance for credit losses is allocated to these loans since they are sufficiently collateralized or had charge-offs

(2) Excludes accrued interest receivable and loan origination fees, net due to immateriality

Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

The following tables present the aging of the recorded investment in past due loans as of June 30, 2012 and December 31, 2011 by class of loans.

	June 30, 2012
	30 - 89 Days		90 Days or		Nonaccrual		Total		Loans Not
	Past Due		More Past Due		Loans		Past Due		Past Due		Total
	(Dollars in thousands)
Commercial, financial, and agricultural:
Commerical	$	318		8		202		528		99,319		99,847
Financial		—		—		—		—		15,030		15,030
Agricultural		597		—		889		1,486		8,616		10,102
Equity lines		201		—		1,141		1,342		35,738		37,080
Other		—		—		87		87		17,648		17,735
Commercial real estate:
Owner occupied		786		—		2,865		3,651		192,162		195,813
Non Owner occupied		1,570		—		12,317		13,887		116,663		130,550
Residential real estate:
Secured by first liens		1,851		—		5,366		7,217		148,023		155,240
Secured by junior liens		93		—		313		406		7,762		8,168
Acquisition, development and construction:
Residential		—		—		208		208		43,136		43,344
Other		1,319		—		11,234		12,553		107,437		119,990
Consumer		35		2		292		329		14,283		14,612
	$	6,770		10		34,914		41,694		805,817		847,511

	December 31, 2011
	30 - 89 Days		90 Days or		Nonaccrual		Total		Loans Not
	Past Due		More Past Due		Loans		Past Due		Past Due		Total
	(Dollars in thousands)
Commercial, financial, and agricultural:
Commerical	$	120		—		78		198		98,295		98,493
Financial		—		—		—		—		15,231		15,231
Agricultural		287		—		840		1,127		13,633		14,760
Equity lines		72		—		1,407		1,479		37,148		38,627
Other		—		—		—		—		4,639		4,639
Commercial real estate:
Owner occupied		1,346		—		6,216		7,562		186,458		194,020
Non Owner occupied		1,373		—		14,740		16,113		122,533		138,646
Residential real estate:
Secured by first liens		1,870		—		4,386		6,256		143,981		150,237
Secured by junior liens		251		—		167		418		8,367		8,785
Acquisition, development and construction:
Residential		—		—		201		201		39,707		39,908
Other		992		—		14,531		15,523		112,619		128,142
Consumer		73		—		331		404		14,008		14,412
	$	6,384		—		42,897		49,281		796,619		845,900

Troubled Debt Restructurings:

The Company has troubled debt restructurings (TDRs) with a balance of $2,169 and $4,151 included in impaired loans at June 30, 2012 and December 31, 2011, respectively. No specific reserves were allocated to customers whose loan terms had been modified in TDRs as of June 30, 2012 and December 31, 2011. The Company is not committed to lend additional amounts as of June 30, 2012 and December 31, 2011 to customers with outstanding loans that are classified as TDRs. The following tables present TDRs as of June 30, 2012 and December 31, 2011.

	June 30, 2012
			Pre-Modification		Post-Modification
	Number of		Outstanding		Outstanding
	Loans		Recorded Investment		Recorded Investment
	(Dollars in thousands)
Troubled Debt Restructurings:
Commercial, financial, and agricultural:
Commerical		-	$	-	$	-
Financial		-		-		-
Agricultural		-		-		-
Equity lines		-		-		-
Other		-		-		-
Commercial real estate:
Owner occupied		3		711		358
Non Owner occupied		3		1,023		925
Residential real estate:
Secured by first liens		4		746		645
Secured by junior liens		2		281		205
Acquisition, development and construction:
Residential		-		-		-
Other		-		-		-
Consumer		1		80		36
		13	$	2,841	$	2,169

	December 31, 2011
			Pre-Modification		Post-Modification
	Number of		Outstanding		Outstanding
	Loans		Recorded Investment		Recorded Investment
	(Dollars in thousands)
Troubled Debt Restructurings:
Commercial, financial, and agricultural:
Commerical		1	$	72	$	62
Financial		-		-		-
Agricultural		-		-		-
Equity lines		-		-		-
Other		-		-		-
Commercial real estate:
Owner occupied		3		711		579
Non Owner occupied		4		2,451		1,954
Residential real estate:
Secured by first liens		6		1,712		1,465
Secured by junior liens		1		95		73
Acquisition, development and construction:
Residential		-		-		-
Other		-		-		-
Consumer		1		20		18
		16	$	5,061	$	4,151

During the periods ended June 30, 2012 and 2011, the terms of certain loans were modified as TDRs. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan were for rate reductions ranging from 2.00% to 5.00%. Modifications involving an extension of the maturity date were for periods ranging from 2 months to 84 months.

The following table presents loans by class modified as TDRs that occurred during the three and six months ended June 30, 2012 and 2011.

	Three Months Ended June 30, 2012						Three Months Ended June 30, 2011
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
	Number of		Outstanding		Outstanding		Number of		Outstanding		Outstanding
	Loans		Recorded Investment		Recorded Investment		Loans		Recorded Investment		Recorded Investment
	(Dollars in thousands)						(Dollars in thousands)
Troubled Debt Restructurings:
Commercial, financial, and agricultural:
Commerical		-	$	-	$	-		-	$	-	$	-
Financial		-		-		-		-		-		-
Agricultural		-		-		-		-		-		-
Equity lines		-		-		-		-		-		-
Other		-		-		-		-		-		-
Commercial real estate:
Owner occupied		-		-		-		2		519		398
Non Owner occupied		-		-		-		-		-		-
Residential real estate:
Secured by first liens		-		-		-		3		688		584
Secured by junior liens		-		-		-		-		-		-
Acquisition, development and construction:
Residential		-		-		-		-		-		-
Other		-		-		-		-		-		-
Consumer		1		80		36		1		20		19
		1	$	80	$	36		6	$	1,227	$	1,001

	Six Months Ended June 30, 2012						Six Months Ended June 30, 2011
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
	Number of		Outstanding		Outstanding		Number of		Outstanding		Outstanding
	Loans		Recorded Investment		Recorded Investment		Loans		Recorded Investment		Recorded Investment
	(Dollars in thousands)						(Dollars in thousands)
Troubled Debt Restructurings:
Commercial, financial, and agricultural:
Commerical		-	$	-	$	-		-	$	-	$	-
Financial		-		-		-		-		-		-
Agricultural		-		-		-		-		-		-
Equity lines		-		-		-		-		-		-
Other		-		-		-		-		-		-
Commercial real estate:
Owner occupied		-		-		-		2		519		398
Non Owner occupied		1		208		198		1		76		75
Residential real estate:
Secured by first liens		-		-		-		4		883		753
Secured by junior liens		1		185		133		2		143		120
Acquisition, development and construction:
Residential		-		-		-		-		-		-
Other		-		-		-		-		-		-
Consumer		1		80		36		1		20		19
		3	$	473	$	367		10	$	1,641	$	1,365

A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. During the six months ended June 30, 2012, one consumer loan with a recorded investment of $18 prior to default resulted in an $18 charge-off during the first quarter of 2012 and the default occurred within the twelve month period following the loan modification. During the six months ended June 30, 2011, there were no payment defaults on TDRs that were modified within the previous twelve months. As of June 30, 2012, all other TDRs are performing according to their modified terms.

The TDRs described above increased the allowance for loan losses by $34 for the six months ended June 30, 2012 and resulted in charge-offs of $34 for the six months ended June 30, 2012, respectively.

For the three and six months ended June 30, 2011, the TDRs described above increased the allowance for loan losses by $167 and $202 and resulted in charge-offs of $240 for the three and six months ended June 30, 2011, respectively.

Charge-offs on such loans are factored into the rolling historical loss rate, which is used in the calculation of the allowance for loan losses.

The terms of certain other loans were modified during the six month period ended June 30, 2012 and 2011 that did not meet the definition of a TDR. These loans have a total recorded investment as of June 30, 2012 and 2011 of $4,651 and $5,930, respectively. The modification of these loans involved either a modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company’s internal underwriting policy.

Certain loans which were modified during the six month period ended June 30, 2012 and 2011 and did not meet the definition of a TDR, as the modification was a delay in a payment that was considered to be insignificant, had delays in payment ranging from 30 days to 3 months in 2012 and 2011.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company, through its originating account officer, places an initial credit risk rating on every loan. An annual review and analysis of loan relationships (irrespective of loan types included in the overall relationship) with total related exposure of $500 or greater is performed by the Credit Administration department in order to update risk ratings given current available information.

Through the review of delinquency reports, updated financial statements or other relevant information in the normal course of business, the lending officer and/or Credit Administration review personnel may determine that a loan relationship has weakened to the point that a criticized (Watch grade) or classified (Substandard & Doubtful grades) status is warranted. When a loan relationship with total related exposure of $200 or greater is adversely graded (Watch or above), the lending officer is then charged with preparing a Classified/Watch report which outlines the background of the credit problem, current repayment status of the loans, current collateral evaluation and a workout plan of action. This plan may include goals to improve the credit rating, assisting the borrower in moving the loans to another institution and/or collateral liquidation. All such Classified/Watch reports are reviewed on a quarterly basis by members of Executive Management at a regularly scheduled meeting in which each lending officer presents the workout plans for their criticized credit relationships.

The Company uses the following definitions for risk ratings.

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

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

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of June 30, 2012 and December 31, 2011, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows.

	June 30, 2012
	Pass		Watch		Substandard		Doubtful
	(Dollars in thousands)
Commercial, financial, and agricultural:
Commerical	$	91,762		5,253		2,832		—
Financial		12,000		3,030		—		—
Agricultural		7,582		597		1,923		—
Equity lines		34,346		1,249		1,485		—
Other		17,281		326		128		—
Commercial real estate:
Owner occupied		170,433		14,333		11,047		—
Non Owner occupied		105,908		10,322		14,320		—
Residential real estate:
Secured by first liens		135,955		11,599		7,686		—
Secured by junior liens		7,515		175		478		—
Acquisition, development and construction:
Residential		41,890		1,246		208		—
Other		84,683		15,668		19,639		—
Consumer		13,946		288		378		—
	$	723,301		64,086		60,124		—

	December 31, 2011
	Pass		Watch		Substandard		Doubtful
	(Dollars in thousands)
Commercial, financial, and agricultural:
Commerical	$	89,345		4,701		4,447		—
Financial		12,953		2,278		—		—
Agricultural		11,961		604		2,195		—
Equity lines		35,711		1,095		1,821		—
Other		4,269		327		43		—
Commercial real estate:
Owner occupied		165,171		15,780		13,069		—
Non Owner occupied		109,033		12,118		17,495		—
Residential real estate:
Secured by first liens		130,825		11,208		8,204		—
Secured by junior liens		8,069		329		387		—
Acquisition, development and construction:
Residential		38,890		817		201		—
Other		97,841		7,945		22,356		—
Consumer		13,685		316		411		—
	$	717,753		57,518		70,629		—

Note 4 – Fair Value Measurements

Fair value is the exchange price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair values:

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 market prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

Level 3:

Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

In determining the appropriate levels, the Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on matrix pricing which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities relationship to other benchmark quoted securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other non-observable market indicators (Level 3). The fair values of Level 3 investment securities are determined by an independent third party. These valuations are then reviewed by the Company’s Controller and CFO. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Interest Rate Swap Derivatives: The fair value of interest rate swap derivatives is determined based on discounted cash flow valuation models using observable market data as of the measurement date (Level 2 inputs). The fair value adjustment is included in other liabilities.

Mortgage Banking Derivatives: The fair value of mortgage banking derivatives is determined by individual third party sales contract prices for the specific loans held at each reporting period end (Level 2 inputs). The fair value adjustment is included in other assets.

Loans Held for Sale: Loans held for sale are carried at fair value, as determined by outstanding commitments, from third party investors (Level 2).

Impaired Loans: The fair value of collateral dependent impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. The fair value of other real estate owned is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral dependent impaired loans and other real estate owned are performed by certified general appraisers, certified residential appraisers or state licensed appraisers whose qualifications and licenses are annually reviewed and verified by the Company. Once received, a member of the Real Estate Valuation Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value and determines if reasonable. Appraisals for collateral dependent impaired loans and other real estate owned are updated annually. On an annual basis the Company compares the actual selling costs of collateral that has been liquidated to the selling price to determine what additional adjustment should be made to the appraisal value to arrive at fair value. The most recent analysis performed indicated that an additional discount of 10% should be applied to properties with appraisals performed within 12 months.

Assets and Liabilities Measured on a Recurring Basis

The following tables present the balances of assets and liabilities measured at fair value on a recurring basis by level within the hierarchy as of June 30, 2012 and December 31, 2011.

	June 30,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Available-for-sale securities
Obligations of U.S. Government agencies	$	170,880		88,533		82,347		-
Obligations of states and political subdivisions		119,110		-		119,110		-
Mortgage-backed securities
U.S. GSE’s MBS - residential		149,577		-		149,577		-
U.S. GSE’s CMO		145,306		-		145,306		-
Other CMO		1,978		-		305		1,673
Corporate bonds		78,518		-		78,411		107
Total available-for-sale securities	$	665,369		88,533		575,056		1,780

Loans held for sale		27,197		-		27,197		-

Mortgage banking derivatives		22		-		22		-
	$	692,588		88,533		602,275		1,780

Liabilities:
Interest rate swap derivatives		2,620		-		2,620		-
	$	2,620		-		2,620		-

	December 31,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	2011		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Available-for-sale securities
Obligations of U.S. Government agencies	$	169,752		59,343		110,409		-
Obligations of states and political subdivisions		102,860		-		102,860		-
Mortgage-backed securities
U.S. GSE’s MBS - residential		157,466		-		157,466		-
U.S. GSE’s CMO		120,002		-		120,002		-
Other CMO		2,223		-		315		1,908
Corporate bonds		51,456		-		49,015		2,441
Total available-for-sale securities	$	603,759		59,343		540,067		4,349

Loans held for sale		29,046		-		29,046		-

Mortgage banking derivatives		24		-		24		-
	$	632,829		59,343		569,137		4,349

Liabilities:
Interest rate swap derivatives		2,262		-		2,262		-
	$	2,262		-		2,262		-

Transfers between Level 1 and Level 2:

During the six months ended June 30, 2012, no securities were transferred between Level 1 and Level 2. During the six months ended June 30, 2011, six U.S. agency securities were transferred out of Level 2 and into Level 1. The Company’s policy is to recognize transfers into or out of a level as of the end of the reporting period. As a result, three of these securities with a market value of $8,379 as of March 31, 2011 were transferred on March 31, 2011 and three of these securities with a market value of $7,185 as of June 30, 2011 were transferred on June 30, 2011.

Transfers between Level 2 and Level 3:

During the second quarter of 2012, one corporate security with a market value of $927 as of June 30, 2012 was transferred out of Level 3 and into Level 2 based on observable market data for this security due to increased market activity for this security. The fair value for this security was transferred on June 30, 2012. During the first quarter of 2011, eight corporate securities with a market value of $7,278 as of March 31, 2011 were transferred out of Level 3 and into Level 2 based on observable market data for these securities due to increased market activity for these securities. The fair value for these securities was transferred on March 31, 2011.

The tables below present a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of June 30, 2012 and 2011.

	Total			Other CMO			Corporate bonds
	(Dollars in thousands)

Beginning balance, January 1, 2012	$	4,349		$	1,908		$	2,441
Total gains or losses (realized/unrealized)
Included in earnings
Gain (loss) on sales		-			-			-
Other-than-temporary impairment		(9	)		(9	)		-
Included in other comprehensive income		(133	)		(226	)		93
Purchases, sales, issuances and settlements
Purchases		-			-			-
Sales		(1,500	)		-			(1,500	)
Issuances		-			-			-
Settlements		-			-			-
Transfers into Level 3		-			-			-
Transfers out of Level 3		(927	)		-			(927	)

Ending balance, June 30, 2012	$	1,780		$	1,673		$	107

	Total			Other CMO			Corporate bonds
	(Dollars in thousands)

Beginning balance, January 1, 2011	$	13,657		$	2,919		$	10,738
Total gains or losses (realized/unrealized)
Included in earnings
Gain (loss) on sales		-			-			-
Other-than-temporary impairment		(62	)		(62	)		-
Included in other comprehensive income		(1,567	)		(442	)		(1,125	)
Purchases, sales, issuances and settlements
Purchases		-			-			-
Sales		-			-			-
Issuances		-			-			-
Settlements		-			-			-
Transfers into Level 3		-			-			-
Transfers out of Level 3		(7,278	)		-			(7,278	)
Ending balance, June 30, 2011	$	4,750		$	2,415		$	2,335

The Company uses an independent third party to value its U.S. government agencies, mortgage-backed securities, and corporate bonds. Their approach uses relevant information generated by transactions that have occurred in the market place that involve similar assets, as well as using cash flow information when necessary. These inputs are observable, either directly or indirectly in the market place for similar assets. The Company considers these valuations to be Level 2 pricing.

The fair value of the Company’s municipal securities is determined by another independent third party. Their approach uses relevant information generated by transactions that have occurred in the market place that involve similar assets. These inputs are observable, either directly or indirectly in the market place for similar assets. The Company considers these valuations to be Level 2 pricing.

For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows (Level 3 pricing) as determined by an independent third party. The significant unobservable inputs used in the valuation model include prepayment rates, constant default rates, loss severity and yields.

On a quarterly basis, the Company selects a random sample of investment security valuations as determined by the independent third party to validate pricing.

The following table presents quantitative information about level 3 fair value measurements at June 30, 2012.

	June 30,	Valuation	Unobservable	Range
	2012	Technique	Inputs	(Weighted Avg)
	(Dollars in thousands)
Available-for-sale securities
Mortgage-backed securities
Other CMO	1,673	discounted cash flow	voluntary prepayment rate	5.00% - 10.00% (6.56%)
			constant default rate	31.15% - 3.55% (14.28%)
			loss severity	45.00% - 55.00% (54.42%)
			yield	10.00%

Corporate bonds	107	discounted cash flow	yield	10.00%

The significant unobservable inputs used in the fair value measurement of the Company’s mortgage-backed securities are prepayment rates, constant default rates, loss severity and yields that the market would require for mortgage-backed securities with similar maturities and risk characteristics. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

The significant unobservable inputs used in the fair value measurement of the Company’s corporate bonds are yields that the market would require for corporate debt obligations with similar maturities and risk characteristics.

The table below summarizes changes in unrealized gains and losses recorded in earnings for the six months ended June 30, 2012 and 2011 for Level 3 assets that are still held at June 30, 2012 and 2011.

	Other CMO
	2012			2011
	(Dollars in thousands)

Changes in unrealized gains (losses) included in earnings	$	(9	)	$	(62	)
Other changes in fair value		-			-
	$	(9	)	$	(62	)

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis as of June 30, 2012 and December 31, 2011 are summarized below.

	June 30,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Impaired loans (1)
Commercial, financial, and agricultural	$	130		-		-		130
Real estate:
Commercial		5,032		-		-		5,032
Residential		5,210		-		-		5,210
Acquisition, development and construction		3,338		-		-		3,338
Consumer installment		120		-		-		120
	$	13,830		-		-		13,830

Other real estate owned
Real estate:
Commercial		96		-		-		96
Acquisition, development and construction		716		-		-		716
	$	812		-		-		812
	$	14,642		-		-		14,642

(1) Includes loans directly charged down to fair value.

	December 31,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	2011		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Impaired loans
Commercial, financial, and agricultural	$	130		-		-		130
Real estate:
Commercial		8,426		-		-		8,426
Residential		3,602		-		-		3,602
Acquisition, development and construction		4,984		-		-		4,984
Consumer installment		123		-		-		123
	$	17,265		-		-		17,265

Other real estate owned
Real estate:
Commercial		146		-		-		146
Residential		444		-		-		444
Acquisition, development and construction		3,701		-		-		3,701
	$	4,291		-		-		4,291
	$	21,556		-		-		21,556

The following represents impairment charges recognized during the period:

Impaired loans, which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying amount of $14,268, with a valuation allowance of $438, resulting in an additional provision for loan losses of $1,585 and $2,334 for the three and six months ended June 30, 2012. Impaired loans that are not carried at fair value had a carrying amount of $19,403 at June 30, 2012.

As of December 31, 2011, impaired loans had a carrying amount of $17,532, with a valuation allowance of $267, resulting in an additional provision for loan losses of $5,712 for the year ending 2011. Impaired loans that are not carried at fair value had a carrying amount of $24,522 at December 31, 2011.

Other real estate owned, which is carried at fair value less costs to sell, was $812 which consisted of the outstanding balance of $2,329, less a valuation allowance of $1,517, resulting in a write down of $50 and $497 for the three and six months ended June 30, 2012.

As of December 31, 2011, other real estate owned was $4,291 which consisted of the outstanding balance of $6,829, less a valuation allowance of $2,538, resulting in a write down of $1,464 for the year ending 2011.

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012.

	June 30,	Valuation	Unobservable	Range
	2012	Techniques	Inputs	(Weighted Avg)
	(Dollars in thousands)
Impaired loans
Commercial, financial, and agricultural	130	liquidation value
		of inventory

Real estate:
Commercial	5,032	sales comparison	adjustment for	0.00% - 50.00% (18.52%)
			differences between
			the comparable sales

		income approach	capitalization rate	10.00%

Residential	5,210	sales comparison	adjustment for	0.00% - 95.63% (10.35%)
			differences between
			the comparable sales

Acquisition, development and construction	3,338	sales comparison	adjustment for	0.00% - 65.01% (29.07%)
			differences between
			the comparable sales

		income approach	discount rate	12.00%

Consumer installment	120	quoted market price
		of equity security


Other real estate owned
Real estate:
Commercial	96	sales comparison	adjustment for	10.60% - 74.50% (42.55%)
			differences between
			the comparable sales

Acquisition, development and construction	716	sales comparison	adjustment for	0.00% - 39.95% (14.28%)
			differences between
			the comparable sales

Disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value is required. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.

Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

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

The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow and other valuation techniques. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather a good-faith estimate of the fair value of financial instruments held by the Company. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

(a)

Cash and Cash Equivalents

Fair value equals the carrying value of such assets due to their nature and is classified as Level 1.

(b)

Loans, net

The fair value of loans is calculated using discounted cash flows by loan type resulting in a Level 3 classification. The discount rate used to determine the present value of the loan portfolio is an estimated market rate that reflects the credit and interest rate risk inherent in the loan portfolio without considering widening credit spreads due to market illiquidity. The estimated maturity is based on the Company’s historical experience with repayments adjusted to estimate the effect of current market conditions. The carrying amount of related accrued interest receivable, due to its short-term nature, approximates its fair value, is not significant and is not disclosed. The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification. The allowance for loan losses is considered a reasonable discount for credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(c)

Restricted Equity Securities

The fair value of Federal Home Loan Bank (“FHLB”) stock was not practicable to determine due to restrictions placed on its transferability.

(d)

Deposits

Fair values for certificates of deposit have been determined using discounted cash flows. The discount rate used is based on estimated market rates for deposits of similar remaining maturities and are classified as Level 2. The carrying amounts of all other deposits, due to their short-term nature, approximate their fair values and are classified as Level 1. The carrying amount of related accrued interest payable, due to its short-term nature, approximates its fair value, is not significant and is not disclosed.

(e)

Securities Sold Under Repurchase Agreements

Fair value approximates the carrying value of such liabilities due to their short-term nature and is classified as Level 1.

(f)

Advances from FHLB

The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flows using an estimated interest rate based on the current rates available to the Company for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

(g)

Subordinated debentures

The fair value for subordinated debentures is calculated using discounted cash flows based upon current market spreads to LIBOR for debt of similar remaining maturities and collateral terms resulting in a Level 3 classification.

(h)

Commitments

The difference between the carrying values and fair values of commitments to extend credit are not significant and are not disclosed.

The carrying amounts and estimated fair values of the Company’s financial instruments at June 30, 2012 and December 31, 2011 are as follows:

	June 30, 2012
	Carrying		Fair Value Measurements
	amount		Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Financial assets:
Cash and cash equivalents	$	59,320		59,320		59,320		-		-
Loans, net		804,377		807,780		-		-		807,780
Restricted equity securities		5,399		N/A
Financial liabilities:
Deposits with stated maturities		410,259		412,483		-		412,483		-
Deposits without stated maturities		1,024,756		1,024,756		1,024,756		-		-
Securities sold under repurchase agreements		664		664		664		-		-
Advances from FHLB		66,000		72,716		-		72,716		-
Subordinated debentures		21,547		13,879		-		-		13,879

	December 31, 2011
	Carrying		Estimated
	amount		fair value
	(Dollars in thousands)
Financial assets:
Cash and cash equivalents	$	69,841		69,841
Loans, net		799,699		799,590
Restricted equity securities		5,086		N/A
Financial liabilities:
Deposits with stated maturities		411,085		413,885
Deposits without stated maturities		1,008,137		1,008,137
Securities sold under repurchase agreements		701		701
Advances from FHLB		39,000		45,262
Subordinated debentures		22,947		15,169

Note 5 – Interest Rate Swap Derivatives

The Company utilizes interest rate swap agreements as part of its asset liability management strategy to help manage its interest rate risk position. The notional amount of the interest rate swaps does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements.

During May 2011, the Company entered into two interest rate swaps with notional amounts totaling $10 million, which were designated as cash flow hedges of certain subordinated debentures and were determined to be fully effective during all periods presented. As such, no amount of ineffectiveness has been included in net income. Therefore, the aggregate fair value of the swaps is recorded in other liabilities with changes in fair value recorded in other comprehensive income. The Company expects the hedges to remain highly effective during the remaining terms of the swaps. Summary information about the interest rate swaps designated as cash flow hedges as of June 30, 2012 and December 31, 2011 is as follows:

	June 30, 2012			December 31, 2011
	(Dollars in thousands)

Notional Amounts	$	10,000		$	10,000
Weighted average pay rates		5.35	%		5.35	%
Weighted average receive rates		1.87	%		1.95	%
Weigted average maturity	16.58 years			16.75 years
Unrealized losses	$	2,620		$	2,262

The swaps are forward starting and had effective dates of March 15, 2012 and June 15, 2012. Interest expense recorded on these swap transactions totaled $56 at June 30, 2012 and is reported as a component of interest expense in other borrowings. If the fair value falls below specified levels, the Company is required to pledge collateral against these derivative contract liabilities. As of June 30, 2012, the Company had pledged $2,699 with the counterparty. Under certain circumstances, including a downgrade of its credit rating below specified levels, the counterparty is required to pledge collateral against these derivative contract liabilities. As of June 30, 2012, no collateral had been received from the counterparty.

Note 6 – Dividends

The Company suspended the payment of quarterly cash dividends on the Company’s common stock effective April 22, 2009. The Company considered the action prudent in order to maintain its capital position in the current state of the economy. The Company plans to reinstate the dividend payment at an appropriate time once economic conditions improve and stabilize.

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

(Dollar amounts are expressed in thousands unless otherwise noted)

Overview

Southeastern Bank Financial Corporation (the “Company”) is a Georgia corporation that is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). Southeastern Bank Financial Corporation (OTCQB: SBFC) trades on OTCQB, the marketplace for companies that are current in their reporting with a U.S. regulator. Investors can find Real-Time quotes and market information for the Company on www.otcmarkets.com. The Company’s wholly-owned subsidiary, Georgia Bank & Trust Company of Augusta (“GB&T”), primarily does business in the Augusta-Richmond County, GA-SC metropolitan area. GB&T was organized by a group of local citizens and commenced business on August 28, 1989, with one branch location. Today, it is Augusta’s largest community banking company operating nine full service branches in Augusta, Martinez, and Evans, Georgia. GB&T also operates three full service branches in North Augusta and Aiken, South Carolina under the name “Southern Bank & Trust, a division of Georgia Bank & Trust Company of Augusta.” Mortgage origination offices are located in Augusta and Savannah, Georgia and in Aiken, South Carolina. The Company’s Operations Center is located in Martinez, Georgia.

The Company’s primary market includes Richmond and Columbia Counties in Georgia and Aiken County in South Carolina, all part of the Augusta-Richmond County, GA-SC metropolitan statistical area (MSA). The Augusta market area has a diversified economy based principally on government, public utilities, health care, manufacturing, construction, and wholesale and retail trade. Augusta is one of the leading medical centers in the Southeast.

The Company’s services include the origination of residential and commercial real estate loans, construction and development loans, and commercial and consumer loans. The Company also offers a variety of deposit programs, including noninterest-bearing demand, interest checking, money management, savings, and time deposits. In the primary market area, Augusta-Richmond County, GA-SC metropolitan area, the Company had 19.46% of all deposits and was the second largest depository institution at June 30, 2011, as cited from the Federal Deposit Insurance Corporation’s (“FDIC”) website. Securities sold under repurchase agreements are also offered. Additional services include wealth management, trust, retail investment, and mortgage. As a matter of practice, most mortgage loans are sold in the secondary market; however, some mortgage loans are placed in the portfolio based on asset/liability management strategies. The Company continues to concentrate on increasing its market share through various new deposit and loan products and other financial services and by focusing on the customer relationship management philosophy. The Company is committed to building life-long relationships with its customers, employees, shareholders, and the communities it serves.

The Company’s primary source of income is from its lending activities followed by interest income from its investment activities, service charges and fees on deposits, and gain on sales of mortgage loans in the secondary market. Interest income on loans decreased during the first six months of 2012 as compared to the first six months of 2011 due primarily to decreased loan yields and reduced volume. Interest income on investment securities was relatively the same but with declining yields offset by a larger investment portfolio. Decreases in consumer non-sufficient funds (“NSF”) income on retail checking accounts, due primarily to decreased economic activity, were mostly offset by increases in such fees on commercial accounts and also from increased ATM/Debit card income for the first six months of 2012. For the six month period, gain on sales of loans increased due to increased mortgage originations and refinancing activity during the first six months of the year. Investment securities gains increased on a net basis during the first six months of 2012 as compared to the same period last year due in part to selected sales of higher duration securities to reduce exposure to rising interest rates and the reduction of other-than-temporary losses during the first six months of 2012.

Table 1 - Selected Financial Data

	June 30,			December 31,			June 30,
	2012			2011			2011
	(Dollars in thousands)

Assets	$	1,666,127		$	1,614,773		$	1,599,921
Investment securities		665,369			603,759			569,500
Loans		847,759			846,010			873,801
Deposits		1,435,015			1,419,222			1,402,000

Annualized return on average total assets		0.82	%		0.69	%		0.64	%
Annualized return on average equity		11.01	%		10.23	%		10.09	%

The Company continues to focus on the net interest margin, regulatory capital levels, liquidity management, asset quality and risk mitigation. Asset levels have remained relatively flat due to the Company’s focus on improving regulatory capital levels. Loan balances have trended lower as demand has remained weak while investment portfolio balances have increased over the comparable periods in order to maintain net interest income.

Annualized return on average total assets and annualized return on average equity have improved in 2012 as compared to 2011. The increased returns were due primarily to reduced provision for loan losses, increased sales of mortgage loans and increased net interest income. Partially offsetting these were increased salaries and employee expenses and other real estate losses. Net income for the six months ended June 30, 2012 was $6,663 compared to $5,107 for the same period in 2011. The effects of the economic downturn continue to negatively affect financial results primarily through a lack of loan demand and a somewhat elevated level of provision for loan losses.

The Company meets its liquidity needs by managing cash and due from banks, federal funds purchased and sold, maturity of investment securities, principal repayments from mortgage-backed securities, and draws on lines of credit. Additionally, liquidity can be managed through structuring deposit and loan maturities. The Company funds loan and investment growth with core deposits, securities sold under repurchase agreements, Federal Home Loan Bank advances and other wholesale funding including brokered certificates of deposit. During inflationary periods, interest rates generally increase and operating expenses generally rise. When interest rates rise, variable rate loans and investments produce higher earnings; however, deposit and other borrowings interest expense also rise. The Company monitors its interest rate risk as it applies to net interest income in a ramp up and down annually 400 basis points (4.00%) scenario and as it applies to economic value of equity in a shock up and down 400 basis points (4.00%) scenario. The Company monitors operating expenses through responsibility center budgeting.

Forward-Looking Statements

Southeastern Bank Financial Corporation may, from time to time, make written or oral forward-looking statements, including statements contained in the Company’s filings with the Securities and Exchange Commission (the “Commission”) and its reports to shareholders. Statements made in such documents, other than those concerning historical information, should be considered forward-looking and subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The Company’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors, including unanticipated changes in the Company’s local economies, the national economy, governmental monetary and fiscal policies, deposit levels, loan demand, loan collateral values and securities portfolio values; difficulties in interest rate risk management; the effects of competition in the banking business; difficulties in expanding the Company’s business into new markets; changes in governmental regulation relating to the banking industry, including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act; failure of assumptions underlying the establishment of reserves for loan losses, including the value of collateral underlying delinquent loans; and other factors. The Company cautions that such factors are not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by, or on behalf of, the Company.

Critical Accounting Estimates

The accounting and financial reporting policies of the Company and its subsidiary conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Of these policies, management has identified the allowance for loan losses, determining the fair values of financial instruments including other real estate owned, interest rate swap derivatives, investment securities, and other-than-temporary impairment as critical accounting estimates that requires difficult, subjective judgment and are important to the presentation of the financial condition and results of operations of the Company.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to expense, which affects the Company’s earnings directly. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that reflects management’s estimate of the level of probable incurred losses in the portfolio. Factors considered by management in determining the adequacy of the allowance include, but are not limited to: (1) detailed reviews of individual loans; (2) historical and current trends in loan charge-offs for the various portfolio segments evaluated; (3) the level of the allowance in relation to total loans and to historical loss levels; (4) levels and trends in non-performing and past due loans; (5) collateral values of properties securing loans; and (6) management’s assessment of economic conditions. The Company’s Board of Directors reviews the recommendations of management regarding the appropriate level for the allowance for loan losses based upon these factors.

The provision for loan losses is the charge to operating earnings necessary to maintain an adequate allowance for loan losses. The Company has developed policies and procedures for evaluating the overall quality of its loan portfolio and the timely identification of problem credits. Management continues to review these policies and procedures and makes further improvements as needed. The adequacy of the Company’s allowance for loan losses and the effectiveness of the Company’s internal policies and procedures are also reviewed periodically by the Company’s regulators and the Company’s internal loan review personnel. The Company’s regulators may advise the Company to recognize additions to the allowance based upon their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result.

The Company continues to refine the methodology on which the level of the allowance for loan losses is based, by comparing historical loss ratios utilized to actual experience and by classifying loans for analysis based on similar risk characteristics. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement; however, cash receipts on impaired and nonaccrual loans for which the accrual of interest has been discontinued are applied to principal and interest income depending upon the overall risk of principal loss to the Company.

Fair Value of Financial Instruments

A significant portion of the Company’s assets are financial instruments carried at fair value. This includes securities available-for-sale, loans held for sale, certain impaired loans, mortgage banking derivatives, interest rate swap derivatives and other real estate owned. At June 30, 2012 and December 31, 2011 the percentage of total assets measured at fair value was 42.45% and 40.52%, respectively. The majority of assets carried at fair value are based on either quoted market prices or market prices for similar instruments. At June 30, 2012, 2.32% of assets measured at fair value were based on significant unobservable inputs. This represents approximately 0.99% of the Company’s total assets. See Note 4 “Fair Value Measurements” in the “Notes to Consolidated Financial Statements” herein for additional disclosures regarding the fair value of financial instruments.

Other Real Estate Owned

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed. Costs related to the development and improvement of real estate owned are capitalized.

Interest Rate Swap Derivatives

The fair value of interest rate swap derivatives is determined based on discounted cash flow valuation models using observable market data as of the measurement date. The fair value adjustment is included in other liabilities. See Note 1 “Summary of Significant Accounting Policies” in the “Notes to Consolidated Financial Statements” herein for additional disclosures regarding the fair value of financial instruments.

Investment Securities

The fair values for available-for-sale securities are generally based upon quoted market prices or observable market prices for similar instruments. These values take into account recent market activity as well as other market observable data such as interest rate, spread and prepayment information. When market observable data is not available, which generally occurs due to the lack of liquidity for certain securities, the valuation of the security is subjective and may involve substantial judgment. The Company conducts periodic reviews to identify and evaluate each available-for-sale security that has an unrealized loss for other-than-temporary impairment. An unrealized loss exists when the fair value of an individual security is less than its amortized cost basis. The primary factors the Company considers in determining whether an impairment is other-than-temporary are the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer and whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. As of June 30, 2012, the Company had approximately $1,780 of available-for-sale securities, which is approximately 0.11% of total assets, valued using unobservable inputs (Level 3). These securities were primarily non-agency mortgage-backed securities and single issuer subordinated debentures issued by financial institutions.

Results of Operations

Net income for the first six months of 2012 was $6,663, an increase of $1,556 compared with net income of $5,107 for the first six months of 2011. The change in net income was primarily due to reduced provision for loan losses, increased gain on sales of mortgage loans and increased net interest income offset in part by increased operating expenses.

Noninterest income increased a net of $1,562 or 17.90% for the six months ended June 30, 2012 and resulted primarily from increased gain on sales of loans and investment securities. Retail investment income, trust fees and cash surrender value of bank-owned life insurance also increased over the comparable periods. The increase in gain on sales of loans was primarily due to increased origination volumes and spreads during the first six months of 2012. Retail investment income increased due to increased brokerage activity and assets under management. Net investment securities gains year to date are $478 as compared to net securities gains of $118 in 2011.

Noninterest expense totaled $22,168 for the six months ended June 30, 2012, an increase of $2,330, or 11.75% compared to the same period ended June 30, 2011. Notable changes included an increase in salaries and other personnel expense of $1,522, an increase of $888 in other real estate losses and a decrease in FDIC insurance of $200.

Table 2 - Selected Balance Sheet Data

	June 30,		December 31,		Variance
	2012		2011		Amount			%
	(Dollars in thousands)
Cash, due from banks and interest-bearing deposits	$	59,320	$	69,841	($	10,521	)		(15.06	%)
Investment securities		665,369		603,759		61,610			10.20	%
Loans		847,759		846,010		1,749			0.21	%
Other real estate owned		7,773		6,209		1,564			25.19	%
Assets		1,666,127		1,614,773		51,354			3.18	%
Deposits		1,435,015		1,419,222		15,793			1.11	%
Securities sold under repurchase agreements		664		701		(37	)		(5.28	%)
Advances from Federal Home Loan Bank		66,000		39,000		27,000			69.23	%
Liabilities		1,540,010		1,497,744		42,266			2.82	%
Stockholders’ equity		126,117		117,029		9,088			7.77	%

Table 2 highlights significant changes in the balance sheet at June 30, 2012 as compared to December 31, 2011. Total assets increased $51,354 and reflect an increase in investment securities of $61,610 coupled with an decrease in cash, due from banks and interest bearing deposits of $10,521. Total liabilities increased $42,266 and reflect an increase in deposits of $15,793 and an increase in advances from Federal Home Loan Bank of $27,000.

The Company has continued to maintain a relatively high level of liquid funds in light of current economic conditions but has elected to invest a portion of these funds and funds obtained through deposit growth and loan repayments into the investment portfolio. Loan demand was weak during the first six months of 2012 and resulted in a minor increase in loans of $1,749 or 0.21%. The change in investment securities during the year included maturities and calls of bonds and selected sales of high duration securities for interest rate risk management purposes. These changes coupled with reinvestment of proceeds contributed to the average yield of the taxable investment portfolio declining from 3.00% to 2.69%. The yield on the tax exempt portfolio declined from 4.01% to 3.48% and resulted primarily from additions to the portfolio with lower yielding securities.

The $15,793 increase in deposits was primarily in savings accounts, demand deposit and interest bearing demand deposits. Brokered deposits remained relatively unchanged and totaled $153,463 at June 30, 2012 compared to $153,560 at December 31, 2011. Savings and money market accounts increased $7,376, noninterest-bearing accounts increased $6,851, NOW accounts increased $2,392 and retail time deposits decreased $826.

The annualized return on average assets for the Company was 0.82% for the six months ended June 30, 2012, compared to 0.64% for the same period last year.

The annualized return on average stockholders’ equity was 11.01% for the six months ended June 30, 2012, compared to 10.09% for the same period last year.

Net Interest Income

The primary source of earnings for the Company is net interest income, which is the difference between income on interest-earning assets, such as loans and investment securities, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings. The following table shows the average balances of interest-earning assets and interest-bearing liabilities, annualized average yields earned and rates paid on those respective balances, and the actual interest income and interest expense for the periods indicated. Average balances are calculated based on daily balances, yields on non-taxable investments are not reported on a tax equivalent basis and average balances for loans include nonaccrual loans even though interest was not earned.

Table 3 - Average Balances, Income and Expenses, Yields and Rates

	Three Months Ended June 30, 2012							Three Months Ended June 30, 2011
	Average Amount		Annualized Average Yield or Rate			Amount Paid or Earned		Average Amount		Annualized Average Yield or Rate			Amount Paid or Earned
	(Dollars in thousands)
Interest-earning assets:
Loans	$	865,072		5.31	%	$	11,558	$	881,038		5.78	%	$	12,827
Investment securities
Taxable		571,893		2.66	%		3,805		524,054		3.07	%		4,027
Tax-exempt		71,255		3.46	%		617		48,533		3.98	%		483
Interest-bearing deposits in other banks		19,242		0.46	%		22		30,952		0.45	%		35
Total interest-earning assets	$	1,527,462		4.17	%	$	16,002	$	1,484,577		4.66	%	$	17,372

Interest-bearing liabilities:
Deposits	$	1,277,295		0.75	%	$	2,377	$	1,272,288		1.21	%	$	3,839
Securities sold under repurchase agreements		4,417		0.72	%		8		696		0.86	%		1
Other borrowings		76,999		3.30	%		631		77,606		3.43	%		663
Total interest-bearing liabilities	$	1,358,711		0.89	%	$	3,016	$	1,350,590		1.34	%	$	4,503

Net interest margin/income:				3.38	%	$	12,986				3.44	%	$	12,869

Table 4 - Average Balances, Income and Expenses, Yields and Rates

	Six Months Ended June 30, 2012							Six Months Ended June 30, 2011
	Average Amount		Annualized Average Yield or Rate			Amount Paid or Earned		Average Amount		Annualized Average Yield or Rate			Amount Paid or Earned
	(Dollars in thousands)
Interest-earning assets:
Loans	$	866,468		5.32	%	$	23,218	$	880,580		5.77	%	$	25,455
Investment securities
Taxable		554,283		2.69	%		7,443		525,598		3.00	%		7,890
Tax-exempt		70,382		3.48	%		1,224		46,879		4.01	%		940
Interest-bearing deposits in other banks		24,025		0.40	%		47		33,096		0.43	%		70
Total interest-earning assets	$	1,515,158		4.19	%	$	31,932	$	1,486,153		4.62	%	$	34,355

Interest-bearing liabilities:
Deposits	$	1,274,875		0.80	%	$	5,091	$	1,276,307		1.25	%	$	7,907
Securities sold under repurchase agreements		2,585		0.70	%		9		684		0.88	%		3
Other borrowings		75,572		3.26	%		1,227		80,262		3.46	%		1,377
Total interest-bearing liabilities	$	1,353,032		0.94	%	$	6,327	$	1,357,253		1.38	%	$	9,287

Net interest margin/income:				3.35	%	$	25,605				3.36	%	$	25,068

Second Quarter 2012 compared to Second Quarter 2011:

Net interest income increased $117 (0.91%) during the three month period as compared to the same period in 2011. Loan interest income decreased $1,269 (9.89%) in the three month period primarily as a result of decreased yields and slightly lower volumes. Nonaccrual loans resulted in the reversal of $118 in interest income compared to $106 in 2011. Deposit interest expense decreased $1,462 (38.08%) in the three month period primarily as a result of declining deposit costs on the Company’s checking and savings account products. Due to these reductions and the low interest rate environment, the quarterly annualized average rate of interest bearing liabilities decreased from 1.34% at June 30, 2011 to 0.89% at June 30, 2012.

The Company’s net interest margin for the quarter was 3.38% as compared to 3.44% for the 2011 quarter. The decrease in the net interest margin for the three month period was impacted primarily by declining loans, loan yields and investment portfolio yields offset in part by decreased costs of interest bearing deposits. In addition, the Company added to both its taxable and tax exempt investment securities portfolios. Average taxable investment securities increased $47,839 (9.13%) while the average yield decreased from 3.07% to 2.66%. Average tax exempt investment securities increased $22,722 (46.82%) while the average yield decreased from 3.98% to 3.46%. Average loans decreased $15,966 (1.81%) with the average yield decreasing from 5.78% to 5.31%. Average interest bearing deposits increased $5,007 (0.39%) while the average rate paid decreased from 1.21% to 0.75%.

Six Months Ended 2012 compared to Six Months Ended 2011:

Net interest income increased $537 (2.14%) during the six month period as compared to the same period in 2011. Loan interest income decreased 2,237 (8.79%) in the six month period primarily as a result of decreased yields and slightly lower volumes. Nonaccrual loans resulted in the reversal of $201 in interest income compared to $174 in 2011. Deposit interest expense decreased $2,816 (35.61%) in the six month period primarily as a result of declining deposit costs on the Company’s checking and savings account products. Due to these reductions and the low interest rate environment, the annualized average rate of interest bearing liabilities decreased from 1.38% at June 30, 2011 to 0.94% at June 30, 2012.

The Company’s net interest margin for the six months ended June 30, 2012 was 3.35% as compared to 3.36% for the six months ended June 30, 2011. The minor change in the net interest margin for the six month period was impacted primarily by decreased costs of interest bearing deposits offset in part by declining loans, loan yields and investment portfolio yields. In addition, the Company added to both its taxable and tax exempt portfolios. Average taxable investment securities increased $28,685 (5.46%) while the average yield decreased from 3.00% to 2.69%. Average tax exempt investment securities increased $23,503 (50.14%) while the average yield decreased from 4.01% to 3.48%. Average loans decreased $14,112 (1.60%) with the average yield decreasing from 5.77% to 5.32%. Average interest bearing deposits decreased $1,432 (0.11%) while the average rate paid decreased from 1.25% to 0.80%. Average other borrowings decreased $4,690 (5.84%) and the average rate paid decreased from 3.46% to 3.26%.

Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, increases or decreases in the average rates earned and paid on such assets and liabilities, the ability to manage the earning asset portfolio, and the availability of particular sources of funds, such as noninterest-bearing deposits. The following tables present the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have impacted the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to changes attributable to change in volume (change in volume multiplied by prior rate), changes attributable to change in rate (change in rate multiplied by prior volume), and changes in rate/volume (change in rate multiplied by change in volume).

Table 5- Rate/Volume Analysis


	Three Months Ended
	June 30, 2012 compared to June 30, 2011
	Increase (Decrease) due to
	Volume			Rate			Combined			Total
	(Dollars in thousands)
Interest-earning assets:
Loans		(232	)		(1,056	)		19			(1,269	)
Investment securities
Taxable		367			(539	)		(50	)		(222	)
Tax-exempt		226			(63	)		(29	)		134
Interest-bearing deposits in other banks		(13	)		-			-			(13	)
Total interest-earning assets		348			(1,658	)		(60	)		(1,370	)

Interest-bearing liabilities:
Deposits		15			(1,471	)		(6	)		(1,462	)
Securities sold under repurchase agreements		5			-			2			7
Other borrowings		(5	)		(27	)		-			(32	)
Total interest-bearing liabilities		15			(1,498	)		(4	)		(1,487	)

Net change in net interest income										$	117

Table 6 - Rate/Volume Analysis


	Six Months Ended
	June 30, 2012 compared to June 30, 2011
	Increase (Decrease) due to
	Volume			Rate			Combined			Total
Interest-earning assets:	(Dollars in thousands)
Loans		(408	)		(1,859	)		30			(2,237	)
Investment securities
Taxable		431			(832	)		(46	)		(447	)
Tax-exempt		471			(125	)		(62	)		284
Interest-bearing deposits in other banks		(19	)		(5	)		1			(23	)
Total interest-earning assets		475			(2,821	)		(77	)		(2,423	)

Interest-bearing liabilities:
Deposits		(9	)		(2,810	)		3			(2,816	)
Securities sold under repurchase agreements		8			(1	)		(1	)		6
Other borrowings		(80	)		(74	)		4			(150	)
Total interest-bearing liabilities		(81	)		(2,885	)		6			(2,960	)
Net change in net interest income										$	537

Provision for Loan Losses

The provision for loan losses is the charge to operating earnings necessary to maintain the allowance for loan losses at a level which, in management’s estimate, is adequate to cover the estimated amount of probable incurred losses in the loan portfolio. The provision for loan losses totaled $1,950 for the three months ended June 30, 2012 compared to $3,424 for the three months ended June 30, 2011 and $4,166 for the six months ended June 30, 2012 compared to $6,664 for the same period in 2011. See “Allowance for Loan Losses” for further analysis of the provision for loan losses.

Noninterest Income

Table 7 - Noninterest Income


	Three Months Ended											Six Months Ended
	June 30,					Variance						June 30,				Variance
	2012		2011			Amount			%			2012		2011		Amount			%
	(Dollars in thousands)											(Dollars in thousands)

Service charges and fees on deposits	$	1,685	$	1,750		$	(65	)		(3.71	%)	$	3,296	$	3,328	$	(32	)		(0.96	%)
Gain on sales of loans		2,003		1,720			283			16.45	%		4,022		2,927		1,095			37.41	%
(Loss) gain on sale of fixed assets, net		8		-			8			N/A			6		17		(11	)		(64.71	%)
Investment securities gains (losses), net of other-than-temporary impairment		92		(30	)		122			(406.67	%)		469		56		413			737.50	%
Retail investment income		505		507			(2	)		(0.39	%)		1,027		964		63			6.54	%
Trust services fees		288		292			(4	)		(1.37	%)		577		565		12			2.12	%
Earnings from cash surrender value of bank-owned life insurance		265		248			17			6.85	%		526		466		60			12.88	%
Miscellaneous income		176		191			(15	)		(7.85	%)		366		404		(38	)		(9.41	%)
Total noninterest income	$	5,022	$	4,678		$	344			7.35	%	$	10,289	$	8,727	$	1,562			17.90	%

Second Quarter 2012 compared to Second Quarter 2011:

Noninterest income increased $344 (7.35%) during the three month period as compared to the same period in 2011. The most significant change for the three month period was an increase in gain on sales of loans due to increased mortgage originations. Gain on sales of loans increased $283 (16.45%). Also contributing to the increase was an increase in investment securities gains, net of other-than-temporary impairment of $122 and earnings from cash surrender value of life insurance which increased $17 (6.85%) compared to June 30, 2011. Service charges and fees on deposits decreased $65 (3.71%) primarily due to decreased consumer overdraft fees offset in part by increased interchange fees and commercial overdraft fees. Trust service fees and retail investment income decreased slightly in the comparable quarters.

Six Months Ended 2012 compared to Six Months Ended 2011:

Noninterest income increased $1,562 (17.90%) during the six month period as compared to the same period in 2011. The most significant change for the six month period was an increase in gain on sales of loans due to increased mortgage originations. Gain on sales of loans increased $1,095 (37.41%). Also contributing to the increase was an increase in investment securities gains, net of other-than-temporary impairment of $413. In addition retail investment income increased $63 (6.54%) due to higher retail brokerage activity and earnings from cash surrender value of life insurance increased $60 (12.88%) compared to June 30, 2011. Service charges and fees on deposits decreased $32 (0.96%) primarily due to decreased consumer overdraft fees offset in part by increased interchange fees and commercial overdraft fees.

Noninterest Expense

Table 8 - Noninterest Expense


	Three Months Ended										Six Months Ended
	June 30,				Variance						June 30,				Variance
	2012		2011		Amount			%			2012		2011		Amount			%
	(Dollars in thousands)										(Dollars in thousands)

Salaries and other personnel expense	$	6,543	$	5,654	$	889			15.72	%	$	12,740	$	11,218	$	1,522			13.57	%
Occupancy expenses		1,043		1,112		(69	)		(6.21	%)		2,097		2,227		(130	)		(5.84	%)
Marketing & business development		388		365		23			6.30	%		778		699		79			11.30	%
Processing expense		460		408		52			12.75	%		920		820		100			12.20	%
Legal and professional fees		388		350		38			10.86	%		821		743		78			10.50	%
Data processing expense		354		389		(35	)		(9.00	%)		733		738		(5	)		(0.68	%)
FDIC insurance		400		362		38			10.50	%		779		979		(200	)		(20.43	%)
Communications expense		177		275		(98	)		(35.64	%)		366		452		(86	)		(19.03	%)
Loss on sale of other real estate		638		231		407			176.19	%		852		213		639			300.00	%
Provision for other real estate losses		50		135		(85	)		(62.96	%)		497		248		249			100.40	%
Other operating expenses		804		782		22			2.81	%		1,585		1,501		84			5.60	%
Total noninterest expense	$	11,245	$	10,063	$	1,182			11.75	%	$	22,168	$	19,838	$	2,330			11.75	%

Second Quarter 2012 compared to Second Quarter 2011:

Noninterest expense increased $1,182 (11.75%) during the three month period as compared to the same period in 2011. The most significant changes for the three month period were salaries and other personnel expense which increased $889 (15.72%) due to normal merit increases to staff salaries, an addition to staff in the compliance and audit area, commissions paid on retail brokerage activities due to volume, increased accruals for post-retirement benefit plans, incentive compensation and to a lesser extent increased group insurance costs.

Other real estate losses totaled $688 for the quarter, an increase of $322 (87.98%) from the 2011 quarter. The increase was primarily due to an auction of several properties acquired through foreclosure that management had been unable to traditionally market. The auction resulted in proceeds of approximately $443 and generated losses of approximately $572. Marketing, processing, legal and professional expenses all increased slightly during the three month period as compared to the same period in 2011.

Occupancy expenses decreased $69 (6.21%) during the three month period and were primarily due to decreased depreciation expense as a result of certain assets becoming fully depreciated.

Six Months Ended 2012 compared to Six Months Ended 2011:

Noninterest expense increased $2,330 (11.75%) during the six month period as compared to the same period in 2011. The most significant changes for the six month period were salaries and other personnel expense which increased $1,522 (13.57%) during the six month period as compared to the same period in 2011 and was due primarily to normal merit increases to staff salaries, an addition to staff in the compliance and audit area, commissions paid on retail brokerage activities due to volume, increased accruals for incentives and post-retirement benefit plans and to a lesser extent increased group insurance costs.

Occupancy expenses decreased $130 (5.84%) during the six month period and were primarily due to decreased depreciation expense as a result of certain assets becoming fully depreciated.

Other real estate expenses increased $888 and resulted primarily from losses related to sales of OREO during the second quarter as described above.

Income Taxes

The Company recognized income tax expense of $1,452 and $2,897 for the three and six months ended June 30, 2012 as compared to an income tax expense of $1,255 and $2,186 for the same period in 2011. The significant increase in pretax income resulted in an increase in income tax expense and a slightly higher effective income tax rate for the three and six month periods. The effective income tax rate for the three and six months ended June 30, 2012 was 30.17% and 30.30%, respectively.

At June 30, 2012, the Company maintains net deferred tax assets of $11,523. A valuation allowance is required for deferred tax assets if, based on available evidence, it is more likely than not that all or some portion of the asset may not be realized due to the inability to generate sufficient taxable income in the period and/or of the character necessary to utilize the benefit of the deferred tax asset. In making this assessment, all sources of taxable income available to realize the deferred tax asset are considered including taxable income in prior carry-back years, future reversals of existing temporary differences, tax planning strategies and future taxable income exclusive of reversing temporary differences and carryforwards. Based on management’s assessment, no valuation allowance was deemed necessary at June 30, 2012.

Loans

The following table presents the composition of the Company’s loan portfolio as of June 30, 2012 and December 31, 2011.

Table 9 - Loan Portfolio Composition

	June 30, 2012					December 31, 2011
	Amount		%			Amount		%
	(Dollars in thousands)
Commercial financial and agricultural	$	179,794		21.21	%	$	171,750		20.30	%
Real estate
Commercial		326,363		38.50	%		332,666		39.32	%
Residential		163,408		19.28	%		159,022		18.80	%
Acquisition, development and construction		163,334		19.27	%		168,050		19.86	%
Total real estate		653,105		77.05	%		659,738		77.98	%
Consumer
Direct		13,996		1.65	%		13,600		1.61	%
Indirect		199		0.02	%		384		0.05	%
Revolving		417		0.05	%		428		0.05	%
Total consumer		14,612		1.72	%		14,412		1.71	%
Deferred loan origination costs (fees)		248		0.02	%		110		0.01	%
Total	$	847,759		100.00	%	$	846,010		100.00	%

At June 30, 2012, the loan portfolio is comprised of 77.05% real estate loans. Commercial, financial and agricultural loans comprise 21.21%, and consumer loans comprise 1.72% of the portfolio.

Commercial real estate comprises 38.50% of the loan portfolio and consist of both non-owner occupied and owner occupied properties where the operations of the commercial entity provide the necessary cash flow to service the debt. For this portion of the real estate loan portfolio, repayment is generally not dependent upon the sale of the real estate held as collateral. Construction and development loans comprise 19.27% of the real estate loan portfolio and the Company has recognized significant losses in this portfolio. The Company carefully monitors the loans in this category since the repayment of these loans is generally dependent upon the sale of the real estate in the normal course of business and can be impacted by national and local economic conditions. New construction and absorption of existing real estate inventory in the Company’s primary market area of the Augusta-Richmond County, GA-SC MSA have slowed and prices have declined but less than the national rate. The residential category, 19.28% of the portfolio, represents those loans that the Company chooses to maintain in its portfolio rather than selling into the secondary market for marketing and competitive reasons and commercial loans secured by residential real estate.

The Company has no large loan concentrations to individual borrowers. Unsecured loans at June 30, 2012 totaled $15,849.

Interest reserves are established for certain ADC (acquisition development and construction) loans based on the feasibility of the project, the timeframe for completion, the creditworthiness of the borrower and guarantors, and collateral. An interest reserve allows the borrower’s interest cost to be capitalized and added to the loan balance. As a matter of practice GB&T does not generally establish loan funded interest reserves on ADC loans; however, the Company’s loan portfolio includes six loans with interest reserves at June 30, 2012, which are fully advanced.

Underwriting for ADC loans with interest reserves follows the same process as those loans without reserves. In order for GB&T to establish a loan-funded interest reserve, the borrower must have the ability to repay without the use of a reserve and a history of developing and stabilizing similar properties. All ADC loans, including those with interest reserves, are carefully monitored through periodic construction site inspections by bank employees or third party inspectors to ensure projects are moving along as planned. Management assesses the appropriateness of the use of interest reserves during the entire term of the loan as well as the adequacy of the reserve. Collateral inspections are completed before approval of advances. Two of these loans have been renewed; one due to delays and time needed to obtain current financial information on the guarantors and another to allow for completion of the final punch list and negotiation of the permanent loan. None of these loans have been restructured or are currently on nonaccrual.

Loan Review and Classification Process

The Company maintains a loan review and classification process which involves multiple officers of the Company and is designed to assess the general quality of credit underwriting and to promote early identification of potential problem loans. All loan officers are charged with the responsibility of risk rating all loans in their portfolios and updating the ratings, positively or negatively, on an ongoing basis as conditions warrant. Risk ratings are selected from an 8-point scale with ratings as follows: ratings 1- 4 Satisfactory (pass), rating 5 Watch (potential weakness), rating 6 Substandard (well-defined weakness), rating 7 Doubtful and rating 8 Loss.

When a loan officer originates a new loan, he or she documents the credit file with an offering sheet summary, supplemental underwriting analyses, relevant financial information and if applicable, collateral evaluations. All of this information is used in the determination of the initial loan risk rating. Then, the Company’s Credit Administration department undertakes an independent credit review of that relationship in order to validate the lending officer’s rating. Lending relationships with total related exposure of $500 or greater are also placed into a tracking database and reviewed by Credit Administration personnel on an annual basis in conjunction with the receipt of updated borrower and guarantor financial information. The individual loan reviews analyze such items as: loan type; nature, type and estimated value of collateral; borrower and/or guarantor estimated financial strength; most recently available financial information; related loans and total borrower exposure; and current/anticipated performance of the loan. The results of such reviews are presented to Executive Management.

Through the review of delinquency reports, updated financial statements or other relevant information in the normal course of business, the lending officer and/or Credit Administration review personnel may determine that a loan relationship has weakened to the point that a criticized (loan grade 5) or classified (loan grade 6 through 8) status is warranted. When a loan relationship with total related exposure of $200 or greater is adversely graded (5 or above), the lending officer is then charged with preparing a Classified/Watch report which outlines the background of the credit problem, current repayment status of the loans, current collateral evaluation and a workout plan of action. This plan may include goals to improve the credit rating, assisting the borrower in moving the loans to another institution and/or collateral liquidation. All such Classified/Watch reports are reviewed on a quarterly basis by members of Executive Management at a regularly scheduled meeting in which each lending officer presents the workout plans for their criticized credit relationships.

Depending upon the individual facts, circumstances and the result of the Classified/Watch review process, Executive Management may categorize the loan relationship as impaired. Once that determination has occurred, Executive Management in conjunction with Credit Administration personnel, will complete an evaluation of the collateral (for collateral-dependent loans) based upon appraisals on file adjusting for current market conditions and other local factors that may affect collateral value. This judgmental evaluation may produce an initial specific allowance for placement in the Company’s Allowance for Loan Losses calculation. As soon as practical, updated appraisals on the collateral backing that impaired loan relationship are ordered. When the updated appraisals are received, Executive Management with assistance from Credit Administration department personnel reviews the appraisal, and updates the specific allowance analysis for each loan relationship accordingly. The Director’s Loan Committee reviews on a quarterly basis the Classified/Watch reports including changes in credit grades of 5 or higher as well as all impaired loans, the related allowances and OREO.

In general, once the specific allowance has been finalized, Executive Management will authorize a charge-off prior to the following calendar quarter-end in which that reserve calculation is finalized.

The review process also provides for the upgrade of loans that show improvement since the last review.

Nonperforming Assets

Non-performing assets include nonaccrual loans, loans past due 90 days or more, restructured loans and other real estate owned. Table 10 shows the current and prior period amounts of non-performing assets. Non-performing assets were $43,743 at June 30, 2012, compared to $51,436 at December 31, 2011 and $36,582 at June 30, 2011. The most significant change from June 2011 to June 2012 was a $7,666 increase in nonaccrual commercial real estate loans which are described below.

In the fourth quarter 2011 three commercial real estate loans totaling $9,560 with a common guarantor secured by first mortgages on Augusta-area franchised hotels were placed on nonaccrual. The three hotels filed for Chapter 11 bankruptcy protection to assist in resolving tax issues. The hotels continue normal daily operations and the Company expects to receive monthly adequate protection payments on its debt through the bankruptcy plan. Updated appraisals were obtained on the three properties which did not result in adjustment to the carrying value of the loans.

There were $10 of loans past due 90 days or more and still accruing at June 30, 2012, and no loans past due 90 days or more and still accruing at December 31, 2011 and June 30, 2011.

Troubled debt restructurings (TDRs) are troubled loans in which the original terms have been modified in favor of the borrower or either principal or interest has been forgiven due to deterioration in the borrower’s financial condition. There were $2,169 in TDRs at June 30, 2012, of which $1,113 were on nonaccrual status. TDRs totaled $4,151 at December 31, 2011, of which $1,821 were on nonaccrual status, and $4,733 at June 30, 2011, of which $1,941 were on nonaccrual status.

Table 10 - Non-Performing Assets

	June 30, 2012			December 31, 2011			June 30, 2011
	(Dollars in thousands)
Nonaccrual loans:
Commercial financial and agricultural	$	2,318		$	2,325		$	2,972
Real Estate:
Commercial		15,182			20,956			7,516
Residential		5,679			4,553			5,232
Acquisition, development and construction		11,443			14,732			9,258
Consumer		292			331			254
Total Nonaccrual loans		34,914			42,897			25,232
Restructured loans (1)		1,056			2,330			2,792
Other real estate owned		7,773			6,209			8,558
Total Non-performing assets	$	43,743		$	51,436		$	36,582

Loans past due 90 days or more and still accruing interest	$	10		$	-		$	-

Non-performing assets to total assets		2.63	%		3.19	%		2.29	%

Non-performing assets to period end loans and OREO		5.11	%		6.04	%		4.15	%

Allowance for loan loss to period end nonaccrual loans		84.64	%		67.71	%		112.59	%

(1) Restructured loans on nonaccrual status at period end are included under nonaccrual loans in the table.

The ratio of non-performing assets to total loans and other real estate was 5.11% at June 30, 2012 compared to 6.04% at December 31, 2011 and 4.15% at June 30, 2011. The ratio of allowance for loan losses to total nonaccrual loans was 84.64% at June 30, 2012 compared to 67.71% at December 31, 2011 and 112.59% at June 30, 2011. The resolution of non-performing assets continues to be a priority of management.

Nonaccrual loans have increased from June 30, 2011 despite a significant decline in ADC properties that the Company has been actively addressing over the past two years. Although the exposure has declined, a significant portion of nonaccrual loans continues to be collateral dependent ADC loans as well as commercial real estate loans. The following table provides further information regarding the Company’s nonaccrual loans.

Nonaccrual

Appraisal

Appraised

Balance

Originated

Date

Trigger

Collateral

Allowance

Method

Date

Value

(Dollars in thousands)

ADC Loan / 1-4 Family / Equity lines (1)

1,938

03/07-09/08

11/09-09/10

delinquency

houses, lots & land

collateral value

03/12

2,453

Commercial Real Estate

9,231

08/08-01/11

11/18/11

bankruptcy

commercial bldg

collateral value

12/11

14,150

ADC Loan - CSRA

6,758

03/29/11

03/11-11/11

financial condition

lots & land

collateral value

06/11

9,070

ADC Loan - Other

1,039

09/30/08

05/06/10

delinquency

lots & land

collateral value

09/11

1,269

1-4 Family Residential

1,415

01/31/07

06/27/12

financial condition

house

101

collateral value

01/07

(2)

1,900

Commercial Real Estate

1,230

09/18/08

10/28/11

financial condition

commercial bldg

collateral value

12/11

1,531

21,611

Other, net

13,303

Nonaccrual loans at June 30, 2012

34,914

(1) Cross collateralized loans to one borrower

(2) Updated appraisal ordered

The following table presents a roll forward of other real estate owned for the six month periods ended June 30, 2012 and 2011, respectively.

Table 11 - Other Real Estate Owned


	2012			2011
	(Dollars in thousands)
Beginning balance, January 1	$	6,209		$	7,751
Additions		6,623			3,353
Increase in valuation allowance		(497	)		(248	)
Sales		(3,710	)		(2,085	)
Loss on sale of OREO		(852	)		(213	)
Ending balance, June 30	$	7,773		$	8,558

The following table provides details of other real estate owned as of June 30, 2012 and 2011, respectively.

	2012			2011
	(Dollars in thousands)
Other Real Estate:
Commercial, financial and agricultural	$	-		$	-
Real Estate
Commercial		6,349			298
Residential		17			13
Acquisition, development and construction		2,924			10,239
Consumer		-			130
		9,290			10,680

Valuation allowance		(1,517	)		(2,122	)
	$	7,773		$	8,558

The decrease in other real estate owned is due to the continuing process of resolving problem loans. In the first six months of 2012, additions to other real estate owned totaled $6,623 and proceeds from sales of other real estate totaled $3,710. In addition, there was a $497 increase to the valuation allowance primarily as a result of updated valuations on two properties.

Allowance for Loan Losses

The allowance for loan losses represents an allocation for the estimated amount of probable incurred losses in the loan portfolio. The adequacy of the allowance for loan losses is evaluated periodically based on a review of all significant loans, with particular emphasis on impaired, non-accruing, past due, and other loans that management believes require special attention. The determination of the allowance for loan losses is considered a critical accounting estimate of the Company. See “Critical Accounting Estimates.”

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may advise additions to the allowance based on their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result.

Additions to the allowance for loan losses are made periodically to maintain the allowance at an appropriate level based upon management’s analysis of risk in the loan portfolio. Loans determined to be uncollectible are charged to the allowance for loan losses and subsequent recoveries are added to the allowance. A provision for losses in the amount of $1,950 was charged to expense for the three months ended June 30, 2012 compared to $3,424 for the three months ended June 30, 2011 and $4,166 was charged to expense for the six months ended June 30, 2012 compared to $6,664 for the six months ended June 30, 2011. Significant portions of the overall level of losses in 2012 relate to the charge off of specific reserve allowances on impaired loans.

At June 30, 2012 the ratio of allowance for loan losses to period end loans was 3.49% compared to 3.43% at December 31, 2011 and 3.25% at June 30, 2011. Net charge-offs totaled $3,660 of which $1,408, or 38.47% were related to commercial real estate loans, $945 or 25.82% were related to ADC loans, and $543 or 14.84% were related to residential mortgage real estate loans. Of the ADC charge-offs, $236 or 24.97% were related to ADC loans in the CSRA and $709 or 75.03% were related to ADC loans in other markets. The provisions for loan losses allocated to individual portfolio segments are affected by the calculation of average historical net loss rate factors and by the internal and external qualitative factors within each category. The loan loss provision allocated to commercial real estate loans was $1,216 and was affected primarily by net charge-offs of $1,408. The loan loss provision allocated to ADC loans was $644 and was affected primarily by net charge-offs of $945 and qualitative factors related to trends in volume and terms of loans. The loan loss provision allocated to the commercial, financial and agricultural portfolio was $1,081 and was affected primarily by net charge-offs of $479, growth in the portfolio and qualitative factors related to trends in volume and terms of loans. The loan loss provision allocated to the 1-4 family portfolio was $757 and was affected primarily by net charge-offs of $543 and growth in the portfolio. The loan loss provision allocated to the consumer portfolio was $468 and was affected by net charge-offs of $285.

Management considers the current allowance for loan losses appropriate based upon its analysis of risk in the portfolio using the methods previously discussed. Management’s judgment is based upon a number of assumptions about events which are believed to be reasonable, but which may or may not prove correct. While it is the Company’s policy to charge off in the current period the loans in which a loss is considered probable, there are additional risks of losses which cannot be quantified precisely or attributed to a particular loan or class of loans. Because management evaluates such factors as changes in the nature and volume of the loan portfolio, historical loss rates, overall portfolio quality, review of specific problem loans, and current economic conditions and trends that may affect a borrower’s ability to repay, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. Thus, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional increases in the allowance will not be required.

Liquidity and Capital Resources

The Company has maintained adequate liquidity to meet operating and loan funding requirements despite the lack of such demand due to current market conditions. The loan to deposit ratio at June 30, 2012 was 59.08% compared to 59.61% at December 31, 2011 and 62.33% at June 30, 2011. The decrease in the loan to deposit ratio from June 30, 2011 to June 30, 2012 reflects the decreased demand for loans. Deposits at June 30, 2012 and December 31, 2011 include $153,463 and $153,560 of brokered certificates of deposit, respectively. GB&T has also utilized borrowings from the Federal Home Loan Bank. GB&T maintains a line of credit with the Federal Home Loan Bank approximating 10% of its total assets. Federal Home Loan Bank advances are collateralized by eligible first mortgage loans, commercial real estate loans and investment securities. Federal Home Loan Bank advances totaled $66,000 at June 30, 2012. GB&T maintains repurchase lines of credit with SunTrust Robinson Humphrey, Atlanta, Georgia, for advances up to $20,000, of which no amounts were outstanding at June 30, 2012. GB&T has a federal funds purchased accommodation with SunTrust Bank, Atlanta, Georgia for advances up to $10,000, of which none were outstanding at June 30, 2012. GB&T also has a $10,000 repurchase line of credit with Center State Bank, Orlando, Florida, of which none were outstanding at June 30, 2012. GB&T also has a federal funds purchased accommodation with Center State Bank for advances up to $10,000, none of which were outstanding at June 30, 2012. Additionally, liquidity needs can be supplemented by the structuring of the maturities of investment securities and the pricing and maturities on loans and deposits offered to customers. The Company also uses retail securities sold under repurchase agreements to fund operations. Retail securities sold under repurchase agreements were $664 at June 30, 2012.

Stockholders’ equity to total assets was 7.57% at June 30, 2012 compared to 7.25% at December 31, 2011 and 6.86% at June 30, 2011. The capital of the Company exceeded all required regulatory guidelines at June 30, 2012. The Company’s Tier 1 risk-based, total risk-based and leverage capital ratios were 13.31%, 14.61%, and 8.49%, respectively, at June 30, 2012.

The following table reflects the current regulatory capital levels in more detail, including comparisons to the regulatory minimums.

Table 12 - Regulatory Capital Requirements
June 30, 2012

						Required for capital
	Actual					adequacy purposes					Excess
	Amount		Percent			Amount		Percent			Amount		Percent
	(Dollars in thousands)
Southeastern Bank Financial Corporation

Risk-based capital:
Tier 1 capital	$	139,958		13.31	%		42,047		4.00	%		97,911		9.31	%
Total capital		153,609		14.61	%		84,094		8.00	%		69,515		6.61	%
Tier 1 leverage ratio		139,958		8.49	%		65,966		4.00	%		73,992		4.49	%

Georgia Bank & Trust Company

Risk-based capital:
Tier 1 capital	$	137,357		13.11	%		41,912		4.00	%		95,445		9.11	%
Total capital		150,658		14.38	%		83,824		8.00	%		66,834		6.38	%
Tier 1 leverage ratio		137,357		8.41	%		73,481		4.50	%		63,876		3.91	%

Georgia Bank & Trust Company is regulated by the Department of Banking and Finance of the State of Georgia (DBF). The DBF requires that state banks in Georgia generally maintain a minimum ratio of Tier 1 capital to total assets of four and one-half percent (4.50%).

Management is not aware of any other events or uncertainties that are reasonably likely to have a material effect on the Company’s liquidity, capital resources or operations.

Commitments and Contractual Obligations

The Company is a party to lines of credit with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Lines of credit are unfunded commitments to extend credit. These instruments involve, in varying degrees, exposure to credit and interest rate risk in excess of the amounts recognized in the financial statements. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for unfunded commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company evaluates acquisition, development and construction loans for the percentage completed before extending additional credit. The Company follows the same credit policies in making commitments and contractual obligations as it does for on-balance sheet instruments.

Unfunded commitments to extend credit where contract amounts represent potential credit risk totaled $169,909 at June 30, 2012. These commitments are primarily at variable interest rates.

The Company’s commitments are funded through internal funding sources of scheduled repayments of loans and sales and maturities of investment securities available-for-sale or external funding sources through acceptance of deposits from customers or borrowings from other financial institutions.

The following table is a summary of the Company’s commitments to extend credit, commitments under contractual leases as well as the Company’s contractual obligations, consisting of deposits, FHLB advances, which are subject to early termination options, and borrowed funds by contractual maturity date.

Table 13 - Commitments and Contractual Obligations

	Less than 1 Year		1 - 3 Years		3 - 5 Years		More than 5 Years
	(Dollars in thousands)
Lines of credit	$	169,909		-		-		-
Lease agreements		247		399		277		-
Deposits		1,278,957		120,821		34,833		404
Securities sold under repurchase agreements		664		-		-		-
FHLB advances		12,000		-		15,000		39,000
Subordinated debentures		-		1,547		-		20,000
Total commitments and contractual obligations	$	1,461,777	$	122,767	$	50,110	$	59,404

Although management regularly monitors the balance of outstanding commitments to fund loans to ensure funding availability should the need arise, management believes that the risk of all customers fully drawing on all these lines of credit at the same time is remote.

Effects of Inflation and Changing Prices

Inflation generally increases the cost of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on the performance of a financial institution than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction and to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates. In addition, inflation can increase a financial institution’s cost of goods and services purchased, the cost of salaries and benefits, occupancy expense and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders’ equity. Mortgage originations and refinances tend to slow as interest rates increase, and can reduce the Company’s earnings from such activities and the income from the sale of residential mortgage loans in the secondary market.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of June 30, 2012, there were no substantial changes in the interest rate sensitivity analysis or the sensitivity of market value of portfolio equity for various changes in interest rates calculated as of December 31, 2011. A detailed discussion of market risk is provided in the Company’s 2011 Annual Report on Form 10-K.

Item 4. Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer (principal executive officer) and its Group Vice President and Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, such officers concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) that is required to be included in the Company’s periodic filings with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls or, to the Company’s knowledge, in other factors during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

Part II

OTHER INFORMATION


Item 1.	Legal Proceedings

	There are no material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is subject.

Item 1A.	Risk Factors

	In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, which could materially affect its business, financial condition or future results. The risks described in the Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to management or that management currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds

	Issuer Purchases of Equity Securities

	On April 15, 2004, the Company announced the commencement of a stock repurchase program, pursuant to which it will, from time to time, repurchase up to 100,000 shares of its outstanding stock. The program does not have a stated expiration date. No stock repurchase programs were terminated during the second quarter of 2012 and there were no shares repurchased under the existing stock repurchase plan or otherwise during the second quarter.

Item 3.	Defaults Upon Senior Securities

	Not applicable

Item 4.	Mine Safety Disclosures

	Not applicable

Item 5.	Other Information

	None


Item 6.	Exhibits

	* 31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	* 31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	* 32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	**101	Interactive Data Files providing financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 in XBRL (eXtensible Business Reporting Language). Pursuant to Regulation 406T of Regulation S-T, these Interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.


*		Filed herewith
**		The registant will file this exhibit within the 30day grace period allowed in accordance with SEC release 34-59324

SOUTHEASTERN BANK FINANCIAL CORPORATION

Form 10-Q Signatures

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

		SOUTHEASTERN BANK FINANCIAL CORPORATION

Date:	July 27, 2012		By:	/s/ Darrell R. Rains
			Darrell R. Rains
			Group Vice President, Chief
			Financial Officer (Duly Authorized
			Officer of Registrant and Principal
			Financial Officer)

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