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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
(Mark One)
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
For the Quarterly Period Ended
September 30, 2014
 
 
 
[  ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
For the transition period from _____________________________to_____________________________________
 
 
 
Commission File Number:  000-28342
VALLEY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
VIRGINIA
54-1702380
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
36 Church Avenue, S.W.
 
Roanoke, Virginia
24011
(Address of principal executive offices)
(Zip Code)
(540) 342-2265
(Registrant’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 registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes þNo 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 (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).          Yes þ Noo

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

Large accelerated filer o
Accelerated filer o
 
 
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company þ
 
Indicate by checkmark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act.)
Yes o No þ

At November 3, 2014, 4,823,865 shares of common stock, no par value, of the registrant were outstanding.
 

1


VALLEY FINANCIAL CORPORATION
FORM 10-Q
September 30, 2014

TABLE OF CONTENTS
 
 
 

2


Forward-Looking and Cautionary Statements
 
The Private Securities Litigation Reform Act of 1995 (the “1995 Act”) provides a safe harbor for forward-looking statements made by or on our behalf.  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of our management and on information available at the time these statements and disclosures were prepared.
 
This report includes forward-looking statements within the meaning of the 1995 Act. These statements are included throughout this report and relate to, among other things, projections of revenues, earnings, earnings per share, cash flows, capital expenditures, or other financial items, expectations regarding acquisitions, discussions of estimated future revenue enhancements, potential dispositions, and changes in interest rates. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins, profitability, liquidity, and capital resources. The words “believe”, “anticipate”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “will”, and similar terms and phrases identify forward-looking statements in this report.
 
Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside of our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct.  Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a number of factors. Factors that may cause actual results to differ materially from those expected include the following:
 
General economic conditions may deteriorate and negatively impact the ability of borrowers to repay loans and depositors to maintain balances;
General decline in the residential real estate construction and finance market;
Decline in market value of real estate in the Company’s markets;
Changes in interest rates could reduce net interest income and/or the borrower’s ability to repay loans;
Competitive pressures among financial institutions may reduce yields and profitability;
Legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses that the Company is engaged in;
Increased regulatory supervision could limit our ability to grow and could require considerable time and attention of our management and board of directors;
New products developed or new methods of delivering products could result in a reduction in business and income for the Company;
The Company’s ability to continue to improve operating efficiencies;
Natural events and acts of God such as earthquakes, fires and floods;
Loss or retirement of key executives; and
Adverse changes may occur in the securities market.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein.  We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.

3


PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements.

VALLEY FINANCIAL CORPORATION
Consolidated Balance Sheets
(In 000s, except share data)
 
(Unaudited)
 
(Audited)
Assets
September 30, 2014
 
December 31, 2013
Cash and due from banks
$
7,294

 
$
11,404

Interest bearing deposits
6,967

 
4,958

Total cash and cash equivalents
14,261

 
16,362

Securities available for sale
184,336

 
159,861

Securities held to maturity (fair value 12/31/13: $22,471)
0

 
21,992

Loans, net of allowance for loan losses, 9/30/14: $6,535; 12/31/13: $7,200
600,006

 
563,160

Foreclosed assets
11,994

 
19,705

Premises and equipment, net
9,354

 
9,722

Bank owned life insurance
19,371

 
18,872

Accrued interest receivable
2,363

 
2,576

Other assets
15,660

 
13,096

Total assets
$
857,345

 
$
825,346

Liabilities and Shareholders' Equity
 
 
 
Liabilities:
 
 
 
Non-interest bearing deposits
$
32,410

 
$
21,237

Interest bearing deposits
649,692

 
655,798

Total deposits
682,102

 
677,035

Securities sold under agreements to repurchase
23,983

 
22,397

FHLB borrowings
58,000

 
43,000

Junior subordinated notes
27,386

 
27,476

Accrued interest payable
394

 
424

Other liabilities
8,313

 
6,094

Total liabilities
800,178

 
776,426

Shareholders' equity:
 
 
 
Preferred stock, no par value; 10,000,000 shares authorized; no shares issued and outstanding at September 30, 2014 and December 31, 2013
0

 
0

Common stock, no par value; 10,000,000 shares authorized; 4,823,865 shares issued and outstanding at September 30, 2014 and 4,787,605 shares issued and outstanding at December 31, 2013
23,013

 
22,626

Retained earnings
35,383

 
30,897

Accumulated other comprehensive loss
(1,229
)
 
(4,603
)
Total shareholders' equity
57,167

 
48,920

Total liabilities and shareholders' equity
$
857,345

 
$
825,346

See accompanying notes to consolidated financial statements

4


VALLEY FINANCIAL CORPORATION
Consolidated Income Statements
(In 000s, except share and per share data)
 
Three Months Ended (Unaudited)
 
Nine Months Ended (Unaudited)
 
9/30/2014
 
9/30/2013
 
9/30/2014
 
9/30/2013
Interest income
 
 
 
 
 
 
 
Interest and fees on loans
$
7,001

 
$
6,824

 
$
20,710

 
$
20,496

Interest on securities - taxable
926

 
830

 
2,955

 
2,361

Interest on securities - nontaxable
152

 
175

 
524

 
470

Interest on deposits in banks
5

 
4

 
18

 
17

Total interest income
8,084

 
7,833

 
24,207

 
23,344

Interest expense
 
 
 
 
 
 
 
Interest on deposits
577

 
603

 
1,719

 
1,955

Interest on borrowings
546

 
381

 
1,619

 
1,207

Total interest expense
1,123

 
984

 
3,338

 
3,162

Net interest income
6,961

 
6,849

 
20,869

 
20,182

Provision for loan losses
(143
)
 
(332
)
 
1,414

 
(267
)
Net interest income after provision for loan losses
7,104

 
7,181

 
19,455

 
20,449

Noninterest income
 
 
 
 
 
 
 
Service charges on deposit accounts
535

 
482

 
1,519

 
1,349

Mortgage fee income
143

 
173

 
372

 
569

Brokerage fee income, net
150

 
225

 
641

 
724

Bank owned life insurance income
166

 
167

 
499

 
499

Realized gain on sale of securities
9

 
15

 
730

 
83

Other  income
113

 
93

 
490

 
386

Total noninterest income
1,116

 
1,155

 
4,251

 
3,610

Noninterest expense
 
 
 
 
 
 
 
Compensation expense
3,155

 
2,978

 
9,317

 
8,908

Occupancy and equipment expense
485

 
439

 
1,445

 
1,361

Data processing expense
421

 
385

 
1,239

 
1,133

Insurance expense
219

 
212

 
667

 
614

Professional fees
208

 
206

 
524

 
568

Foreclosed asset expense, net
299

 
589

 
699

 
1,090

Other operating expense
905

 
842

 
2,670

 
2,502

Total noninterest expense
5,692

 
5,651

 
16,561

 
16,176

Income before income taxes
2,528

 
2,685

 
7,145

 
7,883

Income tax expense
723

 
756

 
2,080

 
2,333

Net income
$
1,805

 
$
1,929

 
$
5,065

 
$
5,550

Preferred dividends and accretion of discounts on warrants
0

 
167

 

 
592

Net income available to common shareholders
$
1,805

 
$
1,762

 
$
5,065

 
$
4,958

Earnings per share
 

 
 

 
 

 
 

Basic earnings per common share
$
0.37

 
$
0.37

 
$
1.05

 
$
1.04

Diluted earnings per common share
$
0.37

 
$
0.36

 
$
1.04

 
$
1.01

Weighted average common shares outstanding
4,821,282

 
4,787,269

 
4,815,326

 
4,785,520

Diluted average common shares outstanding
4,873,218

 
4,950,080

 
4,866,498

 
4,923,772

Dividends declared per common share
$
0.04

 
$
0.035

 
$
0.12

 
$
0.11

See accompanying notes to consolidated financial statements

5


VALLEY FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income
(In 000s)
 
Three Months Ended (Unaudited)
 
Nine Months Ended (Unaudited)
 
9/30/2014
 
9/30/2013
 
9/30/2014
 
9/30/2013
Net Income
$
1,805

 
$
1,929

 
$
5,065

 
$
5,550

Other comprehensive income (loss)  ("OCI"):
 
 
 
 
 
 
 
Unrealized gains (losses) on securities:
 
 
 
 
 
 
 
Unrealized holding gains (losses) arising during period
(100
)
 
(152
)
 
5,963

 
(5,819
)
Tax related to unrealized (gains) losses
34

 
52

 
(2,027
)
 
1,978

Reclassification adjustment for realized gains included in net income
(9
)
 
(15
)
 
(730
)
 
(83
)
Tax related to realized gains
3

 
5

 
248

 
28

Holding gains on securities transferred to HTM from AFS:
 
 
 
 
 
 
 
Holding gains amortized during period
0

 
(15
)
 
(120
)
 
(17
)
Tax related to amortized holding gains
0

 
5

 
41

 
6

Total other comprehensive income (loss)
(72
)
 
(120
)
 
3,375

 
(3,907
)
Total comprehensive income
$
1,733

 
$
1,809

 
$
8,440

 
$
1,643

See accompanying notes to consolidated financial statements



6


VALLEY FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(In 000s)
 
Nine Months Ended (Unaudited)
 
9/30/2014
 
9/30/2013
Cash flows from operating activities
 
 
 
Net income
$
5,065

 
$
5,550

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
 
 
Provision for loan losses
1,414

 
(267
)
Depreciation and amortization of bank premises, equipment and software
614

 
602

Net amortization of bond premiums/discounts
1,171

 
1,248

Stock compensation expense
303

 
217

Net gains on sale of securities
(730
)
 
(83
)
Net losses and impairment writedowns on foreclosed assets and premises
161

 
595

Increase in value of life insurance contracts
(499
)
 
(500
)
Increase in other assets
(792
)
 
(1,906
)
Increase in other liabilities
2,189

 
471

Net cash and cash equivalents provided by operating activities
8,896

 
5,927

Cash flows from investing activities
 
 
 
Purchases of bank premises, equipment and software
(236
)
 
(1,341
)
Purchases of securities available-for-sale
(45,228
)
 
(61,041
)
Proceeds from maturities, calls, and paydowns of securities available-for-sale
45,166

 
37,755

Proceeds from maturities, calls, and paydowns of securities held-to-maturity
512

 
3,030

Proceeds from sale of foreclosed assets
7,800

 
3,239

Capitalized costs related to foreclosed assets
(188
)
 
(690
)
Increase in loans, net
(39,891
)
 
(19,299
)
Net cash and cash equivalents used in investing activities
(32,065
)
 
(38,347
)
Cash flows from financing activities
 
 
 
Increase in non-interest bearing deposits
11,173

 
2,306

Increase (decrease) in interest bearing deposits
(6,106
)
 
25,805

Proceeds from borrowings, net
15,000

 
5,000

Principal payments made on junior subordinated notes
(90
)
 
0

Increase in securities sold under agreements to repurchase
1,586

 
1,605

Net proceeds from issuance of common stock
49

 
4

Redemptions of preferred stock
0

 
(4,800
)
Excess tax benefits from share-based payment agreements
35

 
52

Purchase and retirement of treasury stock
0

 
(54
)
Cash dividends paid
(579
)
 
(984
)
Net cash and cash equivalents provided by financing activities
21,068

 
28,934

Net decrease in cash and cash equivalents
(2,101
)
 
(3,486
)
Cash and cash equivalents at beginning of period
16,362

 
19,803

Cash and cash equivalents at end of period
$
14,261

 
$
16,317

Supplemental disclosure of cash flow information
 
 
 
Cash paid during the period for interest
$
3,369

 
$
3,153

Cash paid during the period for income taxes
$
1,953

 
$
2,577

Noncash financing and investing activities
 
 
 
Transfer of loans to foreclosed property
$
1,536

 
$
2,896

Transfer of foreclosed assets to other assets
$
1,474

 
$
0

Transfer of HTM securities into the AFS security portfolio
$
21,482

 
$
0

See accompanying notes to consolidated financial statements.

7

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)


Note 1.  Organization and Summary of Significant Accounting Policies

Valley Financial Corporation (the "Company") was incorporated under the laws of the Commonwealth of Virginia on March 15, 1994, primarily to serve as a holding company for Valley Bank (the "Bank"), which opened for business on May 15, 1995. The Company's fiscal year end is December 31.

The consolidated financial statements of the Company conform to generally accepted accounting principles and to general banking industry practices. The interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments of a normal recurring nature which are necessary for a fair presentation of the consolidated financial statements herein have been included. The consolidated financial statements herein should be read in conjunction with the Company's 2013 Annual Report on Form 10-K.

Interim financial performance is not necessarily indicative of performance for the full year.

The Company reports its activities as a single business segment.

Use of Estimates
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Subsequent Events
In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

Recent and Future Accounting Considerations
In August 2014, the FASB issued guidance that is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. In connection with preparing financial statements, management will need to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the organization’s ability to continue as a going concern within one year after the date that the financial statements are issued. The amendments will be effective for the Company for annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. The Company does not expect these amendments to have a material effect on its financial statements.

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

Note 2.  Securities

The carrying values, unrealized gains, unrealized losses, and approximate fair values of available-for-sale and held-to-maturity investment securities at September 30, 2014 are shown in the tables below. As of September 30, 2014, investment securities with amortized costs and fair values of $110,695 and $109,308 respectively, were pledged as collateral for public deposits, a line of credit available from the Federal Home Loan Bank, customer sweep accounts, and for other purposes as required or permitted by law.

On May 30, 2014, the Company transferred all of its investment and mortgage-backed securities classified as held to maturity to available for sale. Based on changes in the current rate environment, management elected this change in an effort to more effectively manage the investment portfolio, including subsequently selling some securities that were formerly classified as held to maturity. The amortized cost of the securities that were transferred totaled $21,482 and the net unrealized gain related to these securities totaled $961 on the date of the transfer. As a result of the transfer and subsequent sales, the Company believes it has tainted its held to maturity classification and judgment will be required in the future in determining when circumstances have changed such that management can assert with a great degree of credibility that it has the intent and ability to hold debt securities to maturity. Based on this guidance, the Company does not expect to classify any securities as held to maturity within the near future.

8

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)


The amortized costs, gross unrealized gains and losses, and approximate fair values of securities available-for-sale (“AFS”) as of September 30, 2014 and December 31, 2013 were as follows:

 
Amortized
Unrealized
Unrealized
 
September 30, 2014
Cost
Gains
Losses
Fair Values
U.S. Government and federal agency
$
14,104

$
97

$
(266
)
$
13,935

Government-sponsored enterprises *
31,073

0

(1,197
)
29,876

Mortgage-backed securities
94,862

341

(906
)
94,297

Collateralized mortgage obligations
13,642

49

(109
)
13,582

States and political subdivisions
32,517

443

(314
)
32,646

 
$
186,198

$
930

$
(2,792
)
$
184,336

December 31, 2013




U.S. Government and federal agency
$
10,844

$
13

$
(550
)
$
10,307

Government-sponsored enterprises *
33,580

0

(2,269
)
31,311

Mortgage-backed securities
74,375

132

(2,118
)
72,389

Collateralized mortgage obligations
9,261

40

(107
)
9,194

States and political subdivisions
38,896

0

(2,236
)
36,660

 
$
166,956

$
185

$
(7,280
)
$
159,861

* Such as FNMA, FHLMC and FHLB.

There were no securities classified as held-to-maturity (“HTM”) as of September 30, 2014. The amortized costs, gross unrealized gains and losses, and approximate fair values of securities HTM as of December 31, 2013 were as follows:
December 31, 2013
 
 
 
 
U.S. Government and federal agency
$
7,470

$
161

$
(76
)
$
7,555

Mortgage-backed securities
147

9

0

156

Collateralized mortgage obligations
93

5

0

98

States and political subdivisions
14,282

407

(27
)
14,662

 
$
21,992

$
582

$
(103
)
$
22,471


The following tables present the maturity ranges of AFS securities as of September 30, 2014 and the weighted average yields of such securities. Maturities may differ from scheduled maturities on mortgage-backed securities and collateralized mortgage obligations because the mortgages underlying the securities may be repaid prior to the scheduled maturity date. Maturities on all other securities are based on the contractual maturity. The weighted average yields are calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. Weighted average yields on tax-exempt obligations have been computed on a taxable equivalent basis using a tax rate of 34%.


9

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Investment Portfolio Maturity Distribution
 
Available-for-Sale
 
Amortized
Fair
 
In thousands
Costs
Value
Yield
U.S. Government and federal agency:
 
 
 
After five but within ten years
$
8,492

$
8,395

2.58
%
After ten years
5,612

5,540

2.70
%
Government-sponsored enterprises:






After one but within five years
10,553

10,330

1.35
%
After five but within ten years
10,547

10,254

1.83
%
After ten years
9,973

9,292

2.85
%
Obligations of states and subdivisions:






After one but within five years
1,620

1,651

2.60
%
After five but within ten years
13,749

13,716

2.54
%
After ten years
17,148

17,279

3.55
%
Mortgage-backed securities
94,862

94,297

2.11
%
Collateralized mortgage obligations
13,642

13,582

2.21
%
Total
$
186,198

$
184,336

 
 
 
 
 
Total Securities by Maturity Period
 
 
 
After one but within five years
$
12,173

$
11,981

 
After five but within ten years
32,788

32,365

 
After ten years
32,733

32,111

 
Mortgage-backed securities*
94,862

94,297

 
Collateralized mortgage obligations*
13,642

13,582

 
Total by Maturity Period
$
186,198

$
184,336

 

*  Maturities on mortgage-backed securities and collateralized mortgage obligations are not presented in this table because maturities may differ substantially from contractual terms due to early repayments of principal.

The following tables detail unrealized losses and related fair values in the Company’s AFS and HTM investment securities portfolios.  This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of September 30, 2014 and December 31, 2013, respectively.

 
Temporarily Impaired Securities in AFS Portfolio
In thousands
Less than 12 months
Greater than 12 months
Total
 
 
Unrealized
 
Unrealized
 
Unrealized
September 30, 2014
Fair Value
Losses
Fair Value
Losses
Fair Value
Losses
U.S. Government and federal agency
$
0

$
0

$
7,536

$
(266
)
$
7,536

$
(266
)
Government-sponsored enterprises
0

0

26,426

(1,197
)
26,426

(1,197
)
Mortgage-backed securities
30,941

(135
)
33,673

(771
)
64,614

(906
)
Collateralized mortgage obligations
6,134

(53
)
1,840

(56
)
7,974

(109
)
States and political subdivisions
1,684

(13
)
12,988

(301
)
14,672

(314
)
 
$
38,759

$
(201
)
$
82,463

$
(2,591
)
$
121,222

$
(2,792
)

10

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

 
Temporarily Impaired Securities in AFS Portfolio
In thousands
Less than 12 months
Greater than 12 months
Total
 
 
Unrealized
 
Unrealized
 
Unrealized
December 31, 2013
Fair Value
Losses
Fair Value
Losses
Fair Value
Losses
U.S. Government and federal agency
$
9,287

$
(550
)
$
0

$
0

$
9,287

$
(550
)
Government-sponsored enterprises
16,797

(1,236
)
11,064

(1,033
)
27,861

(2,269
)
Mortgage-backed securities
62,336

(2,019
)
1,777

(99
)
64,113

(2,118
)
Collateralized mortgage obligations
5,050

(107
)
5

0

5,055

(107
)
States and political subdivisions
30,950

(1,744
)
4,838

(492
)
35,788

(2,236
)
 
$
124,420

$
(5,656
)
$
17,684

$
(1,624
)
$
142,104

$
(7,280
)

There were no securities classified as HTM as of September 30, 2014. Temporarily impaired securities in the HTM portfolio as of December 31, 2013 are detailed in the table below:

 
Temporarily Impaired Securities in HTM Portfolio
In thousands
Less than 12 months
Greater than 12 months
Total
 
 
Unrealized
 
Unrealized
 
Unrealized
December 31, 2013
Fair Value
Losses
Fair Value
Losses
Fair Value
Losses
U.S. Government and federal agency
$
2,387

$
(76
)
$
0

$
0

$
2,387

$
(76
)
States and political subdivisions
1,842

(27
)
0

0

1,842

(27
)
 
$
4,229

$
(103
)
$
0

$
0

$
4,229

$
(103
)

Management considers the nature of the investment, the underlying causes of the decline in the market value and the severity and duration of the decline in market value in determining if impairment is other than temporary.  Consideration is given to (1)the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. At September 30, 2014, there were fifty-one securities in the AFS portfolio with an unrealized loss for a period greater than 12 months of $2,591. As of September 30, 2014, management believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.  The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased.  The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline.  Management does not believe such securities are other-than-temporarily impaired due to reasons of credit quality.  Accordingly, as of September 30, 2014, management believes the impairments detailed in the table above are temporary and no impairment loss has been realized in the Company's consolidated income statement.


11

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Note 3.  Loans and Allowance for Loan and Lease Losses

The major components of loans in the consolidated balance sheets at September 30, 2014 and December 31, 2013 are as follows:
In thousands
9/30/2014
12/31/2013
Commercial
$
81,849

$
88,119

Real estate:
 
 
Commercial real estate
289,846

278,215

Construction real estate
52,230

44,368

Residential real estate
177,197

155,280

Consumer
5,472

4,336

Deferred loan fees, net
(53
)
42

Gross loans
606,541

570,360

Allowance for loan losses
(6,535
)
(7,200
)
Net loans
$
600,006

$
563,160


Substantially all one-four family residential and commercial real estate loans collateralize the line of credit available from the Federal Home Loan Bank and substantially all commercial and construction loans collateralize the line of credit with the Federal Reserve Bank of Richmond Discount Window.  The aggregate amount of deposit overdrafts that have been reclassified as loans and included in the consumer category in the above table as of September 30, 2014 and December 31, 2013 was $193 and $82, respectively.

Loan Origination.  The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management and the Board of Directors review and approve these policies and procedures on a periodic basis. A reporting system supplements the review process by providing management and the Board of Directors with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

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

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate market or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus income producing loans. At September 30, 2014, approximately 41% of the outstanding principal balance of the Company’s commercial real estate loans was secured by owner-occupied properties and 50% was secured by income-producing properties.


12

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

With respect to construction and development loans that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by recurring on-site inspections during the construction phase and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Residential real estate loans are secured by deeds of trust on 1-4 family residential properties.  The Bank also serves as a correspondent lender for residential real estate loans placed in the secondary market.  There are occasions when a borrower or the real estate does not qualify under secondary market criteria, but the loan request represents a reasonable credit risk.  On these occasions, if the loan meets the Bank’s internal underwriting criteria, the loan will be closed and placed in the Company’s portfolio.  Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of collateral.

The Company routinely makes consumer loans, both secured and unsecured, for financing automobiles, home improvements, education, and personal investments.  The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision.  Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property.  Negative changes in a customer’s financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk.  In addition, deterioration in collateral value can add risk to consumer loans.

Risk Management. It is the Company’s policy that loan portfolio credit risk shall be continually evaluated and categorized on a consistent basis.  The Board of Directors recognizes that commercial, commercial real estate and construction lending involve varying degrees of risk, which must be identified, managed, and monitored through established risk rating procedures. Management’s ability to accurately segment the loan portfolio by the various degrees of risk enables the Bank to achieve the following objectives:

1.
Assess the adequacy of the Allowance for Loan and Lease Losses;
2.
Identify and track high risk situations and ensure appropriate risk management;
3.
Conduct portfolio risk analysis and make informed portfolio planning and strategic decisions; and
4.
Provide risk profile information to management, regulators and independent accountants as requested in a timely manner.

There are three levels of accountability in the risk rating process:
1.
Risk Identification -  The primary responsibility for risk identification lies with the account officer.  It is the account officer's responsibility for the initial and ongoing risk rating of all notes and commitments in his or her portfolio.  The account officer is the one individual who is closest to the credit relationship and is in the best position to identify changing risks.  Account officers are required to continually review the risk ratings for their credit relationships and make timely adjustments, up or down, at the time the circumstances warrant a change.  Account officers are responsible for ensuring that accurate and timely risk ratings are maintained at all times.   Account officers are allowed a maximum 30-day period to assess current financial information (e.g. prepare credit analysis) which may influence the current risk rating. Account officers are required to review the risk ratings of loans assigned to their portfolios on a monthly basis and to certify to the accuracy of the ratings.  Certifications are submitted to the Chief Credit Officer and Chief Lending Officer for review.  All risk rating changes (upgrades and downgrades) must be approved by the Chief Credit Officer prior to submission for input into the Commercial Loan System.
2.
Risk Supervision -  In addition to the account officer’s process of assigning and managing risk ratings, the Chief Credit Officer is responsible for periodically reviewing the risk rating process employed by the account officers.  Through credit administration, the Chief Credit Officer manages the credit process which, among other things, includes maintaining and managing the risk identification process.  The Chief Credit Officer is responsible for the accuracy and timeliness of account officer risk ratings and has the authority to override account officer risk ratings and initiate rating changes, if warranted.  Upgrades from a criticized or classified category to a pass category or upgrades within the

13

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

criticized/classified categories require the approval of the Senior Loan Committee or Directors’ Loan Committee based upon aggregate exposure. Upgrades must be reported to the Directors' Loan Committee and Board of Directors at their next scheduled meetings.
3.
Risk Monitoring - Valley Bank has a loan review program to provide an independent validation of portfolio quality. This independent review is intended to assess adherence to underwriting guidelines, proper credit analysis and documentation.  In addition, the loan review process is required to test the integrity, accuracy, and timeliness of account officer risk ratings and to test the effectiveness of the credit administration function's controls over the risk identification process.  Portfolio quality and risk rating accuracy are evaluated during regularly scheduled portfolio reviews.  Risk Management is required to report all loan review findings to the quarterly joint meeting of the Audit Committee and Directors’ Loan Committee.

Related party loans.  In the ordinary course of business, the Company has granted loans to certain directors, executive officers, significant shareholders and their affiliates (collectively referred to as “related parties”). These loans were made on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other unaffiliated persons, and do not involve more than normal credit risk or present other unfavorable features.

Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The following schedule is an aging of past due loans receivable by portfolio segment as of September 30, 2014 and December 31, 2013:
In thousands
30 - 59 Days Past Due
60 - 89 Days Past Due
Greater than 90 Days Past Due
Total Past Due
Current
Total Loans
Recorded Investment > 90 Days, Accruing
September 30, 2014
 
 
 
 
 
 
 
Commercial
$
0

$
0

$
201

$
201

$
81,648

$
81,849

$
0

Commercial real estate
 

 

 

 

 

 
 

Owner occupied
27

528

387

942

119,092

120,034

387

Income producing
4,061

0

1,288

5,349

139,773

145,122

0

Multifamily
0

0

0

0

24,690

24,690

0

Construction real estate
 

 

 

 

 

 
 

1 - 4 Family
0

0

0

0

18,560

18,560

0

Other
0

70

2,030

2,100

30,278

32,378

0

Farmland
0

0

0

0

1,292

1,292

0

Residential real estate
 

 

 

 

 

 
 

Equity Lines
72

0

0

72

27,940

28,012

0

1 - 4 Family
233

126

29

388

140,801

141,189

29

Junior Liens
22

0

0

22

7,974

7,996

0

Consumer
 

 

 

 

 

 
 

Credit Cards
35

0

0

35

1,217

1,252

0

Other
0

3

5

8

4,212

4,220

0

Deferred loan fees, net
0

0

0

0

(53
)
(53
)
0

Total
$
4,450

$
727

$
3,940

$
9,117

$
597,424

$
606,541

$
416



14

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

In thousands
30 - 59 Days Past Due
60 - 89 Days Past Due
Greater than 90 Days Past Due
Total Past Due
Current
Total Loans
Recorded Investment > 90 Days, Accruing
December 31, 2013
 
 
 
 
 
 
 
Commercial
$
186

$
0

$
384

$
570

$
87,549

$
88,119

$
0

Commercial real estate
 

 

 

 

 

 

 

Owner occupied
0

0

0

0

116,137

116,137

0

Income producing
0

20

0

20

137,319

137,339

0

Multifamily
0

0

0

0

24,739

24,739

0

Construction real estate
 

 

 

 

 

 

 

1 - 4 Family
5

0

0

5

17,434

17,439

0

Other
0

0

3,161

3,161

22,285

25,446

0

Farmland
0

0

0

0

1,483

1,483

0

Residential real estate
 

 

 

 

 

 

 

Equity Lines
449

0

54

503

26,731

27,234

0

1 - 4 Family
174

156

0

330

119,736

120,066

0

Junior Liens
44

0

0

44

7,936

7,980

0

Consumer
 

 

 

 

 

 

 

Credit Cards
13

0

0

13

1,316

1,329

0

Other
10

0

5

15

2,992

3,007

0

Deferred loan fees, net
0

0

0

0

42

42

0

Total
$
881

$
176

$
3,604

$
4,661

$
565,699

$
570,360

$
0


As noted in the chart above, total loans past due 30-59 days increased from December 31, 2013 to September 30, 2014 by $3,569 from $881 to $4,450. The increase in total accruing loans past due 30-59 days is primarily due to a borrower who became past due during the second quarter of 2014. As discussed last quarter, the Company has negotiated a forbearance agreement to allow the borrower sufficient time to bring the notes current and/or sell one or more pieces of real estate collateralizing the loan. At this time, the Company believes the loans are adequately secured.


15

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Nonaccrual Loans.  Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Loans will be placed on nonaccrual status automatically when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of collection.  In this case, the loan will continue to accrue interest despite its past due status.  When interest accrual is discontinued, all unpaid accrued interest is reversed and any subsequent payments received are applied to the outstanding principal balance. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.  The following is a schedule of loans receivable, by portfolio segment, on nonaccrual status as of September 30, 2014 and December 31, 2013:

In thousands
September 30, 2014
December 31, 2013
Commercial
$
201

$
383

Commercial real estate
 

 

Income Producing
1,287

0

Construction real estate
 

 

1 - 4 Family
0

0

Other
2,030

3,161

Residential real estate
 

 

Equity Lines
48

54

1 - 4 Family
0

62

Consumer
 

 

Other
5

5

Total
$
3,571

$
3,665

Had nonaccrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income in the amount of $202 during the nine months ended September 30, 2014; $222 during the year ended December 31, 2013, and $228 during the nine months ended September 30, 2013.  There was one restructured loan totaling $2,364 at September 30, 2014 compared to the four restructured loans totaling $2,922 at December 31, 2013.


16

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Impaired Loans.  Impaired loans are identified by the Company as loans in which it is determined to be probable that the borrower will not make interest and principal payments according to the contract terms of the loan.  In determining impaired loans, our credit administration department reviews past-due loans, examiner classifications, Bank classifications, and a selection of other loans to provide evidence as to whether the loan is impaired.  All loans rated as substandard are evaluated for impairment by the Bank’s Allowances for Loan and Lease Losses (“ALLL”) Committee.  Once classified as impaired, the ALLL Committee individually evaluates the total loan relationship, including a detailed collateral analysis, to determine the reserve appropriate for each one.  Any potential loss exposure identified in the collateral analysis is set aside as a specific reserve (valuation allowance) in the allowance for loan and lease losses.  If the impaired loan is subsequently resolved and it is determined the reserve is no longer required, the specific reserve will be taken back into income during the period the determination is made.  Impaired loans, or portions thereof, are charged off when deemed uncollectible.  Impaired loans as of September 30, 2014 and December 31, 2013 are set forth in the following table:

In thousands
Recorded Investment
Unpaid Principal Balance (1)
Related Allowance
Average Recorded Investment
Interest Income Recognized
September 30, 2014
 
 
 
 
 
With no related allowance:
 
 
 
 
 
Commercial
$
709

$
997

$
0

$
750

$
20

Commercial real estate
 

 

 

 

 

Owner occupied
2,779

2,779

0

2,787

145

Income producing
8,517

8,517

0

8,614

332

Construction real estate
 

 

 

 

 

1 - 4 Family
0

0

0

0

0

Other
2,100

4,866

0

2,381

3

Farmland
0

0

0

0

0

Residential real estate
 

 

 

 

 

Equity Lines
137

146

0

141

2

1 - 4 Family
479

479

0

488

23

Consumer
 

 

 

 

 

Other
5

10

0

5

0

Total loans with no allowance
$
14,726

$
17,794

$
0

$
15,166

$
525

 
 
 
 
 
 
Total loans with an allowance
$
0

$
0

$
0

$
0

$
0

Total:
 

 

 

 

 

Commercial
$
709

$
997

$
0

$
750

$
20

Commercial real estate
11,296

11,296

0

11,401

477

Construction real estate
2,100

4,866

0

2,381

3

Residential real estate
616

625

0

629

25

Consumer
5

10

0

5

0

Totals
$
14,726

$
17,794

$
0

$
15,166

$
525



17

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

In thousands
Recorded Investment
Unpaid Principal Balance (1)
Related Allowance
Average Recorded Investment
Interest Income Recognized
December 31, 2013
 
 
 
 
 
With no related allowance:
 
 
 
 
 
Commercial
$
1,570

$
1,706

$
0

$
1,433

$
50

Commercial real estate
 

 

 

 

 

Owner occupied
5,182

5,182

0

5,249

340

Income producing
4,538

4,538

0

4,577

287

Construction real estate
 

 

 

 

 

1 - 4 Family
580

580

0

489

23

Other
4,294

6,279

0

4,457

206

Farmland
171

171

0

175

10

Residential real estate
 

 

 

 

 

Equity Lines
493

500

0

499

21

1 - 4 Family
473

530

0

543

26

Consumer
 

 

 

 

 

Other
13

18

0

21

2

Total loans with no allowance
$
17,314

$
19,504

$
0

$
17,443

$
965

With an allowance recorded:
 

 

 

 

 

Construction real estate
 

 

 

 

 

Other
$
2,566

$
2,566

$
1,337

$
2,566

$
0

Residential real estate
 

 

 

 

 

1 - 4 Family
26

26

20

26

1

Total loans with an allowance
$
2,592

$
2,592

$
1,357

$
2,592

$
1

Total:
 

 

 

 

 

Commercial
$
1,570

$
1,706

$
0

$
1,433

$
50

Commercial real estate
9,720

9,720

0

9,826

627

Construction real estate
7,611

9,596

1,337

7,687

239

Residential real estate
992

1,056

20

1,068

48

Consumer
13

18

0

21

2

Totals
$
19,906

$
22,096

$
1,357

$
20,035

$
966

(1) Balances transferred to foreclosed assets are not included as unpaid principal balance.

Cash basis interest income on impaired loans was $550 for the nine months ended September 30, 2014 and $1,011 for the year ended December 31, 2013.

Credit Quality Indicators. The Company categorizes loans and leases 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. This categorization is made on all commercial, commercial real estate and construction and development loans.  The Company analyzes loans and leases individually by classifying the loans and leases as to credit risk. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings: 

Risk rated 1
Highest Caliber Credit – to qualify as a “1”, a credit must be either fully secured by cash or secured by a portfolio of marketable securities within margin.


18

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Risk rated 2
Very High Caliber Credit – to qualify as a “2”, a credit must be a borrower within an industry exhibiting strong trends.  The borrower must be a highly-rated individual or company whose management, profitability, liquidity, and leverage are very strong and above industry averages.  Borrower should show substantial liquidation net worth and income or alternative fund sources to retire the debt as agreed.

Risk rated 3
High Caliber Credit - to qualify as a “3”, the criteria of management, industry, profitability, liquidity, and leverage must be generally strong and comparable to industry averages.  Borrower should show above average liquidation net worth and sufficient income or alternative fund sources to retire the debt as agreed.

Risk rated 4
Satisfactory Credit – to qualify as a “4”, a credit should be performing relatively close to expectations, with adequate evidence that the borrower is continuing to generate adequate cash flow to service debt.  There should be no significant departure from the intended source and timing of repayment, and there should be no undue reliance on secondary sources of repayment.  To the extent that some variance exists in one or more criteria being measured, it may be offset by the relative strength of other factors and/or collateral pledged to secure the transaction.  A credit secured by a portfolio of marketable securities in an out-of-margin condition would qualify as a “4”.  Borrower should show average liquidation net worth and income sufficient to retire the debt on an amortizing basis.

Risk rated 5
Monitored Satisfactory Credit – there are certain satisfactory credits, which have elements of risk that the Bank chooses to monitor formally.  The objective of the monitoring process is to assure that no weaknesses develop in credits with certain financial or operating leverage, or credits, which are subject to cyclical economic or variable industry conditions.  Also included in this category are credits with positive operating trends and satisfactory financial conditions, which are achieving performance expectations at a slower pace than anticipated.  This rating may also include loans which exhibit satisfactory credit quality but which are improperly structured as evidenced by excessive renewals, unusually long repayment schedules, the lack of a specific repayment plan, or which exhibit loan policy exceptions or documentation deficiencies.

Risk rated 6
Special Mention – assets in this category are still adequately protected by the borrower’s capital adequacy and payment capability, but exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

Risk rated 7
Substandard - substandard loans are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Risk rated 8
Doubtful – an asset classified as doubtful has all the weaknesses inherent in one classified 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.  Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimate loss is deferred until its more exact status may be determined.  
 
Risk rated 9
Loss – assets classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

19

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)


As of  September 30, 2014 and December 31, 2013, and based on the most recent analysis performed at those dates, the risk category of loans and leases is as follows:

Internal Risk Rating Grades
 
 
 
 
 
In thousands
1-4
5
6
7
8
September 30, 2014
 

 

 

 

 

Commercial
$
20,714

$
59,609

$
25

$
1,300

$
201

Commercial real estate
 

 

 

 

 

Owner occupied
36,670

74,051

2,476

6,837

0

Income producing
18,806

114,645

2,332

9,339

0

Multifamily
13,304

11,386

0

0

0

Construction real estate
 

 

 

 

 

1 - 4 Family
6,073

10,076

1,305

1,106

0

Other
1,044

25,210

441

4,248

1,435

Farmland
211

916

0

165

0

Totals
$
96,822

$
295,893

$
6,579

$
22,995

$
1,636

Total:
 

 

 

 

 
Commercial
$
20,714

$
59,609

$
25

$
1,300

$
201

Commercial real estate
68,780

200,082

4,808

16,176

0

Construction real estate
7,328

36,202

1,746

5,519

1,435

Totals
$
96,822

$
295,893

$
6,579

$
22,995

$
1,636

December 31, 2013
 
 
 
 
 
Commercial
$
22,054

$
63,329

$
765

$
1,971

$
0

Commercial real estate
 

 

 

 

 
Owner occupied
36,025

70,048

2,694

7,370

0

Income producing
14,921

110,200

3,155

9,063

0

Multifamily
13,690

11,049

0

0

0

Construction real estate
 

 

 

 

 
1 - 4 Family
3,921

10,809

1,129

1,580

0

Other
874

14,943

441

9,188

0

Farmland
220

1,092

0

171

0

Totals
$
91,705

$
281,470

$
8,184

$
29,343

$
0

Total:
 

 

 

 

 
Commercial
$
22,054

$
63,329

$
765

$
1,971

$
0

Commercial real estate
64,636

191,297

5,849

16,433

0

Construction real estate
5,015

26,844

1,570

10,939

0

Totals
$
91,705

$
281,470

$
8,184

$
29,343

$
0


The loans classified as doubtful (risk rated 8) at September 30, 2014 is secured by land that is currently involved in litigation between the land owner and the Virginia Department of Transportation ("VDOT") regarding an imminent domain action brought by VDOT. The current appraisal supports the carrying value at September 30, 2014. There are no loans classified as 9 as of September 30, 2014 or December 31, 2013.


20

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

All consumer-related loans, including residential real estate are evaluated and monitored based upon payment activity.  Once a consumer-related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment.  At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances.
 
Risk Based on Payment Activity
Performing
Non-Performing
In thousands
9/30/2014
12/31/2013
9/30/2014
12/31/2013
Residential real estate
 
 
 
 
Equity Lines
$
27,964

$
27,180

$
48

$
54

1 - 4 Family
141,160

120,004

29

62

Junior Liens
7,996

7,980

0

0

Consumer
 

 

 

 

Credit Cards
1,252

1,329

0

0

Other
4,215

3,002

5

5

Totals
$
182,587

$
159,495

$
82

$
121

Total:
 

 

 

 

Residential real estate
$
177,120

$
155,164

$
77

$
116

Consumer
5,467

4,331

5

5

Totals
$
182,587

$
159,495

$
82

$
121


Allowance for Loan Losses

The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.

21

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)


Specific Valuation
The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan is added to the internal watch list, the ALLL Committee analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, and economic conditions affecting the borrower’s industry, among other things.

Historical Valuation
Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company uses a rolling 8-quarter analysis to determine its historical loss ratio for the specific pool. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the average balance of loans in the pool for the respective quarter. The loss factors used at September 30, 2014 and December 31, 2013 are as follows:
 
 
9/30/2014
12/31/2013
Commercial
0.255%
0.210%
Commercial real estate - Owner occupied
0.000%
0.000%
Commercial real estate - Income producing
0.000%
0.000%
Commercial real estate - Multifamily
0.000%
0.000%
Construction real estate - 1-4 Family
0.655%
0.420%
Construction real estate - Other
4.675%
2.230%
Construction real estate - Farmland
0.000%
0.000%
Residential real estate - Equity lines
0.257%
0.260%
Residential real estate - 1-4 Family
0.085%
0.360%
Residential real estate - Junior Liens
0.000%
0.000%
Consumer & credit cards
0.802%
0.590%
Loans held for sale
0.000%
0.000%

The Company applies the historical loss ratios to balances of all loans within each category to establish the reserve needed for this section of the allowance calculation. All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above.

As can be seen from the above table, the loss factors changed in several categories at September 30, 2014 as compared to December 31, 2013 based upon historical charge-offs experienced during the respective 8-quarter look-back periods.    The most significant change is in the construction real estate - other category as $1,887 of the $2,079 net charge-offs for the 2014 were in this category. The net effect of these changes is an approximate $570 increase in the reserve requirement for the historical valuation section of the allowance calculation at September 30, 2014. The remaining $190 increase in the historical loss section is due to loan growth in all of the categories.

General Valuation
General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in credit quality; (ii) trends in the volume of loans; (iii) the experience, ability and effectiveness of the bank’s lending management and staff; (iv) local economic trends and conditions; (v) credit concentration risk; (vi) current industry conditions; (vii) real estate market conditions; (viii) and large relationship credit risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a general allocation matrix to determine an

22

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

appropriate general valuation allowance, based on the risk assessment performed by management and the loss factors established.  Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.
 Environmental Factors
9/30/2014
6/30/2014
12/31/2013
Levels and trends in credit quality
0.15%
0.175%
0.15%
Trends in volume of loans
1.35%
1.35%
1.00%
Experience, ability, and depth of lending management and staff
0.00%
0.00%
0.00%
Local economic trends and conditions
0.20%
0.20%
0.25%
Credit concentration risk
0.05%
0.05%
0.05%
Current industry conditions/general economic conditions
0.05%
0.05%
0.10%
Commercial Real Estate Devaluation
0.20%
0.20%
0.25%
Residential Real Estate Devaluation
0.15%
0.15%
0.15%
Credit concentration risk - large relationships > $8 Million
0.15%
0.30%
0.30%

All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above.  The loss factors are multiplied by the loan balances related to each environmental factor at quarter-end.  Therefore for example, only commercial real estate balances are used in the determination for the estimated loss for the commercial real estate devaluation factor. 

The Company reduced the loss factor associated with the credit quality environmental factor due to the improvement in impaired loans, watchlist loans, nonaccrual loans and charge-offs during the quarter. Additionally, the Company reduced the loss factor related to large relationships due to the significant reduction in the balances of these large relationships that were credit risk rated watchlist at September 30, 2014. The net effect of these changes on the increased balances is an approximate $201 decrease in the environmental factor section of the allowance calculation as compared to June 30, 2014.

As a result of the Company's analysis, changes in the allowance for loan losses for the nine months ended September 30, 2014 by segment are as follows:

In thousands
Beginning
 
 
 
Ending
September 30, 2014
Balance
Charge-offs
Recoveries
Provision
Balance
Commercial
$
544

$
(157
)
$
16

$
121

$
524

Commercial real estate
2,587

0

0

166

2,753

Construction real estate
2,894

(1,988
)
12

1,562

2,480

Residential real estate
1,081

(25
)
66

(428
)
694

Consumer
50

(5
)
2

32

79

Unallocated
44

0

0

(39
)
5

Total
$
7,200

$
(2,175
)
$
96

$
1,414

$
6,535




23

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

As of September 30, 2014 and December 31, 2013, loans individually and collectively evaluated for impairment, by loan portfolio segment, and the corresponding allowance are as follows:

 
Individually Evaluated for Impairment
 
9/30/2014
12/31/2013
In thousands
Allowance
Total Loans
Allowance
Total Loans
Commercial
$
0

$
709

$
0

$
1,570

Commercial real estate
0

11,296

0

9,720

Construction real estate
0

2,100

1,337

7,611

Residential real estate
0

616

20

992

Consumer
0

5

0

13

Total
$
0

$
14,726

$
1,357

$
19,906


 
Collectively Evaluated for Impairment
 
9/30/2014
12/31/2013
In thousands
Allowance
Total Loans
Allowance
Total Loans
Commercial
$
524

$
81,140

$
544

$
86,549

Commercial real estate
2,753

278,550

2,587

268,495

Construction real estate
2,480

50,130

1,557

36,757

Residential real estate
694

176,581

1,061

154,288

Consumer
79

5,467

50

4,323

Unallocated
5

(53
)
44

42

Total
$
6,535

$
591,815

$
5,843

$
550,454


Troubled Debt Restructurings ("TDRs”)

Modifications of terms for loans and their inclusion as TDRs are based on individual facts and circumstances.  Loan modifications that are included as TDRs may involve either an increase or reduction of the interest rate, extension of the term of the loan, or deferral of principal payments, regardless of the period of the modification.  The loans included in all loan classes as TDRs at September 30, 2014 had either an interest rate modification or a deferral of principal payments, which we consider to be a concession.  All loans designated as TDRs were modified due to financial difficulties experienced by the borrower.

There were no TDRs identified during the three months ended September 30, 2014 and 2013.

TDR Defaults are those TDRs that were greater than 90 days past due, and aligns with our internal definition of default for those loans not identified as TDRs.  The Company did not experience any TDR defaults during the three month periods ended September 30, 2014 or 2013.


24

VALLEY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
September 30, 2014 (Unaudited)
(In thousands, except share and per share data)

Note 4.  Foreclosed Assets

The following table summarizes the activity in foreclosed assets for the nine months ended September 30, 2014 and the year ended December 31, 2013:
 
9/30/2014
12/31/2013
Balance, beginning of period
$
19,705

$
21,364

Additions
1,536

2,896

Capitalized items
188

794

Sales
(7,800
)
(4,284
)
Transfers to other assets (1)
(1,474
)
0

Valuation adjustments
(174
)
(1,125
)
Gain (loss)
13

60

Balance, end of period
$
11,994

$
19,705

(1) Transfers to Other Assets represents the net present value of cash flow proceeds of a tax incentive agreement associated with a building that was sold during the second quarter.

Note 5.  Earnings Per Share

Basic earnings per share are based upon the weighted average number of common shares outstanding during the period.  The weighted average common shares outstanding for the diluted earnings per share computations were adjusted to reflect the assumed conversion of shares available under stock options.  The following tables summarize earnings per share and the shares utilized in the computations for the three months ended September 30, 2014 and 2013, respectively: 

 
Net Income
Available to Common
Shareholders (000s)
Weighted Average
Common Shares
Per Share Amount
Quarter ended September 30, 2014
 
 
 
Basic earnings per common share
$
1,805<