BAY BANKS OF VIRGINIA INC - FORM 10-Q

BAY BANKS OF VIRGINIA INC - FORM 10-Q - August 10, 2016

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EX-32.1 - EX-32.1 - BAY BANKS OF VIRGINIA INC	d209960dex321.htm
EX-31.2 - EX-31.2 - BAY BANKS OF VIRGINIA INC	d209960dex312.htm
EX-31.1 - EX-31.1 - BAY BANKS OF VIRGINIA INC	d209960dex311.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2016

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

COMMISSION FILE NUMBER: 0-22955

BAY BANKS OF VIRGINIA, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

VIRGINIA

54-1838100

(STATE OR OTHER JURISDICTION OF

INCORPORATION OR ORGANIZATION)

(I.R.S. EMPLOYER

IDENTIFICATION NO.)

100 SOUTH MAIN STREET, KILMARNOCK, VA 22482

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(804) 435-1171

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

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

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

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

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

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

4,774,856 shares of common stock on August 1, 2016

FORM 10-Q

For the interim period ending June 30, 2016

INDEX


PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS JUNE 30, 2016 (UNAUDITED) AND DECEMBER 31, 2015			3

CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2016 AND 2015 (UNAUDITED)			4

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2016 AND 2015 (UNAUDITED)			5

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE SIX MONTHS ENDED JUNE 30, 2016 (UNAUDITED)			5

CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2016 AND 2015 (UNAUDITED)			6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)			7

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			25

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			31

ITEM 4. CONTROLS AND PROCEDURES			32

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS			32

ITEM 1A. RISK FACTORS			32

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			32

ITEM 3. DEFAULTS UPON SENIOR SECURITIES			32

ITEM 4. MINE SAFETY DISCLOSURES			32

ITEM 5. OTHER INFORMATION			32

ITEM 6. EXHIBITS			33

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED BALANCE SHEETS


	June 30, 2016			December 31, 2015 (1)
(Dollars in thousands)	(unaudited)
ASSETS
Cash and due from banks	$	5,141		$	4,969
Interest-bearing deposits		20,050			15,330
Certificates of deposit		5,456			5,735
Federal funds sold		1,546			271
Securities available-for-sale, at fair value		54,012			54,090
Restricted securities		2,422			2,731
Loans receivable, net of allowance for loan losses of $3,547 and $4,223		347,755			343,323
Loans held for sale		2,425			270
Premises and equipment, net		11,231			11,646
Accrued interest receivable		1,270			1,318
Other real estate owned, net		2,641			1,870
Bank owned life insurance		7,719			7,595
Goodwill		2,808			2,808
Mortgage servicing rights		620			658
Other assets		3,243			3,682

Total assets	$	468,339		$	456,296

LIABILITIES
Noninterest-bearing deposits	$	74,157		$	65,842
Savings and interest-bearing demand deposits		177,075			166,628
Time deposits		127,797			127,388

Total deposits		379,029			359,858
Securities sold under repurchase agreements		8,182			7,161
Federal Home Loan Bank advances		30,000			40,000
Subordinated debt, net of issuance costs		6,852			6,844
Other liabilities		3,064			2,864

Total liabilities		427,127			416,727

SHAREHOLDERS’ EQUITY
Common stock ($5 par value; authorized - 10,000,000 shares; outstanding - 4,774,856 and 4,774,856 shares, respectively)		23,874			23,874
Additional paid-in capital		2,828			2,812
Retained earnings		14,769			13,659
Accumulated other comprehensive loss, net		(259	)		(776	)

Total shareholders’ equity		41,212			39,569

Total liabilities and shareholders’ equity	$	468,339		$	456,296

(1)	Derived from Audited December 31, 2015 Financial Statements

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)


	For the three months ended						For the six months ended
(Dollars in thousands except per share amounts)	June 30, 2016			June 30, 2015			June 30, 2016			June 30, 2015
INTEREST INCOME
Loans, including fees	$	4,013		$	3,715		$	7,987		$	7,390
Securities:
Taxable		211			132			418			258
Tax-exempt		135			86			271			174
Federal funds sold		1			—			1			—
Interest-bearing deposit accounts		12			13			27			21
Certificates of deposit		20			9			42			17

Total interest income		4,392			3,955			8,746			7,860

INTEREST EXPENSE
Deposits		641			570			1,286			1,086
Federal funds purchased		1			—			1			—
Securities sold under repurchase agreements		4			2			6			4
Subordinated debt		118			42			236			42
FHLB advances		117			87			242			172

Total interest expense		881			701			1,771			1,304

Net interest income		3,511			3,254			6,975			6,556

Provision for loan losses		183			205			148			270

Net interest income after provision for loan losses		3,328			3,049			6,827			6,286

NON-INTEREST INCOME
Income from fiduciary activities		236			171			443			392
Service charges and fees on deposit accounts		228			226			455			449
VISA-related fees		59			62			105			109
Non-deposit product income		74			117			180			247
Other service charges and fees		149			139			297			270
Secondary market lending income		223			140			300			238
Increase in cash surrender value of life insurance		61			62			124			125
Net gains on sale of securities available for sale		104			6			110			2
Other real estate losses		(53	)		(41	)		(88	)		(80	)
Net losses on the disposal of fixed assets		—			(7	)		—			(7	)
Other income		3			42			16			57

Total non-interest income		1,084			917			1,942			1,802

NON-INTEREST EXPENSES
Salaries and employee benefits		1,815			1,840			3,870			3,888
Occupancy expense		451			442			899			877
Software maintenance		181			145			342			290
Bank franchise tax		61			50			121			98
VISA expense		22			33			61			64
Telephone expense		35			33			66			66
FDIC assessments		103			64			184			129
Foreclosure property expense		17			11			29			21
Consulting expense		74			90			129			165
Other expense		877			908			1,615			1,663

Total non-interest expenses		3,636			3,616			7,316			7,261

Net income before income taxes		776			350			1,453			827
Income tax expense		190			56			343			152

Net income	$	586		$	294		$	1,110		$	675

*Basic Earnings Per Share*
Average basic shares outstanding		4,774,856			4,802,032			4,774,856			4,805,922
Earnings per share, basic	$	0.12		$	0.06		$	0.23		$	0.14
*Diluted Earnings Per Share*
Average diluted shares outstanding		4,794,783			4,819,322			4,792,574			4,819,487
Earnings per share, diluted	$	0.12		$	0.06		$	0.23		$	0.14

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)


	For the three months ended						For the six months ended
	June 30,						June 30,
(Dollars in thousands)	2016			2015			2016			2015
Net income	$	586		$	294		$	1,110		$	675
Other comprehensive income:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period		385			(564	)		893			(264	)
Deferred tax (expense) benefit		(130	)		192			(303	)		90
Reclassification of net securities gains recognized in net income		(104	)		(6	)		(110	)		(2	)
Deferred tax expense		35			2			37			1

Unrealized gains (losses) adjustment, net of tax		186			(376	)		517			(175	)

Defined benefit pension plan:
Net periodic pension cost		7			3			12			4
Net pension loss		(7	)		(3	)		(12	)		(4	)
Deferred tax benefit		—			—			—			—

Defined benefit pension plan adjustment, net of tax		—			—			—			—

Post retirement benefit plan:
Net periodic cost		12			13			25			26
Net loss		(12	)		(13	)		(25	)		(26	)
Deferred tax benefit		—			—			—			—

Post retirement benefit plan adjustment, net of tax		—			—			—			—

Total other comprehensive income (loss)		186			(376	)		517			(175	)

Comprehensive income (loss)	$	772		$	(82	)	$	1,627		$	500

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)


(Dollars in thousands, except share data or amounts)	Shares of Common Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Loss			Total Shareholders’ Equity
Six Months ended June 30, 2016
Balance at beginning of period		4,774,856	$	23,874	$	2,812	$	13,659	$	(776	)	$	39,569
Net income		—		—		—		1,110		—			1,110
Other comprehensive income		—		—		—		—		517			517
Stock-based compensation expense		—		—		16		—		—			16

Balance at end of period		4,774,856	$	23,874	$	2,828	$	14,769	$	(259	)	$	41,212

See Notes to Consolidated Financial Statements.

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)


	For the Six Months Ended June 30,
(Dollars in thousands)	2016			2015
Cash Flows From Operating Activities
Net income	$	1,110		$	675
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		528			478
Net amortization and accretion of securities		217			179
Amortization of subordinated debt issuance costs		8			1
Provision for loan losses		148			270
Stock compensation expense		16			17
Deferred tax benefit		(6	)		(12	)
Gain on securities available-for-sale		(110	)		(2	)
Increase in OREO valuation allowance		53			72
Loss on sale of other real estate		35			8
Loss on the disposal of fixed assets		—			7
Mortgage servicing rights		38			(36	)
Loan originations for sale		(9,035	)		(5,801	)
Loan sales		8,274			5,200
Gain on sold loans		(221	)		(109	)
Increase in cash surrender value of life insurance		(124	)		(125	)
Decrease (increase) in accrued income and other assets		227			(124	)
Increase in other liabilities		202			270

Net cash provided by operating activities		1,360			968

Cash Flows From Investing Activities
Proceeds from maturities and principal paydowns of available-for-sale securities		1,683			1,595
Proceeds from sales and calls of available-for-sale securities		9,097			2,076
Maturities of certificates of deposit		248			248
Purchases of available-for-sale securities		(9,995	)		(8,815	)
Sales of restricted securities		309			169
Increase in federal funds sold		(1,275	)		(2,068	)
Loan (originations) and principal collections, net		(6,840	)		(18,480	)
Proceeds from sale of other real estate		227			99
Purchases of premises and equipment		(114	)		(737	)

Net cash used in investing activities		(6,660	)		(25,913	)

Cash Flows From Financing Activities
Net increase in demand, savings, and other interest-bearing deposits		18,762			28,057
Net increase (decrease) in time deposits		409			(2,041	)
Repurchase of common stock		—			(168	)
Net increase in securities sold under repurchase agreements		1,021			2,775
Issuance of subordinated debt, net		—			6,842
Decrease in Federal Home Loan Bank advances		(10,000	)		(5,000	)

Net cash provided by financing activities		10,192			30,465

Net increase in cash and due from banks		4,892			5,520
Cash and cash equivalents (including interest-earning deposits) at beginning of period		20,299			20,965

Cash and cash equivalents (including interest-earning deposits) at end of period	$	25,191		$	26,485

Supplemental Schedule of Cash Flow Information
Cash paid for:
Interest	$	1,758		$	1,251

Income taxes	$	70			390

Non-cash investing and financing:
Unrealized gain (loss) on investment securities		783			(266	)

Change in fair value of pension and post-retirement obligation		—			—

Loans transferred to other real estate owned		1,203			129

Loans originated to facilitate sale of OREO		116			118

Changes in deferred taxes resulting from OCI transactions		266			90

Transfer of loans to held for sale		1,173			—

See Notes to Consolidated Financial Statements.

Notes to Consolidated Financial Statements (Unaudited)

Note 1: General

Bay Banks of Virginia, Inc. (the “Company”) owns 100% of the Bank of Lancaster (the “Bank”), 100% of Bay Trust Company, Inc. (the “Trust Company”) and 100% of Steptoes Holdings, LLC (“Steptoes Holdings”). The consolidated financial statements include the accounts of the Bank, the Trust Company, Steptoes Holdings and Bay Banks of Virginia, Inc.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to the general practices within the banking industry. In management’s opinion, all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year or for any other interim periods. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Certain amounts presented in the consolidated financial statements of prior periods have been reclassified to conform to current year presentations. The reclassifications had no effect on net income, net income per share or shareholders’ equity as previously reported.

Note 2: Significant Accounting Policies

Certificates of Deposit

Prior to January 1, 2016, the Company included its investments in certificates of deposit on the consolidated balance sheets in securities available-for sale, at fair value. Effective January 1, 2016, the Company is presenting certificates of deposit separately on the consolidated balance sheets and removing them from the available-for-sale category. As of December 31, 2015, the unrealized gain related to the certificates of deposit included in securities available-for-sale was $31 thousand and the tax effected unrealized gain included in accumulated other comprehensive income was $20 thousand. The unrealized gain and related impact were reversed the first quarter of 2016.

Loans

The Company grants mortgage loans on real estate, commercial and industrial loans and consumer and other loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans on real estate. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market areas.

Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, and charge-offs. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the related loan yield over the contractual term of the loan, adjusted for early pay-offs, where applicable.

The accrual of interest is generally discontinued at the time a loan is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Payments received for loans no longer accruing interest are applied to the unpaid principal balance. Loans greater than 90 days past due may remain on accrual status if the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are charged off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual and past due policies are materially the same for all types of loans.

All interest accrued but not collected for loans that are placed on non-accrual or charged off are reversed against interest income. Any interest received on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well secured and in the process of collection.

Allowance for loan losses (“ALL”)

The ALL reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the ALL each quarter. To determine the total ALL, the Company estimates the reserves needed for each homogenous segment of the portfolio, plus any loans analyzed individually for impairment. Considerations include historical experience, the nature and volume of the loan portfolio, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing local and national economic conditions, and internal policies and procedures including credit risk management and underwriting. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as conditions change.

Management employs a risk rating system to evaluate and consistently categorize loan portfolio credit risk. Loans assigned risk rating grades include all commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250 thousand with chronic delinquency, and troubled debt restructures (“TDRs”). The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades are evaluated as new information becomes available for each borrowing relationship or at least quarterly. All other loans not specifically assigned a risk rating grade are monitored as a discrete pool of loans generally based on delinquency status. Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention. Any collateral may not be fully adequate to secure the loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The ALL consists of specific, general, and unallocated components. The specific component is determined by identifying impaired loans (as described below) then evaluating each one to calculate the amount of impairment. Impaired loans measured for impairment generally include: (1) non-accruing Special mention, Substandard and Doubtful loans in excess of $250,000; (2) Substandard and Doubtful loans in excess of $500,000; (3) Special Mention loans in excess of $500,000 if any of the loans in the relationship are more than 30 days past due or if the borrower has filed for bankruptcy; and (4) all TDRs. A specific allowance arises when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component collectively evaluates smaller commercial loans, residential mortgages and consumer loans, grouped into segments and classes. Historical loss experience is calculated and applied to each segment or class, then adjusted for qualitative factors. Qualitative factors include changes in the local and national economic outlook, including unemployment, interest rates, inflation rates and real estate trends; the level and trend of past due and nonaccrual loans; strength of policies and procedures; and oversight of credit risk and quality of underwriting. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained if needed to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

The specific component of the ALL calculation accounts for the loan loss reserve necessary on impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. 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 considered impaired. Management determines the significance of payment delays and payment shortfalls on a 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. Accrual of interest may or may not be discontinued for any given impaired loan. Impairment is measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Because large groups of smaller balance homogeneous loans are collectively evaluated for impairment, the Company does not generally separately identify smaller balance individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a troubled debt restructuring agreement.

The general component of the ALL calculation collectively evaluates groups of loans in segments or classes, as noted above. The segments are: (1) Mortgage loans on real estate; (2) Commercial and industrial loans; and (3) Consumer and other loans. The segment for Mortgage loans on real estate is disaggregated into the following classes: (1) Construction, land and land development; (2) Farmland; (3) Residential first mortgages; (4) Residential revolving and junior mortgages; (5) Commercial mortgages (non-owner-occupied); and (6) Commercial mortgages (owner-occupied). Loans in segment 1 are secured by real estate. Loans in segments 2 and 3 are secured by other types of collateral or are unsecured. A given segment or class may not reflect the purpose of a loan. For example, a business owner may provide his residence as collateral for a loan to his company, in which case the loan would be grouped in a residential mortgage class. Historical loss factors are calculated for the prior 19 quarters by segment and class, and then applied to the current balances in each segment and class. Finally, qualitative factors are applied to each segment and class.

Construction and development loans carry risks that the project will not be finished according to schedule or according to budget and the value of the collateral, at any point in time, may be less than the principal amount of the loan. These loans also bear the risk that the general contractor may face financial pressure unrelated to the project. Loans secured by land, farmland and residential mortgages carry the risk of

continued credit-worthiness of the borrower and changes in value of the underlying real estate collateral. Commercial mortgages and commercial and industrial loans carry risks associated with the profitable operation of a business and its related cash flows. Additionally, commercial and industrial loans carry risks associated with the value of collateral other than real estate which may depreciate over time. Consumer loans carry risks associated with the continuing credit-worthiness of the borrower and are more likely than real estate loans to be adversely affected by divorce, unemployment, personal illness or bankruptcy of an individual. Consumer loans secured by automobiles carry risks associated with rapidly depreciating collateral. Consumer loans include credit cards, which are unsecured.

The summation of the specific, general and unallocated components results in the total estimated ALL. Management may also include an unallocated component to cover uncertainties in the level of probable losses. This estimate is inherently subjective and actual losses could be greater or less than the estimates.

Additions to the ALL are made by charges to earnings through the provision for loan losses. Charge-offs result from credit exposures deemed to be uncollectible and the ALL is reduced by these. Recoveries of previously charged off amounts are credited back to the ALL. Charge-off policies are materially the same for all types of loans.

Mortgage servicing rights (“MSRs”)

MSRs are included on the consolidated balance sheet and recorded at fair value on an ongoing basis. Changes in the fair value of the MSRs are recorded in the results of operations. A fair value analysis of MSRs is performed on a quarterly basis.

Note 3: Amendments to the Accounting Standards Codification

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, Financial Instruments – Credit Losses (Topic 326) which is new guidance for the accounting for credit losses on instruments within its scope. It introduces a new model for current expected credit losses (“CECL”) which will apply to financial assets subject to credit losses and measured at amortized cost and certain off-balance sheet credit exposures. This will include loans, held-to-maturity debt securities, loan commitments, financial guarantees, net investments in leases, reinsurance and trade receivables. The CECL model requires an entity to estimate the credit losses expected over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider historical information, current information and reasonable and supportable forecasts, including estimates of prepayments. In addition, ASU 2016-13 replaces the current available-for-sale debt securities other-than-temporary impairment model with an estimate of expected credit losses only when the fair value falls below the amortized cost of the asset. Credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. The available-for-sale debt security model will also require the use of an allowance to record estimated credit losses and subsequent recoveries. The ASU also addresses purchased financial assets with credit deterioration. Disclosure requirements are expanded regarding an entity’s assumptions, models and methods for estimated the ALL. The ASU is effective for interim and annual reporting periods beginning after December 15, 2019. The Company is evaluating the impact that ASU 2016-13 will have on its consolidated financial statements.

During March 2016, the FASB issued ASU No. 2016-09, “Compensation – Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting.” The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: a) income tax consequences; b) classification of awards as either equity or liabilities; and c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company is evaluating the impact that ASU 2016-09 will have on its consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) which requires equity investments, other than those accounted for using the equity method, to be measured at fair value through earnings. There will no longer be an available-for-sale classification measured (changes in fair value reported in other comprehensive income) for equity securities with readily determinable fair values. The cost method is also eliminated for equity instruments without a readily determinable fair value. For these investments, companies can elect to record the investment at cost, less impairment, plus or minus subsequent adjustments for observable price changes. This election only applies to equity investments that do not qualify for the net asset value practical expedient. Public companies will be required to use the exit price when measuring the fair value of financial instruments measured at amortized cost for disclosure purposes. In addition, the ASU requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The classification and measurement guidance is effective for periods beginning after December 15, 2017. The Company is evaluating the impact that ASU 2016-01 will have on its consolidated financial statements.

In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis. The amendments modify the evaluation reporting organizations must perform to determine if certain legal entities should be consolidated as VIEs. Specifically, the amendments: (1) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (“VIEs”) or voting interest entities; (2) eliminate the presumption that a general partner should consolidate a limited partnership; (3) affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships; and (4) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. ASU 2015-02 is effective for interim and annual reporting periods beginning after December 15, 2015. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In January 2015, the FASB issued ASU 2015-01, Income Statement – Extraordinary and Unusual Items. ASU 2015-01 eliminates the concept of extraordinary items. However, the presentation and disclosure requirements for items that are either unusual in nature or infrequent in occurrence remain and will be expanded to include items that are both unusual in nature and infrequent in occurrence. ASU 2015-01 is effective for periods beginning after December 15, 2015. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). The amendments in this ASU modify the guidance companies use to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other standards. The ASU requires that entities apply a specific method to recognize revenue reflecting the consideration expected from customers in exchange for the transfer of goods and services. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. Entities are also required to disclose significant judgments and changes in judgments for determining the satisfaction of performance obligations. Most revenue associated with financial instruments, including interest and loan origination fees, is outside the scope of the guidance. In August 2015, the FASB issued ASU 2014-09 changing the effective date for ASU 2014-09 to annual reporting periods beginning after December 15, 2017 from December 15, 2016. The Company is evaluating the impact that ASU 2014-09 will have on its consolidated financial statements.

Note 4: Securities

The aggregate amortized costs and fair values of the available-for-sale securities portfolio are as follows:


(Dollars in thousands)
Available-for-sale securities June 30, 2016	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Corporate bonds	$	6,445	$	8	$	—		$	6,453
U.S. Government agencies		23,626		201		(16	)		23,811
State and municipal obligations		22,966		782		—			23,748

	$	53,037	$	991	$	(16	)	$	54,012


Available-for-sale securities December 31, 2015	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Corporate bonds	$	3,950	$	—	$	(5	)	$	3,945
U.S. Government agencies		21,375		69		(156	)		21,288
State and municipal obligations		28,599		313		(55	)		28,857

	$	53,924	$	382	$	(216	)	$	54,090

Gross realized gains and gross realized losses on sales and calls of securities were as follows:


	For the three months ended						For the six months ended
	June 30,						June 30,
(Dollars in thousands)	2016			2015			2016			2015
Gross realized gains	$	105		$	24		$	120		$	24
Gross realized losses		(1	)		(18	)		(10	)		(22	)

Net realized gains (losses)	$	104		$	6		$	110		$	2

Aggregate proceeds	$	6,395		$	1,710		$	9,097		$	2,324

Average yields (taxable equivalent) on securities were 3.08% and 2.45% for the three months ended June 30, 2016 and 2015, respectively, and 3.06% and 2.46% for the six months ended June 30, 2016 and 2015, respectively.

Securities with a market value of $10.2 million and $8.6 million were pledged as collateral for repurchase agreements and for other purposes as required by law as of June 30, 2016 and December 31, 2015, respectively. As of June 30, 2016 and December 31, 2015, all the securities pledged to repurchase agreements were state and municipal obligations. All the repurchase agreements had remaining contractual maturities that were overnight and continuous. Securities sold under repurchase agreements were $8.2 million and $7.2 million as of June 30, 2016 and December 31, 2015, respectively, and included in liabilities on the consolidated balance sheets. The securities pledged to each agreement are reviewed daily and can be changed at the option of the Bank with minimal risk of loss due to fair value.

Securities in an unrealized loss position at June 30, 2016 and December 31, 2015, by duration of the unrealized loss, are shown below. The unrealized loss positions were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All agency securities, and states and municipal securities are investment grade or better and their losses are considered temporary. Management does not intend to sell the securities and does not expect to be required to sell the securities. Furthermore, all amortized cost bases are expected to be recovered. Bonds with unrealized loss positions at June 30, 2016 included six federal agencies and two municipals. Bonds with unrealized loss positions at December 31, 2015 included 24 federal agencies, one corporate bond and 17 municipals. The tables are shown below.


(Dollars in thousands)	Less than 12 months					12 months or more					Total
June 30, 2016	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Temporarily impaired securities - U.S. Government agencies	$	901	$	(2	)	$	1,455	$	(14	)	$	2,356	$	(16	)


	Less than 12 months					12 months or more					Total
December 31, 2015	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Corporate bonds	$	495	$	(5	)	$	—	$	—		$	495	$	(5	)
U.S. Government agencies		13,871		(141	)		1,619		(15	)		15,490		(156	)
States and municipal obligations		2,566		(17	)		3,281		(38	)		5,847		(55	)

Total temporarily impaired securities	$	16,932	$	(163	)	$	4,900	$	(53	)	$	21,832	$	(216	)

The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $1.7 million and $2.0 million at June 30, 2016 and December 31, 2015, respectively. The Company also had an investment in Federal Reserve Bank of Richmond (“FRB”) stock which totaled $565 thousand and $505 thousand at June 30, 2016 and December 31, 2015, respectively. The investments in both FHLB and FRB stock are required investments related to the Bank’s membership with the FHLB and FRB. These securities do not have a readily determinable fair value as their ownership is restricted, and they lack an active market for trading. Additionally, per charter provisions related to the FHLB and FRB stock, all repurchase transactions of such stock must occur at par. Accordingly, these securities are carried at cost, and are periodically evaluated for impairment. The Company’s determination as to whether its investment in FHLB and FRB stock is impaired is based on management’s assessment of the ultimate recoverability of its par value rather than recognizing temporary declines in its value. The determination of whether the decline affects the ultimate recoverability of the investments is influenced by available information regarding various factors. These factors include, among others, the significance of the decline in net assets of the issuing banks as compared to the capital stock amount reported by these banks, and the length of time a decline has persisted; commitments by such banks to make payments required by law or regulation and the level of such payments in relation to the operating performance of the issuing bank; and the overall liquidity position of the issuing bank. Based on its most recent analysis of publicly available information regarding the financial condition of the issuing banks, management concluded that no impairment existed in the carrying value of FHLB and FRB stock.

Note 5: Loans

The following is a summary of the balances of loans:


(Dollars in thousands)	June 30, 2016			December 31, 2015
Mortgage loans on real estate:
Construction, Land and Land Development	$	39,044		$	42,129
Farmland		1,038			1,030
Commercial Mortgages (Non-Owner Occupied)		29,578			29,086
Commercial Mortgages (Owner Occupied)		46,965			43,956
Residential First Mortgages		172,780			164,405
Residential Revolving and Junior Mortgages		25,987			26,497
Commercial and Industrial loans		31,767			35,104
Consumer Loans		3,790			5,015

Total loans		350,949			347,222
Net unamortized deferred loan costs		353			324
Allowance for loan losses		(3,547	)		(4,223	)

Loans, net	$	347,755		$	343,323

The recorded investment in past due and non-accruing loans is shown in the following table. A loan past due by more than 90 days is generally placed on nonaccrual unless it is both well secured and in the process of collection.


			90 Days or
(Dollars in thousands)	30-89		More Past				Total Past
Loans Past Due and Nonaccruals	Days		Due and				Due and				Total
June 30, 2016	Past Due		Still Accruing		Nonaccruals		Nonaccruals		Current		Loans
Construction, Land and Land Development	$	63	$	—	$	632	$	695	$	38,349	$	39,044
Farmland		—		—		—		—		1,038		1,038
Commercial Mortgages (Non-Owner Occupied)		—		—		—		—		29,578		29,578
Commercial Mortgages (Owner Occupied)		943		—		1,759		2,702		44,263		46,965
Residential First Mortgages		509		205		2,461		3,175		169,605		172,780
Residential Revolving and Junior Mortgages		51		—		177		228		25,759		25,987
Commercial and Industrial		—		—		94		94		31,673		31,767
Consumer Loans		19		11		24		54		3,736		3,790

Total	$	1,585	$	216	$	5,147	$	6,948	$	344,001	$	350,949


			90 Days or
	30-89		More Past				Total Past
Loans Past Due and Nonaccruals	Days		Due and				Due and				Total
December 31, 2015	Past Due		Still Accruing		Nonaccruals		Nonaccruals		Current		Loans
Construction, Land and Land Development	$	93	$	—	$	672	$	765	$	41,364	$	42,129
Farmland		—		—		—		—		1,030		1,030
Commercial Mortgages (Non-Owner Occupied)		264		—		—		264		28,822		29,086
Commercial Mortgages (Owner Occupied)		133		—		2,350		2,483		41,473		43,956
Residential First Mortgages		1,304		—		2,841		4,145		160,260		164,405
Residential Revolving and Junior Mortgages		70		—		277		347		26,150		26,497
Commercial and Industrial		10		—		285		295		34,809		35,104
Consumer Loans		32		11		8		51		4,964		5,015

Total	$	1,906	$	11	$	6,433	$	8,350	$	338,872	$	347,222

Note 6: Allowance for Loan Losses

Loans Evaluated for Impairment

Loan receivables evaluated for impairment individually and collectively by segment as of June 30, 2016 and December 31, 2015 are as follows:


	Mortgage		Commercial
(Dollars in thousands)	Loans		and		Consumer
As of June 30, 2016	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	11,041	$	92	$	—	$	11,133
Collectively evaluated for impairment		304,351		31,675		3,790		339,816

Total Gross Loans	$	315,392	$	31,767	$	3,790	$	350,949


	Mortgage		Commercial
	Loans		and		Consumer
As of December 31, 2015	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	10,542	$	284	$	—	$	10,826
Collectively evaluated for impairment		296,561		34,820		5,015		336,396

Total Gross Loans	$	307,103	$	35,104	$	5,015	$	347,222

Allowance for Loan Losses

The allowance for loan losses disaggregated based on loan receivables evaluated for impairment individually and collectively by segment as of June 30, 2016 and December 31, 2015 are as follows:


	Mortgage		Commercial
(Dollars in thousands)	Loans		and		Consumer
As of June 30, 2016	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	564	$	92	$	—	$	656
Collectively evaluated for impairment		2,431		343		117		2,891

Total allowance for loan losses	$	2,995	$	435	$	117	$	3,547


	Mortgage		Commercial
	Loans		and		Consumer
As of December 31, 2015	on Real Estate		Industrial		Loans		Total
Individually evaluated for impairment	$	1,256	$	278	$	—	$	1,534
Collectively evaluated for impairment		2,246		321		122		2,689

Total allowance for loan losses	$	3,502	$	599	$	122	$	4,223

A disaggregation and an analysis of the change in the allowance for loan losses by segment is shown below.


(Dollars in thousands)	Mortgage			Commercial
For the Three Months Ended	Loans on			and			Consumer
June 30, 2016	Real Estate			Industrial			Loans			Total
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	3,410		$	579		$	118		$	4,107
(Charge-offs)		(573	)		(158	)		(20	)		(751	)
Recoveries		4			—			4			8
Provision		154			14			15			183

Ending Balance	$	2,995		$	435		$	117		$	3,547


	Mortgage			Commercial
For the Three Months Ended	Loans on			and			Consumer
June 30, 2015	Real Estate			Industrial			Loans			Total
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,763		$	315		$	169		$	3,247
(Charge-offs)		—			—			(54	)		(54	)
Recoveries		5			—			36			41
Provision		121			105			(21	)		205

Ending Balance	$	2,889		$	420		$	130		$	3,439


(Dollars in thousands)	Mortgage			Commercial
For the Six Months Ended	Loans on			and			Consumer
June 30, 2016	Real Estate			Industrial			Loans			Total
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	3,502		$	599		$	122		$	4,223
(Charge-offs)		(656	)		(158	)		(31	)		(845	)
Recoveries		10			5			6			21
Provision		139			(11	)		20			148

Ending Balance	$	2,995		$	435		$	117		$	3,547


	Mortgage			Commercial
For the Six Months Ended	Loans on			and			Consumer
June 30, 2015	Real Estate			Industrial			Loans			Total
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	2,778		$	323		$	104		$	3,205
(Charge-offs)		(1	)		—			(86	)		(87	)
Recoveries		10			—			41			51
Provision		102			97			71			270

Ending Balance	$	2,889		$	420		$	130		$	3,439

Internal Risk Rating Grades

Internal risk rating grades are generally assigned to commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250,000 with chronic delinquency, and TDRs, as shown in the following table. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades (refer to Note 2) are evaluated as new information becomes available for each borrowing relationship or at least quarterly.


	Construction,				Commercial		Commercial
	Land and				Mortgages		Mortgages		Commercial
(Dollars in thousands)	Land				(Non-Owner		(Owner		and
As of June 30, 2016	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	31,736	$	1,038	$	24,815	$	34,255	$	29,202	$	121,046
Watch		5,280		—		4,240		8,561		2,183		20,264
Special mention		—		—		275		1,479		128		1,882
Substandard		2,028		—		248		2,670		254		5,200
Doubtful		—		—		—		—		—		—

Total	$	39,044	$	1,038	$	29,578	$	46,965	$	31,767	$	148,392


	Construction,				Commercial		Commercial
	Land and				Mortgages		Mortgages		Commercial
	Land				(Non-Owner		(Owner		and
As of December 31, 2015	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	34,692	$	1,030	$	24,258	$	33,023	$	29,383	$	122,386
Watch		5,337		—		4,564		4,968		5,202		20,071
Special mention		1,119		—		—		2,687		148		3,954
Substandard		981		—		264		3,278		371		4,894
Doubtful		—		—		—		—		—		—

Total	$	42,129	$	1,030	$	29,086	$	43,956	$	35,104	$	151,305

Loans not assigned internal risk rating grades are comprised of smaller residential mortgages and smaller consumer loans. Payment activity of these loans is reviewed monthly by management. However, some of these loans are graded when the borrower’s total exposure to the Bank exceeds the limits noted above. Loans are considered to be nonperforming when they are delinquent by 90 days or more or non-accruing and credit risk is primarily evaluated by delinquency status, as shown in the table below.


			Residential
(Dollars in thousands)	Residential		Revolving
As of June 30, 2016	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (1)		Mortgages (2)		Loans (3)		Total
Performing	$	170,114	$	25,810	$	3,755	$	199,679
Nonperforming		2,666		177		35		2,878

Total	$	172,780	$	25,987	$	3,790	$	202,557


			Residential
	Residential		Revolving
As of December 31, 2015	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (4)		Mortgages (5)		Loans (6)		Total
Performing	$	161,564	$	26,220	$	4,996	$	192,780
Nonperforming		2,841		277		19		3,137

Total	$	164,405	$	26,497	$	5,015	$	195,917

(1)	Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $3.6 million as of June 30, 2016.

(2)	Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $1.2 million as of June 30, 2016.

(3)	Consumer Loans which have been assigned a risk rating grade of Substandard totaled $16 thousand as of June 30, 2016.

(4)	Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $3.9 million as of December 31, 2015.

(5)	Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $372 thousand as of December 31, 2015.

(6)	No Consumer Loans had been assigned a risk rating grade of Substandard as of December 31, 2015.

Impaired Loans

The following tables show the Company’s recorded investment and the customers’ unpaid principal balances for impaired loans, with the associated allowance amount, if applicable, as of June 30, 2016 and December 31, 2015, along with the average recorded investment and interest income recognized for the three and six months ended June 30, 2016 and 2015, respectively.


(Dollars in thousands)	At June 30, 2016						At December 31, 2015
IMPAIRED LOANS
	Recorded Investment		Customers’ Unpaid Principal Balance		Related Allowance		Recorded Investment		Customers’ Unpaid Principal Balance		Related Allowance
With no related allowance:
Construction, land and land development	$	1,533	$	1,540	$	—	$	445	$	451	$	—
Residential First Mortgages		2,736		2,761		—		3,130		3,166		—
Residential Revolving and Junior Mortgages (1)		991		992		—		233		233		—
Commercial Mortgages (Non-owner occupied)		248		248		—		264		264		—
Commercial Mortgages (Owner occupied)		1,389		1,433		—		1,352		1,390		—
Commercial and Industrial		—		—		—		—		—		—

		6,897		6,974		—		5,424		5,504		—

With an allowance recorded:
Construction, land and land development		253		288		110		262		290		120
Residential First Mortgages		2,238		2,242		170		2,507		2,507		308
Residential Revolving and Junior Mortgages (1)		195		196		151		258		259		150
Commercial Mortgages (Non-owner occupied)		—		—		—		—		—		—
Commercial Mortgages (Owner occupied)		1,458		1,520		133		2,091		2,348		678
Commercial and Industrial		92		92		92		284		285		278

		4,236		4,338		656		5,402		5,689		1,534

Total Impaired Loans:
Construction, land and land development		1,786		1,828		110		707		741		120
Residential First Mortgages		4,974		5,003		170		5,637		5,673		308
Residential Revolving and Junior Mortgages (1)		1,186		1,188		151		491		492		150
Commercial Mortgages (Non-owner occupied)		248		248		—		264		264		—
Commercial Mortgages (Owner occupied)		2,847		2,953		133		3,443		3,738		678
Commercial and Industrial		92		92		92		284		285		278

	$	11,133	$	11,312	$	656	$	10,826	$	11,193	$	1,534

(1)	Junior mortgages include equity lines.


	For the three months ended									For the six months ended
	June 30, 2016					June 30, 2015				June 30, 2016				June 30, 2015
	Average		Interest			Average		Interest		Average		Interest		Average		Interest
	Recorded		Income			Recorded		Income		Recorded		Income		Recorded		Income
(Dollars in thousands)	Investment		Recognized			Investment		Recognized		Investment		Recognized		Investment		Recognized
With no related allowance:
Construction, land and land development	$	1,535	$	14		$	449	$	—	$	1,172	$	27	$	449	$	—
Residential First Mortgages		2,728		(2	)		1,761		18		2,231		14		1,696		36
Residential Revolving and Junior Mortgages (1)		988		8			50		1		675		19		50		2
Commercial Mortgages (Non-owner occupied)		248		4			786		14		253		8		612		18
Commercial Mortgages (Owner occupied)		1,393		1			1,552		18		1,190		17		1,429		27
Commercial and Industrial		—		—			—		—		—		—		—		—
Consumer (2)		—		—			4		—		—		—		4		—

		6,892		25			4,602		51		5,521		85		4,240		83

With an allowance recorded:
Construction, land and land development		255		1			272		1		257		2		274		2
Residential First Mortgages		2,370		21			2,160		26		2,416		42		2,164		52
Residential Revolving and Junior Mortgages (1)		196		2			173		2		195		4		173		4
Commercial Mortgages (Non-owner occupied)		—		—			—		—		—		—		—		—
Commercial Mortgages (Owner occupied)		1,460		6			1,026		8		1,462		11		919		12
Commercial and Industrial		105		1			123		—		109		1		82		—
Consumer (2)		—		—			—		—		—		—		—		—

		4,386		31			3,754		37		4,439		60		3,612		70

Total
Construction, land and land development		1,790		15			721		1		1,429		29		723		2
Residential First Mortgages		5,098		19			3,921		44		4,647		56		3,860		88
Residential Revolving and Junior Mortgages (1)		1,184		10			223		3		870		23		223		6
Commercial Mortgages (Non-owner occupied)		248		4			786		14		253		8		612		18
Commercial Mortgages (Owner occupied)		2,853		7			2,578		26		2,652		28		2,348		39
Commercial and Industrial		105		1			123		—		109		1		82		—
Consumer (2)		—		—			4		—		—		—		4		—

	$	11,278	$	56		$	8,356	$	88	$	9,960	$	145	$	7,852	$	153

(1)	Junior mortgages include equity lines.

(2)	Includes credit cards.

Smaller non-accruing loans and non-accruing loans that are not graded because they are included in homogenous pools generally do not meet the criteria for impairment testing, and are therefore excluded from impaired loan disclosures. At June 30, 2016 and December 31, 2015, non-accruing loans excluded from impaired loan disclosure totaled $108 thousand and $95 thousand, respectively. If interest on these non-accruing loans had been accrued, such income would have approximated $2 thousand and $4 thousand during the three months ended June 30, 2016 and 2015, respectively and $3 thousand and $8 thousand during the six months ended June 30, 2016 and 2015, respectively.

Loan Modifications

Loans modified as TDRs are considered impaired and are individually evaluated for the amount of impairment in the ALL. The following table presents, by segments of loans, information related to loans modified as TDRs during the three and six months ended June 30, 2016 and 2015.

For the three months ended

June 30, 2016

June 30, 2015

Pre-Modification

Post-Modification

Pre-Modification

Post-Modification

(Dollars in thousands)

Outstanding

Number of

Recorded

Number of

Recorded

TROUBLED DEBT RESTRUCTURINGS

Loans

Investment

Loans

Investment

Residential first mortgages (1)

244

—

(1)	Modification was a capitalization of interest.

For the six months ended

June 30, 2016

June 30, 2015

Pre-Modification

Post-Modification

Pre-Modification

Post-Modification

(Dollars in thousands)

Outstanding

Number of

Recorded

Number of

Recorded

TROUBLED DEBT RESTRUCTURINGS

Loans

Investment

Loans

Investment

Residential first mortgages (1)

244

—

Commercial mortgage (Owner occupied) (1)

—

105

124

(1)	Modification was a capitalization of interest.

For the three months ended

(Dollars in thousands)

June 30, 2016

June 30, 2015

TROUBLED DEBT RESTRUCTURINGS

Number of

Recorded

Number of

Recorded

THAT SUBSEQUENTLY DEFAULTED

Loans

Investment

Loans

Investment

Commercial and industrial

—

For the six months ended

(Dollars in thousands)

June 30, 2016

June 30, 2015

TROUBLED DEBT RESTRUCTURINGS

Number of

Recorded

Number of

Recorded

THAT SUBSEQUENTLY DEFAULTED

Loans

Investment

Loans

Investment

Commercial mortgage (Owner occupied)

—

124

Other Real Estate Owned

The table below details the properties included in other real estate owned (“OREO”) as of June 30, 2016 and December 31, 2015. There were no collateralized consumer residential mortgage loans in the process of foreclosure as of June 30, 2016.


	As of June 30, 2016				As of December 31, 2015
	No. of		Carrying		No. of		Carrying
(Dollars in thousands)	Properties		Value		Properties		Value
Residential		3	$	1,172		3	$	540
Land lots		7		413		7		413
Convenience stores		1		59		2		191
Restaurant		1		55		1		55
Commerical properties		3		942		3		671

Total		15	$	2,641		16	$	1,870

Included in other assets as of June 30, 2016, was one residential property purchased in 2013 from a related party with a value of $708 thousand and a former branch, which was closed April 30, 2015, with a value of $403 thousand. Both properties are being marketed for sale.

Note 7: Earnings per share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock.


	For the three months ended								For the six months ended
	June 30, 2016				June 30, 2015				June 30, 2016				June 30, 2015
	Average		Per share		Average		Per share		Average		Per share		Average		Per share
	Shares		Amount		Shares		Amount		Shares		Amount		Shares		Amount
Basic earnings per share		4,774,856	$	0.12		4,802,032	$	0.06		4,774,856	$	0.23		4,805,922	$	0.14
Effect of dilutive securities:
Stock options		19,927				17,290				17,718				13,565

Diluted earnings per share		4,794,783	$	0.12		4,819,322	$	0.06		4,792,574	$	0.23		4,819,487	$	0.14

For the three months ended June 30, 2016 and 2015, options on 46,135 and 54,733 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive. For the six months ended June 30, 2016 and 2015, options on 53,635 and 68,473 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive.

Note 8: Stock-Based Compensation

On June 28, 2013, the Company registered with the Securities and Exchange Commission a stock-based compensation plan, which superseded all other plans. There are 342,000 shares available for grant under this plan at June 30, 2016.

Stock-based compensation expense related to stock awards for both the three month periods ended June 30, 2016 and 2015 was zero. For the six months ended June 30, 2016 and 2015, stock-based compensation expense related to stock awards was $16 thousand and $17 thousand, respectively. Compensation expense for stock options is the estimated fair value of options on the date granted using the Black-Scholes Model amortized on a straight-line basis over the vesting period of the award. There was no unrecognized compensation expense related to stock options as of June 30, 2016.

Options for a total of 7,500 shares were granted and vested during the six months ended June 30, 2016. The aggregate fair value of options granted during the six months ended June 30, 2016 was $16 thousand. Options for a total of 7,500 shares were granted and vested during the six months ended June 30, 2015. The aggregate fair value of options granted during the six months ended June 30, 2015 was $17 thousand.

The variables used in these calculations of the fair value of the options are as follows:


	For the six months ended June 30,
	2016			2015
Risk free interest rate (5 year Treasury)		1.49	%		1.52	%
Expected dividend yield		0.0	%		0.0	%
Expected term (years)		5			5
Expected volatility		40.1	%		47.1	%

Stock option activity for the six months ended June 30, 2016 is summarized below:


						Weighted
						Average
				Weighted Average		Remaining		Aggregate
				Exercise		Contractual		Intrinsic
	Shares			Price		Life (in years)		Value (1)
Options outstanding, January 1, 2016		211,185		$	6.57		6.0
Granted		7,500			5.76
Forfeited		—			—
Exercised		—			—
Expired		(8,598	)		12.84

Options outstanding and exercisable, June 30, 2016		210,087		$	6.54		5.9	$	113,544

(1)

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on June 30, 2016. This amount changes based on changes in the market value of the Company’s common stock.

Note 9: Employee Benefit Plans

The Company has a non-contributory, defined benefit pension plan for full-time employees who were over 21 years of age and vested in the plan as of December 31, 2012, when the plan was frozen. Each participant’s account balance grows based on monthly interest credits. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act.

The Company sponsors a post-retirement benefit plan covering current and future retirees who acquire age 55 and 10 years of service or age 65 and 5 years of service. The post-retirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses. The plan is unfunded and funded as benefits are due.

Components of Net Periodic (Benefit) Cost


(Dollars in thousands)	Pension Benefits						Post-Retirement Benefits
Six months ended June 30,	2016			2015			2016		2015
Service cost	$	—		$	—		$	11	$	11
Interest cost		69			66			14		15
Expected return on plan assets		(96	)		(99	)		—		—
Amortization of unrecognized net loss		—			—			—		—
Recognized net actuarial loss		39			37			—		—

Net periodic cost	$	12		$	4		$	25	$	26

The Company expects to make no contribution to its pension plan and $3 thousand to its post-retirement benefit plan during the remainder of 2016. The Company has contributed $4 thousand towards the post-retirement plan during the first six months of 2016.

Note 10: Long Term Debt

FHLB Debt

As of June 30, 2016, the Bank had $30 million of outstanding FHLB debt, consisting of five advances. As of December 31, 2015, seven advances totaling $40 million were outstanding. Advances for $5 million each that matured in February 2016 and April 2016 were repaid.

The five advances are shown in the following table.


					Current			Maturity
Description	Balance		Originated		Interest Rate			Date
Adjustable Rate Hybrid	$	10,000,000		4/12/2013		3.00985	%		4/13/2020
Adjustable Rate Credit		5,000,000		6/18/2015		0.66660	%		9/19/2016
Fixed Rate Credit		5,000,000		10/20/2015		0.52000	%		10/20/2016
Fixed Rate Credit		5,000,000		12/21/2015		0.99000	%		6/15/2017
Fixed Rate Credit		5,000,000		12/22/2015		1.08000	%		9/15/2017

	$	30,000,000

Advances on the FHLB lines are secured by a blanket lien on qualified 1 to 4 family residential real estate loans. Immediate available credit, as of June 30, 2016, was $52.5 million against a total line of credit of $88.5 million.

As of June 30, 2016 and December 31, 2015, the Company had $30.0 million and $40.0 million, respectively, in FHLB debt outstanding with a weighted average interest rate of 1.55% and 1.17%, respectively.

Subordinated Debt

On May 28, 2015, the Company entered into a Subordinated Note Purchase Agreement (the “Purchase Agreement”) with 29 accredited investors under which the Company issued an aggregate of $7,000,000 of subordinated notes (the “Notes”) to the accredited investors. The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the right to redeem the Notes, in whole or in part, without premium or penalty, at any interest payment date on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.


(Dollars in thousands)	Balance as of
	June 30, 2016
6.5% Subordinated Debt	$	7,000
Less: Issuance costs		(148	)

	$	6,852

Note 11: Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:


Level 1 –		Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 –		Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 –		Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available-for-sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Defined benefit plan assets: Defined benefit plan assets are recorded at fair value on an annual basis at year end.

Mortgage servicing rights: MSRs are recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations. A model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool and applies a discount rate to each pool. Loans are segregated into 14 pools based on each loan’s term and seasoning (age). All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Service costs were assumed to be $6.00 per loan as of both June 30, 2016 and December 31, 2015. Prepayment speeds are determined primarily based on the average interest rate of the loans in each pool. The prepayment scale used is the Public Securities Association (“PSA”) model, where “100% PSA” means prepayments are zero in the first month, then increase by 0.2% of the loan balance each month until reaching 6.0% in month 30. Thereafter, the 100% PSA model assumes an annual prepayment of 6.0% of the remaining loan balance. The average PSA speed assumption in the fair value model is 222% and 163% as of June 30, 2016 and December 31, 2015, respectively. A discount rate of 10% was then applied to each pool as of June 30, 2016 and 11.0% as of December 31, 2015. This discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. MSRs are classified as Level 3.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2016 and December 31, 2015:


(Dollars in thousands)			Fair Value Measurements at June 30, 2016 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	6,453	$	—	$	1,000	$	5,453
U. S. Government agencies		23,811		2,202		21,609		—
State and municipal obligations		23,748		—		23,748		—

Total securities available-for-sale:	$	54,012	$	2,202	$	46,357	$	5,453

Mortgage servicing rights	$	620	$	—	$	—	$	620
Defined benefit plan assets:
Cash and cash equivalents	$	3	$	3	$	—	$	—
Mutual funds - fixed income		1,053		1,053		—		—
Mutual funds - equity		1,549		1,549		—		—

Total defined benefit plan assets	$	2,605	$	2,605	$	—	$	—


			Fair Value Measurements at December 31, 2015 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	3,945	$	—	$	—	$	3,945
U. S. Government agencies		21,288		1,216		20,072		—
State and municipal obligations		28,857		—		28,857		—

Total securities available-for-sale:	$	54,090	$	1,216	$	48,929	$	3,945

Mortgage servicing rights	$	658	$	—	$	—	$	658
Defined benefit plan assets:
Cash and cash equivalents	$	3	$	3	$	—	$	—
Mutual funds - fixed income		1,119		1,119		—		—
Mutual funds - equity		1,684		1,684		—		—

Total defined benefit plan assets	$	2,806	$	2,806	$	—	$	—

The reconciliation of items using Level 3 inputs is as follows:


				Corporate
(Dollars in thousands)	MSRs			Bonds
Balance, January 1, 2016	$	658		$	3,945
Purchases		—			2,500
Impairments		—			—
Fair value adjustments		(38	)		8
Sales		—			—

Balance, June 30, 2016	$	620		$	6,453

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Any given loan may have multiple types of collateral. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable

market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: OREO is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. The initial fair value of OREO is based on an appraisal done at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest income on the Consolidated Statements of Income.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis at the end of the respective period.


			Fair Value Measurements at June 30, 2016 Using
(Dollars in thousands)	Balance as of
Description	June 30, 2016		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,580	$	—	$	—	$	3,580
Other real estate owned, net		2,641		—		—		2,641

			Fair Value Measurements at December 31, 2015 Using
	Balance as of
Description	December 31, 2015		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,868	$	—	$	—	$	3,868
Other real estate owned, net		1,870		—		—		1,870

The following table displays quantitative information about Level 3 Fair Value Measurements as of June 30, 2016:

Range

Balance as of

Valuation

Unobservable

(Weighted

(Dollars in thousands)

June 30, 2016

Technique

Input

Average)

Impaired Loans, net

3,580

Discounted appraised value

Selling Cost

10% - 20% (11%

)

Lack of Marketability

50% (50%

)

Other real estate owned, net

2,641

Discounted appraised value

Selling Cost

3% - 13 (5%

)

Lack of Marketability

10% - 20% (11%

)

The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2015:

Range

Balance as of

Valuation

Unobservable

(Weighted

(Dollars in thousands)

December 31, 2015

Technique

Input

Average)

Impaired Loans, net

3,868

Discounted appraised value

Selling Cost

10% - 25% (13%

)

Lack of Marketability

50% - 60% (51%

)

Other real estate owned, net

1,870

Discounted appraised value

Selling Cost

3% - 13% (4%

)

Lack of Marketability

10% - 20% (12%

)

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.


					Fair Value Measurements at June 30, 2016 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	June 30, 2016		June 30, 2016		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	5,141	$	5,141	$	5,141	$	—	$	—
Interest-bearing deposits		20,050		20,050		20,050		—		—
Certificates of deposit		5,456		5,456		—		5,456		—
Federal funds sold		1,546		1,546		1,546		—		—
Securities available-for-sale		54,012		54,012		2,202		46,357		5,453
Restricted securities		2,422		2,422		—		—		2,422
Loans, net		347,755		356,898		—		—		356,898
Loans held for sale		2,425		2,553		1,301		—		1,252
Accrued interest receivable		1,270		1,270		—		1,270		—
Mortgage servicing rights		620		620		—		—		620
Financial Liabilities:
Non-interest-bearing liabilities	$	74,157	$	74,157	$	74,157	$	—	$	—
Savings and other interest-bearing deposits		177,075		177,075		—		177,075		—
Time deposits		127,797		129,326		—		—		129,326
Securities sold under repurchase agreements		8,182		8,182		—		8,182		—
FHLB advances		30,000		30,813		—		30,813		—
Subordinated debt		6,852		7,000		—		—		7,000
Accrued interest payable		331		331		—		331		—

					Fair Value Measurements at December 31, 2015 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	December 31, 2015		December 31, 2015		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	4,969	$	4,969	$	4,969	$	—	$	—
Interest-bearing deposits		15,330		15,330		15,330		—		—
Certificates of deposit		5,735		5,735		—		5,487		248
Federal funds sold		271		271		271		—		—
Securities available-for-sale		54,090		54,090		1,216		48,929		3,945
Restricted securities		2,731		2,731		—		—		2,731
Loans, net		343,323		347,500		—		—		347,500
Loans held for sale		270		270		—		—		270
Accrued interest receivable		1,318		1,318		—		1,318		—
Mortgage servicing rights		658		658		—		—		658
Financial Liabilities:
Non-interest-bearing liabilities	$	65,842	$	65,842	$	65,842	$	—	$	—
Savings and other interest-bearing deposits		166,628		166,628		—		166,628		—
Time deposits		127,388		127,433		—		—		127,433
Securities sold under repurchase agreements		7,161		7,161		—		7,161		—
FHLB advances		40,000		40,855		—		40,855		—
Subordinated debt		6,844		7,000		—		—		7,000
Accrued interest payable		318		318		—		318		—

The carrying amounts of cash and due from banks, interest-bearing deposits, federal funds sold or purchased, accrued interest receivable, loans held for sale and non-interest-bearing deposits, are payable on demand, or are of such short duration that carrying value approximates market value.

Securities available-for-sale are carried at quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

MSRs are carried at fair value. As described above, a valuation model is used to determine fair value. This model utilizes a discounted cash flow analysis with servicing costs and prepayment assumptions based on comparable instruments and a discount rate.

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does not consider the lack of liquidity and uncertainty in the market that would affect the valuation. In the second quarter of 2016, VISA loans were transferred from Level 3 to Level 1 as they were held for sale as of June 30, 2016, having received a firm purchase offer from a third party. This sale was completed in July 2016.

Time deposits are presented at estimated fair value by discounting the future cash flows using interest rates offered for deposits of similar remaining maturities.

The fair value of the Company’s subordinated debt is estimated by utilizing observable market prices for comparable securities. Qualitative factors like asset quality, market factors and liquidity are also considered.

The fair value of the FHLB advances is estimated by discounting the future cash flows using the current interest rates offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At June 30, 2016 and December 31, 2015, the fair value of loan commitments and standby letters of credit was immaterial and therefore, they are not included in the table above.

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

Note 12: Changes in Accumulated Other Comprehensive Income (Loss)

The balances in accumulated other comprehensive income (loss) are shown in the following tables:


	For the Three Months Ended June 30, 2016
	Net Unrealized			Pension and			Accumulated Other
	Gains (Losses)			Post-retirement			Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance April 1, 2016	$	438		$	(883	)	$	(445	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $130		255			—			255
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $35		(69	)		—			(69	)

Balance June 30, 2016	$	624		$	(883	)	$	(259	)


	For the Three Months Ended June 30, 2015
	Net Unrealized			Pension and			Accumulated Other
	Gains (Losses)			Post-retirement			Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance April 1, 2015	$	246		$	(966	)	$	(720	)
Change in net unrealized holding losses on securities, before reclassification, net of tax benefit of $192		(372	)		—			(372	)
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $2		(4	)		—			(4	)

Balance June 30, 2015	$	(130	)	$	(966	)	$	(1,096	)


	For the Six Months Ended June 30, 2016
	Net Unrealized			Pension and			Accumulated Other
	Gains (Losses)			Post-retirement			Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance January 1, 2016	$	107		$	(883	)	$	(776	)
Change in net unrealized holding gains on securities, before reclassification, net of tax expense of $303		590			—			590
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $37		(73	)		—			(73	)

Balance June 30, 2016	$	624		$	(883	)	$	(259	)


	For the Six Months Ended June 30, 2015
	Net Unrealized			Pension and			Accumulated Other
	Gains (Losses)			Post-retirement			Comprehensive
(Dollars in thousands)	on Securities			Benefit Plans			Income (Loss)
Balance January 1, 2015	$	45		$	(966	)	$	(921	)
Change in net unrealized holding losses on securities, before reclassification, net of tax benefit of $90		(174	)		—			(174	)
Reclassification for previously unrealized net gains recognized in income, net of tax expense of $1		(1	)		—			(1	)

Balance June 30, 2015	$	(130	)	$	(966	)	$	(1,096	)

Reclassification for previously unrealized gains (losses) and impairments on securities are reported in the Consolidated Statements of Income as follows. No unrealized gains (losses) on pension and post-employment related costs were reclassified to the Consolidated Statements of Income in the three and six months ended June 30, 2016 and 2015.

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Three Months Ended

Holding Losses on Securities


(Dollars in thousands)	June 30, 2016			June 30, 2015
Net gains on sale of securities available-for-securities	$	104		$	6
Tax expense		(35	)		(2	)

Impact on net income	$	69		$	4

Accumulated Other Comprehensive Income (Loss)

Reclassification for the Six Months Ended

Holding Losses on Securities


(Dollars in thousands)	June 30, 2016			June 30, 2015
Net gains on sale of securities available-for-securities	$	110		$	2
Tax expense		(37	)		(1	)

Impact on net income	$	73		$	1

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

The following discussion is intended to assist in understanding the results of operations and the financial condition of Bay Banks of Virginia, Inc. This discussion should be read in conjunction with the above consolidated financial statements and the notes thereto.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, expansion activities, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

EXECUTIVE SUMMARY

Earnings for the six months ended June 30, 2016 and 2015 were $1.1 million and $675 thousand, respectively. This is an improvement of $435 thousand, or 64.5%, year over year. Improvements in net interest income, non-interest income and asset quality all contributed to the increase. Net interest income grew by $418 thousand, non-interest income grew by $145 thousand and provision for loan losses declined by $122 thousand. Return on average assets improved to 0.49% from 0.34% for the same comparable period, and return on average equity improved to 5.54% from 3.44%. Earnings continue to be the top priority for 2016.

The in-house loan portfolio grew by $3.7 million, or 1.1%, during the first six months of 2016. Loans originated and sold to Fannie Mae generated growth of $2.4 million in that servicing portfolio since December 31, 2015. This portfolio of loans serviced for Fannie Mae totaled $74.0 million as of June 30, 2016 compared to $71.6 million as of December 31, 2015 and $67.4 million as of June 30, 2015. In the third quarter, the Company expects to announce an affiliation with a third party provider of credit card services, which is expected to provide improved customer service for cardholders and eliminate the Company’s exposure to credit card fraud and security breaches. It is anticipated that this affiliation will have a positive impact on the Company’s income in the third quarter of 2016.

The net interest margin decreased to 3.37% for the first half of 2016 compared to 3.59% for the same period in 2015. Loan rates are falling even further than anyone thought possible, as worldwide economic factors cause additional pressure on U.S. rates. This low rate environment has now existed for more than eight years and as we continue to add new loans at these historic low rates, the yield from the Bank’s loan portfolio continues to decline. Therefore, in order to improve interest income, we have increased loan balances. Expansion into Richmond has generated $51.1 million of loans in that market as of June 30, 2016. Loans in the Richmond market grew $8.7 million in the six months ended June 30, 2016.

Growth in loans requires growth in deposits or other borrowings in order to fund those loans, and retail deposits have grown $9.2 million in the six months ended June 30, 2016. This has allowed us to reduce borrowings from the FHLB by $10.0 million during that same time frame.

Loans past due or non-accruing have declined by $1.4 million to $6.9 million in the six months ended June 30, 2016. Asset quality remains good with non-performing assets down to 1.7% of total assets at June 30, 2016 compared to 1.8% at December 31, 2015.

Finally, the Company’s core capital levels and regulatory ratios remain well above what is considered “well capitalized” by the Company’s regulators.

For more information, visit the Company’s website at www.baybanks.com. Information contained on the Company’s website is not a part of this report.

EARNINGS SUMMATION

For the three months ended June 30, 2016 and 2015, net income was $586 thousand and $294 thousand, respectively, an increase of $292 thousand or 99.3%. Diluted earnings per average share for the three months ended June 30, 2016 and 2015 were $0.12 and $0.06, respectively. The primary factors in the increase were $257 thousand in net interest income related to loan growth, additional investment securities, improved investment yield, a $98 thousand increase in gain from sales of investments, an $83 thousand increase in secondary lending fees and a $65 thousand increase in fees related to fiduciary activities. Annualized return on average assets was 0.51% for the second quarter of 2016 compared to 0.29% for the second quarter of 2015. Annualized return on average equity was 5.74% and 2.96% for the three months ended June 30, 2016 and 2015, respectively.

For the six months ended June 30, 2016 and 2015, net income was $1.1 million and $675 thousand, respectively, an increase of $435 thousand or 64.4%. Diluted earnings per average share for the six months ended June 30, 2016 and 2015 were $0.23 and $0.14, respectively. The primary factor in the increase was $419 thousand in net interest income related to higher loan balances, additional investment securities and improved investment yields. Increases in interest expense related to additional money market accounts and the issuance of subordinated debt in May 2015. Annualized return on average assets was 0.49% for the first half of 2016 compared to 0.34% for the first half of 2015. Annualized return on average equity was 5.54% and 3.44% for the six months ended June 30, 2016 and 2015, respectively.

RESULTS OF OPERATIONS

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of assets which earn interest. Changes in the volume and mix of assets which earn interest and liabilities that bear interest, the associated yields and rates, and the volume of non-performing assets have an effect on net interest income, the net interest margin, and net income.

FOR THE THREE MONTHS ENDED JUNE 30, 2016 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2015

NET INTEREST INCOME


Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in thousands)	Three months ended 6/30/2016							Three months ended 6/30/2015
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	30,240	$	211		2.79	%	$	26,734	$	132		1.97	%
Tax-exempt investments (1)		23,728		205		3.46	%		16,400		132		3.22	%

Total investments		53,968		416		3.08	%		43,134		264		2.45	%
Gross loans (2)		351,765		4,013		4.57	%		309,695		3,715		4.80	%
Interest-bearing deposits		11,635		12		0.41	%		22,900		13		0.23	%
Certificates of deposits		5,456		20		1.47	%		2,245		9		1.60	%
Federal funds sold		887		1		0.31	%		703		—		0.05	%

Total Interest Earning Assets	$	423,711	$	4,462		4.21	%	$	378,677	$	4,001		4.23	%

INTEREST-BEARING LIABILITIES:
Savings deposits	$	42,926	$	22		0.21	%	$	42,774	$	19		0.18	%
NOW deposits		39,988		15		0.15	%		42,228		15		0.14	%
Time deposits => $100,000		61,848		222		1.44	%		55,340		212		1.54	%
Time deposits < $100,000		64,535		216		1.34	%		56,494		199		1.41	%
Time deposits - Wholesale		1,915		3		0.54	%		7,686		8		0.42	%
Money market deposit accounts		85,247		163		0.77	%		56,972		117		0.82	%

Total Deposits		296,459		641		0.87	%		261,494		570		0.87	%
Federal funds purchased		609		1		1.11	%		—		—		—
Securities sold under repurchase agreements		6,708		4		0.20	%		7,424		2		0.11	%
Subordinated debt		6,850		118		6.92	%		2,504		42		6.71	%
FHLB advances		31,056		117		1.51	%		34,722		87		1.00	%

Total Interest-Bearing Liabilities	$	341,682	$	881		1.03	%	$	306,144	$	701		0.92	%

Net interest income and net interest margin			$	3,581		3.37	%			$	3,300		3.49	%

Non-interest-bearing deposits	$	69,951		—		0.00	%	$	61,030		—		0.00	%
Total Cost of funds						0.86	%						0.76	%
Net interest rate spread						3.35	%						3.46	%

Notes:

(1)	Income and yield assumes a federal tax rate of 34%.

(2)	Includes loan fees and nonaccrual loans.

Interest income for the three months ended June 30, 2016, on a tax-equivalent basis, was $4.5 million, an increase of $461 thousand from the second quarter of 2015, due mainly to increases in loan balances, additional investment securities and higher yields on investments. Interest expense for the three months ended June 30, 2016 was $881 thousand, an increase of $180 thousand from the second quarter of 2015, due primarily to subordinated debt that was issued in May 2015, increases in money market deposits, which supported loan growth, and higher average rates on FHLB advances. Net interest income for the three months ended June 30, 2016, on a tax-equivalent basis, was $3.6 million, an increase of $281 thousand from the second quarter of 2015.

The annualized net interest margin was 3.37% and 3.49% for the three months ended June 30, 2016 and 2015, respectively. This decline is due to continued reductions in loan yields, to 4.57% for the second quarter of 2016 from 4.80% for the second quarter of 2015, as market rates remain historically low and new loans are made at rates lower than existing loans. The cost of funds increased to 0.86% for the second quarter of 2016 from 0.76% for the second quarter of 2015, a result of the issuance of 6.50% subordinated debt in May 2015 and higher average costs of FHLB advances.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, decreased to 3.35% for the three months ended June 30, 2016, compared to 3.46% for the three months ended June 30, 2015.

NON-INTEREST INCOME

Non-interest income for the second quarter of 2016 increased by $167 thousand, or 18.2%, compared to the second quarter of 2015. Contributing to this increase was $98 thousand in gains on the sale of investments, an $83 thousand improvement in secondary market lending income and a $65 thousand increase in fiduciary fees from the Trust Company.

NON-INTEREST EXPENSE

For both the three months ended June 30, 2016 and 2015, non-interest expenses totaled $3.6 million. The net increase in non-interest expense was $20 thousand, or 0.6%. Federal Deposit Insurance Corporation assessments increased by $39 thousand as a result of a higher assessment base compared to the second quarter of 2015. Bank franchise taxes increased by $11 thousand due to increased levels of capital. These increases were partially offset by a decrease of $25 thousand in salaries and benefits resulting from the staff reduction in December 2015.

FOR THE SIX MONTHS ENDED JUNE 30, 2016 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2015

NET INTEREST INCOME


Net Interest Income Analysis	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
(Dollars in thousands)	Six months ended 6/30/2016							Six months ended 6/30/2015
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	30,196	$	418		2.77	%	$	26,049	$	258		1.98	%
Tax-exempt investments (1)		24,043		411		3.42	%		16,461		264		3.22	%

Total investments		54,239		829		3.06	%		42,510		522		2.46	%
Gross loans (2)		349,831		7,987		4.57	%		305,868		7,390		4.83	%
Interest-bearing deposits		12,441		27		0.43	%		19,026		21		0.22	%
Certificates of deposits		5,497		42		1.53	%		2,245		17		1.51	%
Federal funds sold		702		1		0.31	%		645		—		0.06	%

Total Interest Earning Assets	$	422,710	$	8,886		4.20	%	$	370,294	$	7,950		4.29	%

INTEREST-BEARING LIABILITIES:
Savings deposits	$	42,444	$	42		0.20	%	$	43,669	$	39		0.18	%
NOW deposits		39,611		30		0.15	%		41,969		31		0.15	%
Time deposits => $100,000		62,275		452		1.46	%		55,844		424		1.53	%
Time deposits < $100,000		63,332		431		1.37	%		56,618		400		1.42	%
Time deposits - Wholesale		3,709		9		0.50	%		7,827		15		0.39	%
Money market deposit accounts		84,225		322		0.77	%		48,414		177		0.74	%

Total Deposits		295,596		1,286		0.88	%		254,341		1,086		0.86	%
Federal funds purchased		304		1		1.11	%		—		—		—
Securities sold under repurchase agreements		6,269		6		0.19	%		6,740		4		0.12	%
Subordinated debt		6,848		236		6.92	%		1,252		42		6.71	%
FHLB advances		34,465		242		1.41	%		34,861		172		0.99	%

Total Interest-Bearing Liabilities	$	343,482	$	1,771		1.04	%	$	297,194	$	1,304		0.88	%

Net interest income and net interest margin			$	7,115		3.37	%			$	6,646		3.59	%

Non-interest-bearing deposits	$	66,738		—		0.00	%	$	61,030		—		0.00	%
Total Cost of funds						0.87	%						0.73	%
Net interest rate spread						3.33	%						3.56	%

Notes:

(1)	Income and yield assumes a federal tax rate of 34%.

(2)	Includes loan fees and nonaccrual loans.

Interest income for the six months ended June 30, 2016, on a tax-equivalent basis, was $8.9 million, an increase of $936 thousand from the first six months of 2015, due mainly to increases in loan balances, investment balances and investment yields. Interest expense for the six months ended June 30, 2016 was $1.8 million, an increase of $467 thousand from the first six months of 2015, due primarily to subordinated debt that was issued in May 2015, higher costs of FHLB advances and increases in money market deposits in Richmond, which supported loan growth. Net interest income for the first six months of 2016, on a tax-equivalent basis, was $7.1 million, an increase of $469 thousand from the same period of 2015.

The annualized net interest margin was 3.37% and 3.59% for the six months ended June 30, 2016 and 2015, respectively. This decline is due to continued reductions in loan yields, to 4.57% for the first half of 2016 from 4.83% for the first half of 2015, as market rates remain historically low and new loans are made at rates lower than existing loans. The cost of funds increased to 0.87% for the first half of 2016 from 0.73% for the first half of 2015, a result of the issuance of 6.50% subordinated debt in May 2015 and the higher cost FHLB advances.

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, decreased to 3.33% for the six months ended June 30, 2016, compared to 3.56% for the six months ended June 30, 2015.

NON-INTEREST INCOME

Non-interest income for the first half of 2016 increased by $140 thousand, or 7.8%, compared to the first half of 2015. Contributing to this increase was $108 thousand in gains on the sale of investments, a $62 thousand increase in secondary market lending income and an increase of $51 thousand in fiduciary fees from the Trust Company. Partially offsetting these increases was a decrease of $63 thousand in non-deposit product income.

NON-INTEREST EXPENSE

Non-interest expense increased $55 thousand, or 0.8% to $7.3 million for the first half of 2016. The primary driver of this increase was Federal Deposit Insurance Corporation assessments which increased by $55 thousand as a result of a higher assessment base compared to 2015.

AVERAGE INTEREST-EARNINGS ASSETS AND AVERAGE INTEREST-BEARING LIABILITIES

Average interest-earning assets increased 14.2% to $422.7 million for the six months ended June 30, 2016, as compared to $370.3 million for the six months ended June 30, 2015, due mainly to growth of $44.0 million in average loans. Average interest-earning assets as a percent of total average assets were 92.8% for the six months ended June 30, 2016 as compared to 90.4% for the same period in 2015. The loan portfolio, with $349.8 million in average balances as of June 30, 2016, is the largest category of interest-earning assets.

Average interest-bearing liabilities increased 15.6% to $343.5 million for the six months ended June 30, 2016, as compared to $297.2 million for the six months ended June 30, 2015, due primarily to the growth in deposits from the Richmond branches. The largest category of interest-bearing liabilities is time deposits, with combined average balances of $125.6 million for the six months ended June 30, 2016, up from $112.5 million for the similar period in 2015. Average balances of money market deposit accounts increased by $35.8 million to $84.2 million for the first half of 2016 compared to the same period in 2015.

ASSET QUALITY

Asset quality remains good. Non-performing assets, which include OREO and non-performing loans, decreased by $310 thousand to $8.0 million, or 1.7% of total assets as of June 30, 2016 compared to $8.3 million as of December 31, 2015. This decrease is primarily related to a decrease of $1.3 million in non-accruing loans partially offset by an increase of $771 thousand of OREO. The increase in OREO was attributable to the foreclosure of two properties related to a borrower who perpetrated fraud against the Company and who has subsequently been sentenced to 18 months in federal prison.

Loans charged off during the first six months of 2016, net of recoveries, totaled $824 thousand compared to $36 thousand for the first six months of 2015, primarily due to the aforementioned borrower. This represents an increase in the annualized net charge-off ratio to 0.47% for the first six months of 2016 compared to 0.02% for the first six months of 2015. Nearly all of those charge-offs were anticipated and specific reserves had been provided for them in the ALL. Management believes it is maintaining an adequate level of the ALL at 1.01% of total loans at June 30, 2016 and 1.22% at December 31, 2015. The reduction is due mainly to anticipated declines in the specific components of the ALL. Historical loss factors have increased and qualitative factors are unchanged.

Non-Performing Assets


(Dollars in thousands)	June 30, 2016			December 31, 2015
Loans past due 90 days or more and still accruing	$	216		$	11
Non-accruing loans		5,147			6,433

Total non-performing loans		5,363			6,444

Other real estate owned		2,641			1,870

Total non-performing assets	$	8,004		$	8,314

Allowance for loan losses	$	3,547		$	4,223

Allowance to non-performing loans		66.1	%		65.5	%
Non-performing assets to total assets		1.7	%		1.8	%

Classified assets, which include loans with risk rating grades of substandard, doubtful and loss, plus OREO, increased by $1.6 million during the first six months of 2016 to $12.7 million, or 29.3% of Tier 1 capital plus the allowance for loan losses. Risk rating grades are assigned conservatively, causing some homogenous loans, such as residential mortgages, to fall into the pool of adversely risk rated loans and thereby evaluated for impairment, even though they may be performing as agreed and therefore not impaired.

As of June 30, 2016, loans valued at $11.1 million were considered impaired, whereas $10.8 million were considered impaired as of December 31, 2015. Between December 31, 2015 and June 30, 2016, eight additional loans were identified as impaired, two dispensed through foreclosure and charged-off, one was paid off and three were upgraded. Management has reviewed the impaired credits and the underlying collateral and the current losses have been specifically reserved.

FINANCIAL CONDITION

Total assets increased to $468.3 million as of June 30, 2016 compared to $456.3 million as of December 31, 2015. Cash and due from banks, which produces no income, increased to $5.1 million from $5.0 million as of June 30, 2016 and December 31, 2015, respectively. Interest-bearing deposits at other banks, which is mainly the Bank’s cash on deposit at the Federal Reserve Bank of Richmond, has increased by $4.7 million to $20.1 million since year-end 2015 primarily as a result of increased deposits.

During the six months ended June 30, 2016, gross loans increased by $3.7 million or 1.1%, to $351.3 million from $347.5 million at year-end 2015. The largest components of this increase were increases of $8.4 million related to residential mortgages and $3.5 million related to commercial mortgages, partially offset by decreases of $3.1 million related to construction, land and land development loans, $3.3 million related to commercial and industrial loans and $1.2 million related to consumer loans as the VISA accounts have been reclassified to loans held for sale. The Company anticipates selling these loans to a third party in the third quarter of 2016.

The Bank had $2.6 million and $1.9 million of OREO at June 30, 2016 and December 31, 2015, respectively. As of June 30, 2016, OREO consists of three residences, seven lots, one former convenience store, one former restaurant and three commercial business properties. During the first six months of 2016, three properties with a total book value of $1.2 million from two borrowers were added through foreclosure, and four properties with a total book value of $379 thousand were sold. There were $53 thousand of write-downs of OREO properties during the first six months of 2016, compared to $72 thousand for the same period in 2015. All properties maintained as OREO are valued at the lesser of cost or fair value less estimated costs to sell and are actively marketed.

As of June 30, 2016, securities available-for-sale at fair value totaled $54.0 million as compared to $54.1 million on December 31, 2015. This represents a net decrease of $78 thousand or 0.1% for the six months ended June 30, 2016. As of June 30, 2016, available-for-sale securities represented 11.5% of total assets and 12.8% of earning assets. All securities in the Company’s investment portfolio are classified as available-for-sale and marked to market on a monthly basis. Unrealized gains or losses, net of tax, are booked as an adjustment to shareholders’ equity, and are not realized as an adjustment to earnings until the securities are actually sold or an other than temporary impairment occurs.

The bank owned life insurance’s cash surrender value as of June 30, 2016 was $7.7 million. The insurance’s purpose is to offset the cost of employee benefits.

As of June 30, 2016, total deposits were $379.0 million compared to $359.9 million at year-end 2015. This represents an increase in balances of $19.2 million or 5.3% during the six months. The increase was driven by a $10.4 million increase in savings and interest bearing deposits, an increase of $409 thousand in time deposits and a $8.3 million increase in noninterest-bearing deposits.

FHLB balances have declined by $10.0 million since December 31, 2015, to $30.0 million as of June 30, 2016.

On May 28, 2015, the Company entered into a Purchase Agreement with 29 accredited investors under which the Company issued an aggregate of $7,000,000 of subordinated notes to the accredited investors. The Notes have a maturity date of May 28, 2025. The Notes bear interest, payable on the 1st of March and September of each year, commencing September 1, 2015, at a fixed interest rate of 6.50% per year. The Notes are not convertible into common stock or preferred stock, and are not callable by the holders. The Company has the

right to redeem the Notes, in whole or in part, without premium or penalty, on any interest payment date on or after May 28, 2020 and prior to the maturity date, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a Note may declare the principal amount of the Note to be due and immediately payable. The Notes are unsecured, subordinated obligations of the Company and will rank junior in right of payment to the Company’s existing and future senior indebtedness. The Notes qualify as Tier 2 capital for regulatory reporting.

As of June 30, 2016, securities sold under repurchase agreements increased by $1.0 million to $8.2 million from $7.2 million at December 31, 2015. This increase was the result of normal seasonality for these customers.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates are major factors for liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At June 30, 2016, cash totaled $5.1 million, federal funds sold totaled $1.5 million, interest-bearing deposits totaled $20.1 million, securities, certificates of deposit maturing in one year or less totaled $2.2 million and loans maturing in one year or less totaled $25.2 million. This results in a liquidity ratio of 12.3% as of June 30, 2016 as compared to 12.1% as of December 31, 2015. The Company determines this ratio by dividing the sum of cash and cash equivalents, investment securities maturing in one year or less, loans maturing in one year or less and federal funds sold, by total assets. The Bank has a formal liquidity management policy and contingency plan, which includes periodic evaluation of cash flow projections.

The parent company has no substantial operations of its own, so its primary sources of liquidity are fees received from the Bank, interest on investments and borrowings. The parent company’s liquid assets consisted of cash and investment securities totaling $2.9 million as of June 30, 2016. The parent company has sufficient liquidity to meet its obligations and provide a source of capital for the Bank.

In addition, the Bank has a line of credit with the FHLB of $88.5 million, with $52.5 million available, plus federal funds lines of credit with correspondent banks totaling $21.5 million.

CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition and quality of the Company’s resources, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allows management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as shareholders’ equity, is comprised mainly of outstanding common stock and retained earnings. Capital can be increased with securities offerings or through earnings.

Several factors impact shareholders’ equity, including net income and regulatory capital requirements. The Company’s capital resources are also impacted by net unrealized gains or losses on securities. The available-for-sale securities portfolio is marked to market monthly and unrealized gains or losses, net of taxes, are recognized as accumulated other comprehensive income (loss) on the balance sheets and statement of changes in shareholders’ equity. Another factor affecting accumulated other comprehensive income (loss) is changes in the market value of the Company’s pension and post-retirement benefit plans. The Company’s shareholders’ equity before accumulated other comprehensive loss was $41.5 million on June 30, 2016 compared to $40.3 million on December 31, 2015. Accumulated other comprehensive loss decreased by $517 thousand between December 31, 2015 and June 30, 2016, primarily as a result of increases in unrealized net gains in the investment portfolio.

Book value per share, before accumulated other comprehensive loss, on June 30, 2016, compared to December 31, 2015, increased to $8.69 from $8.45. Book value per share, including accumulated other comprehensive loss, increased to $8.63 on June 30, 2016 from $8.29 on December 31, 2015. No cash dividends were paid for the six month period ended June 30, 2016, nor for the comparable period ended June 30, 2015.

One source of funds available to the Company is the payment of dividends by the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval from the Bank’s regulators.

The Bank is subject to minimum regulatory capital ratios as defined by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). As of June 30, 2016, the Bank’s capital ratios continue to be well in excess of regulatory minimums.

In July 2013, the Federal Reserve issued final rules that made the changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new Common Equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). The following additional capital requirements related to the capital conservation buffer are being phased in over a four year

period beginning January 1, 2016. When fully phased in on January 1, 2019, the rules will require the Bank to maintain (i) a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% Common Equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets. The capital conservation buffer requirement is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. As of June 30, 2016, the Bank maintained Common Equity Tier 1 capital of $40.7 million, Tier 1 capital of $40.7 million, risk weighted assets of $315.7 million, and total risk-based capital of $44.2 million. As of June 30, 2016, all ratios were in excess of the fully phased-in requirements, with the Common Equity Tier 1 ratio at 12.89% of risk-weighted assets, the Tier 1 capital ratio at 12.89% of risk-weighted assets, the total capital ratio at 14.01% of risk-weighted assets, and the Tier 1 leverage ratio at 9.08% of total assets.

OFF BALANCE SHEET COMMITMENTS

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments may involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Off Balance Sheet Arrangements


	June 30, 2016		December 31, 2015
(Dollars in thousands)
Total loan commitments outstanding	$	26,552	$	42,713
Standby-by letters of credit		396		473
Low income housing tax credit fund		498		499

The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon takedown of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.

There have been no material changes to the off balance sheet items disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

CONTRACTUAL OBLIGATIONS

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

RECENT ACCOUNTING PRONOUNCEMENTS

Refer to Note 3, Amendments to the Accounting Standards Codification, in the Notes to the Consolidated Financial Statements contained in Item 1 of this report, for information related to the adoption of new amendments to the Accounting Standards Codification.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required.

ITEM 4.

CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions. Based upon their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer 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) required to be included in the Company’s periodic Securities and Exchange Commission filings as of June 30, 2016.

CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

There was no change to the Company’s internal control over financial reporting during the six months ended June 30, 2016 that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

ITEM 1A.

RISK FACTORS

Not required.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On December 17, 2014, the Company announced a share repurchase program pursuant to which it is authorized to repurchase up to 240,892 shares of its common stock. The share repurchase program was authorized to last through December 31, 2015. On November 12, 2015, the Board of Directors extended the share repurchase program until December 31, 2016. A total of 43,000 shares have been repurchased as of June 30, 2016. No share repurchases have been made during 2016.

ITEM 3.

DEFAULT UPON SENIOR SECURITIES

None to report.

ITEM 4.

MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.

OTHER INFORMATION

None to report.

ITEM 6.

EXHIBITS



3.1		Bylaws of Bay Banks of Virginia, Inc., as amended May 16, 2016 (incorporated by reference to previously filed Form 8-K filed on May 18, 2016).

31.1		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101		The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2016, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets as of June 30, 2016 and December 31, 2015, (ii) Consolidated Statements of Income for the three and six months ended June 30, 2016 and 2015, (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2016 and 2015, (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2016, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2016 and 2015, and (vi) Notes to Consolidated Financial Statements.

SIGNATURES

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


		Bay Banks of Virginia, Inc.
		(Registrant)


August 10, 2016	By:	/s/ Randal R. Greene
		Randal R. Greene
		President and Chief Executive Officer
		(Principal Executive Officer)

	By:	/s/ Deborah M. Evans
		Deborah M. Evans
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company