UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 September 30, 2012

- or -

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

For the transition period from to   .     

Commission File Number 0-22981

GEORGIA-CAROLINA BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Georgia	58-2326075
(State or other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification Number)

3527 Wheeler Road, Augusta, Georgia 30909

(Address of principal executive offices, including zip code)

(706) 731-6600

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES x   NO o

Indicate by check mark whether the registrant has submitted electronically and has posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES x   NO o

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

Large accelerated filer o                                                                 Accelerated filer  o          

Non-accelerated filer o                                                                   Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES o  NO x

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

Class	Outstanding at November 14, 2012
Common Stock, $.001 Par Value	3,526,396 shares

GEORGIA-CAROLINA BANCSHARES, INC.

Form 10-Q

Index

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Consolidated Statements of Financial Condition as of September 30, 2012 and December 31, 2011	3
	Consolidated Statements of Net Income for the Three and Nine Months Ended September 30, 2012 and 2011	4
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011	5
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011	6
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and  Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	46
Item 4.	Controls and Procedures	46
PART II.	OTHER INFORMATION
Item 6.	Exhibits	47
SIGNATURES		48
EXHIBIT INDEX		49

1

Cautionary Note Regarding Forward-Looking Statements

The Company may, from time to time, make written or oral forward-looking statements, including statements contained in the Company’s filings with the Securities and Exchange Commission (the “Commission”) and its reports to stockholders.  Such forward-looking statements are made based on management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including  governmental  monetary  and  fiscal  policies,  deposit  levels, loan demand, loan collateral values, securities portfolio values and interest rate risk management; the effects of competition in the banking business from other commercial banks, savings and loan associations, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market mutual funds and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating through the Internet; changes in government regulations relating to the banking industry, including regulations relating to branching and acquisitions; failure of assumptions underlying the establishment of reserves for loan losses, including the value of collateral underlying delinquent loans; and other factors detailed from time to time in the Company’s periodic filings with the Commission, including Item 1A. “Risk Factors,” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.  These risks are exacerbated by the continuing effects of the recession which began in 2008 and uncertain economic conditions in the United States and globally, and we are unable to predict with certainty what effects these economic conditions will have on our future operating results and financial condition.  The Company cautions that such factors are not exclusive.  The Company does not undertake to update any forward-looking statements that may be made from time to time by, or on behalf of, the Company.

2

Part I - FINANCIAL INFORMATION

Item 1.                      Financial Statements.

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Financial Condition

(dollars in thousands, except share and per share data)

	September 30, 2012			December 31, 2011
	(Unaudited)
ASSETS
Cash and due from banks	$	50,109		$	34,902
Securities available-for-sale		107,420			100,283
Loans		272,506			285,614
Less allowance for loan losses		(6,557	)		(6,804	)
Loans, net		265,949			278,810
Loans held for sale, at fair value for 2012		56,273			45,227
Bank premises and equipment, net		8,774			8,979
Accrued interest receivable		1,754			1,732
Other real estate owned		7,158			6,990
Federal Home Loan Bank stock		1,865			2,070
Bank-owned life insurance		9,913			9,609
Other assets		6,600			4,650
Total assets	$	515,815		$	493,252
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Non-interest bearing	$	79,100		$	52,735
Interest-bearing:
NOW accounts		53,122			44,646
Savings		61,225			63,210
Money market accounts		57,701			52,981
Time deposits of $100 or more		114,587			134,655
Other time deposits		59,507			63,168
Total deposits		425,242			411,395
Borrowings:
Repurchase agreements		3,360			3,565
FHLB borrowings		25,000			25,000
Other liabilities		5,971			2,847
Total liabilities		459,573			442,807
Shareholders' equity:
Preferred stock, par value $.001; 1,000,000 shares authorized; none issued		-			-
Common stock, par value $.001; 9,000,000 shares authorized; 3,627,397 and 3,592,140 shares issued and outstanding		4			4
Additional paid-in-capital		16,459			16,301
Retained earnings		37,927			32,988
Accumulated other comprehensive income		1,852			1,152
Total shareholders' equity		56,242			50,445
Total liabilities and shareholders' equity	$	515,815		$	493,252

See notes to consolidated financial statements.

3

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Net Income

(Unaudited)

(dollars in thousands, except per share amounts)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
Interest income
Interest and fees on loans	$	4,579		$	4,782	$	13,754		$	14,838
Interest on taxable securities		502			593		1,542			1,736
Interest on nontaxable securities		109			92		335			298
Interest on Federal funds sold and other interest		10			22		51			72
Total interest income		5,200			5,489		15,682			16,944
Interest expense
Interest on time deposits of $100 or more		376			551		1,275			1,842
Interest on other deposits		349			560		1,088			1,901
Interest on funds purchased and other borrowings		220			241		670			795
Total interest expense		945			1,352		3,033			4,538
Net interest income		4,255			4,137		12,649			12,406
Provision for loan losses		(729	)		656		(299	)		1,207
Net interest income after provision for loan losses		4,984			3,481		12,948			11,199
Non-interest income
Service charges on deposits		380			387		1,114			1,122
Gain on sale of loans held for sale		3,929			2,160		8,724			6,022
Gain on sale of securities		10			-		11			14
Other-than-temporary impairment of securities		-			-		-			(38	)
Other income		516			339		1,391			1,023
Total non-interest income		4,835			2,886		11,240			8,143
Non-interest expense
Salaries and employee benefits		3,449			2,953		9,351			8,894
Occupancy expenses		391			392		1,168			1,162
Other real estate expenses		918			447		1,409			719
Other expenses		1,749			1,460		4,610			3,998
Total non-interest expense		6,507			5,252		16,538			14,773
Income before income taxes		3,312			1,115		7,650			4,569
Income tax expense		1,070			326		2,421			1,408
Net income	$	2,242		$	789	$	5,229		$	3,161
Net income per share of common stock
Basic	$	0.62		$	0.22	$	1.45		$	0.89
Diluted	$	0.62		$	0.22	$	1.45		$	0.89
Dividends per share of common stock	$	0.04		$	-	$	0.08		$	-

See notes to consolidated financial statements.

4

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Comprehensive Income

(Unaudited)

(dollars in thousands)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
Net income	$	2,242		$	789		$	5,229		$	3,161
Other comprehensive income:
Unrealized holding gain arising during period		615			864			1,035			1,445
Tax effect of unrealized holding gain arising during the period		(190	)		(311	)		(327	)		(525	)
Reclassification for gain included in net income		(10	)		-			(11	)		(14	)
Tax effect of gain included in net income		3			-			3			5
Reclassification for other-than-temporary impairment included in net income		-			-			-			38
Tax effect of other-than-temporary impairment		-			-			-			(9	)
Total other comprehensive income		418			553			700			940
Comprehensive income	$	2,660		$	1,342		$	5,929		$	4,101

See notes to the consolidated financial statements.

5

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Cash Flows

(Unaudited)

(dollars in thousands)

	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities
Net income	$	5,229		$	3,161
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		478			468
Provision for loan losses		(299	)		1,207
Provision for other real estate owned		726			390
Stock based compensation expense		105			81
Stock compensation		196			232
Increase in cash value of bank-owned life insurance		(304	)		(315	)
Gain on sales of other real estate owned		(16	)		(140	)
(Gain)/loss on sales of premises and fixed assets		(5	)		11
Gain on sales of securities		(11	)		(14	)
Other-than-temporary impairment of security		-			38
Gain on loans held for sale		(8,724	)		(6,022	)
Proceeds from sale of loans held for sale		313,738			295,240
Originations of loans held for sale		(316,060	)		(270,520	)
Increase in accrued interest receivable		(22	)		(73	)
Decrease in accrued interest payable		(37	)		(176	)
Increase in deferred income tax asset, net		(444	)		(148	)
(Increase) decrease in other assets		(1,921	)		300
Increase (decrease) in other liabilities		3,161			(491	)
Net cash provided by (used in) operating activities		(4,210	)		23,229
Cash flows from investing activities
Loan originations and collections, net		8,196			9,547
Purchases of available-for-sale securities		(33,493	)		(54,573	)
Proceeds from maturities & calls of available-for-sale securities, net		24,680			24,187
Proceeds from sales of available-for-sale securities, net		2,722			2,518
Proceeds from sales of FHLB stock		205			337
Proceeds from sales of other real estate owned		4,086			1,567
Net additions to bank premises and fixed assets		(189	)		(166	)
Net cash provided by (used in) investing activities		6,207			(16,583	)
Cash flows from financing activities
Increase in deposits		13,847			19,093
Redemption of FHLB advances		(25,000	)		-
Issuance of FHLB short-term borrowing		25,000			-
Decrease in repurchase agreements and other borrowings		(205	)		(4,075	)
Proceeds from stock options exercised		188			13
Repurchased stock		(330	)		-
Dividends		(290	)		-
Net cash provided by financing activities		13,210			15,031
Net increase in cash and due from banks		15,207			21,677
Cash and due from banks at beginning of period		34,902			31,696
Cash and due from banks at end of period	$	50,109		$	53,373

See notes to the consolidated financial statements.

6

Supplemental Consolidated Cash Flow Information

The Bank had the following significant non-cash transactions during the nine months ended September 30, 2012 and 2011.

	September 30, 2012		September 30, 2011
	(in thousands)
Supplemental cash flow information:
Interest received	$	15,660	$	16,871
Interest paid		3,070		4,714
Income taxes paid		1,725		1,586
Supplemental noncash disclosures:
Transfers from loans to other real estate owned	$	4,964	$	4,828
Unrealized gain on securities		700		940

7

GEORGIA-CAROLINA BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2012

(Unaudited)

Note 1 – Basis of Presentation

The accompanying consolidated financial statements include the accounts of Georgia-Carolina Bancshares, Inc. (the “Company”), its wholly owned subsidiary, First Bank of Georgia (the “Bank”), and the wholly owned subsidiary of the Bank, Willhaven Holdings, LLC.  All intercompany transactions and accounts have been eliminated in consolidation of the Company and the Bank.

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

The financial information included herein reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary to a fair presentation of the financial position and results of operations for interim periods.

Note 2 – Investment Securities

The amortized cost and fair value amounts of securities owned as of September 30, 2012 and December 31, 2011 are shown below:

	September 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Securities available-for-sale:
U.S. Government and agency	$	28,952	$	245	$	(49	)	$	29,148
Corporate bonds		2,065		51		-			2,116
Mortgage-backed		54,649		1,708		(56	)		56,301
State and municipal		18,919		952		(16	)		19,855
Total	$	104,585	$	2,956	$	(121	)	$	107,420

	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Securities available-for-sale:
U.S. Government and agency	$	31,033	$	86	$	(50	)	$	31,069
Mortgage-backed		52,936		1,431		(16	)		54,351
State and municipal		14,514		532		(183	)		14,863
Total	$	98,483	$	2,049	$	(249	)	$	100,283

8

Note 2 – Investment Securities (continued)

The amortized cost and fair value of securities as of September 30, 2012 by contractual maturity are as follows. Actual maturities may differ from contractual maturities in mortgage-backed securities, as the mortgages underlying the securities may be called or prepaid without penalty; therefore, these securities are not included in the maturity categories in the following maturity summary.

	Securities Available-for-Sale
	Amortized Cost		Fair Value
	(in thousands)
Less than one year	$	7,760	$	7,789
One to five years		5,897		6,085
Five to ten years		19,965		20,742
Over ten years		16,314		16,503
Mortgage-backed securities		54,649		56,301
Total	$	104,585	$	107,420

Securities with a carrying amount of approximately $51.0 million at September 30, 2012 and $57.0 million at December 31, 2011 were pledged to secure public deposits and for other purposes.

For the nine months ended September 30, 2012, the Bank had sold $2.7 million in securities available-for-sale, realizing a gain of $11,000.  For the nine months ended September 30, 2011, the Bank sold $2.5 million in securities available-for-sale, realizing a gain of $14,000.

Information pertaining to securities with gross unrealized losses at September 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

	September 30, 2012
	Less than Twelve Months							Over Twelve Months
	Number of Securities		Fair Value		Gross Unrealized Losses			Number of Securities		Fair Value		Gross Unrealized Losses
	(in thousands)
Securities available-for-sale:
U.S. agency		1	$	1,963	$	(37	)		2	$	5,025	$	(13	)
Corporate bonds		-		-		-			-		-		-
State and municipal		5		2,853		(16	)		-		-		-
Mortgage-backed		8		9,753		(55	)		1		6		-	*
Total		14	$	14,569	$	( 108	)		3	$	5,031	$	( 13	)

*Gross unrealized loss is less than $1,000.

9

Note 2 – Investment Securities (continued)

	December 31, 2011
	Less than Twelve Months							Over Twelve Months
	Number of Securities		Fair Value		Gross Unrealized Losses			Number of Securities		Fair Value		Gross Unrealized Losses
	(in thousands)
Securities available-for-sale:
U.S. agency		3	$	6,641	$	(15	)		1	$	3,860	$	(35	)
State and municipal		3		2,583		(70	)		1		709		(113	)
Mortgage-backed		5		4,840		(16	)		1		14		-	*
Total		11	$	14,064	$	(101	)		3	$	4,583	$	(148	)

*Gross unrealized loss is less than $1,000.

Management evaluates investment securities for other-than-temporary impairment on a periodic basis, and more frequently when economic or market conditions warrant such evaluation.  Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuers, and (3) the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  During the first quarter of 2011, the Bank determined that one of its collateralized mortgage obligation securities was other-than-temporarily impaired due to continued deterioration of the underlying collateral.  Based on projected future losses, the Bank impaired the security by $38,000 to a balance of $149,000.  The security was sold in the second quarter of 2011 with an additional loss on sale of $30,000.

At September 30, 2012, the gross unrealized losses in securities available-for-sale are primarily the result of changes in market interest rates and not related to the credit quality of the underlying issuer.  All of the securities are U.S. agency debt securities, mortgage-backed securities, and municipal securities.  The Bank has determined that no declines in market value are deemed to be other than temporary at September 30, 2012.

Included in “Other assets” is an investment of approximately $315,000, net of amortization, in a real estate rehabilitation project located in Georgia that will provide the Bank with state tax credits for approximately the next four years.

10

Note 3 – Loans

The Bank engages in a full complement of lending activities, including commercial, consumer and real estate loans.  The composition of loans for the periods ended September 30, 2012 and December 31, 2011 is summarized as follows:

	September 30, 2012			December 31, 2011
	(in thousands)
Commercial and industrial	$	17,601		$	18,864
Real estate – construction, land and land development		61,463			73,823
Real estate – residential		54,211			56,563
Real estate – commercial		135,252			131,725
Consumer		4,044			4,715
Total loans receivable		272,571			285,690
Deferred loan fees		(65	)		(76	)
Total loans		272,506			285,614
Allowance for loan losses		(6,557	)		(6,804	)
Loans, net of allowance for loan losses	$	265,949		$	278,810

Loan segments

Commercial and industrial loans are directed principally towards individual, partnership or corporate borrowers, for a variety of business purposes.  These loans include short-term lines of credit, short-term to medium-term plant and equipment loans, and loans for general working capital.  Risks associated with this type of lending arise from the impact of economic stresses on the business operations of borrowers. The Bank mitigates such risks to the loan portfolio by diversifying lending across North American Industry Classification System (“NAICS”) codes and has experienced very low levels of loss for this loan type for the past three years.  

Real estate – construction, land and land development loans consist of residential and commercial construction loans as well as land and land development loans.  Land development loans are primarily construction and development loans to builders in the Augusta and Savannah, Georgia markets.  Given the significant decline in value for both developed and undeveloped land due to reduced demand, these loan portfolios possess an increased level of risk compared to other loan types. The Bank’s approach to financing the development, financing the construction and providing the ultimate residential mortgage loans to the residential property purchasers has resulted in less exposure to the effects of the aforementioned decline in property values.  The Bank further evaluates and monitors certain real estate – construction loans classified as acquisition, development & construction.  These loans specifically include land and development loans of regional builders and are managed by the Bank’s construction division.

Real estate – residential loans include residential mortgage lending and are primarily single-family residential loans secured by the residential property.  Due to the decline in residential property values and stagnant resale market, this loan type has experienced a slight increase in losses over the past three years.  Home equity lines are also included in real estate – residential loans.  Due to the present state of the housing market and declining home values, these loans present unique risk possibilities to the Bank.

Real estate – commercial loans include commercial mortgage loans that are generally secured by office buildings, retail establishments and other types of real property, both owner occupied and non-owner occupied. A significant component of this type of lending is to owner occupied borrowers, including churches. The economic slowdown has caused some deterioration in values.  The Bank has experienced an increase in losses over the past three years in real estate – commercial loans that are non-owner occupied.

11

Note 3 – Loans (continued)

Consumer loans consist primarily of installment loans to individuals for personal, family or household purposes, including automobile loans to individuals and pre-approved lines of credit.  The Bank has experienced low levels of loss for this loan type for the past three years compared to the other loan types.

Loan risk grades

The Company categorizes loans into risk grades based on relevant information about the ability of borrowers to service their debt such as:  future repayment ability, financial condition, collateral, administration, management ability of borrower, and history and character of borrower.  Grades are assigned at loan origination and may be changed due to the result of a loan review or at the discretion of management.  The Company uses the following definitions for risk grades:

Grade 1:  Highest quality.  Alternate sources of cash exist, such as the commercial paper market, capital market, internal liquidity or other bank lines.  National or regional companies with excellent cash flow which covers all debt service requirements and a significant portion of capital expenditures.  Balance sheet strength and liquidity are excellent and exceed the industry norms.  Financial trends are positive.    Market leader within the industry and the industry performance is excellent. Loans which are fully secured by cash or equivalents.  Loans secured by marketable securities with no less than 25% margin. Borrowers of unquestionable financial strength.  Financial standing of individual is known and borrower exhibits superior liquidity, net worth, cash flow and leverage.

Grade 2:  Above average quality.  Minimal risk.  Borrowers with strong, stable financial trends.  Strong cash flow covering debt service requirements and some portion of capital expenditures.  Alternate sources of repayment are evident and financial ratios are comparable to or exceed the industry norms.  Financial trends are positive.  Prominent position within the industry or the local economy and the industry performance is above average.  Management is strong in most areas and backup depth is good.  Loans secured by marketable securities with a margin less than 25%.  Individuals with stable and reliable cash flow and above average liquidity and cash flow.  Modest risk from exposure to contingent liabilities.

Grade 3:  Average quality.  Cash flow is adequate to cover all debt service requirements but not capital expenditures.  Balance sheet may be leveraged but still comparable to industry norms.  Financial trends are stable to mixed over the long term but no significant concerns presently exist.  Generally stable industry outlook, may have some cyclical characteristics.  The  position is average in the industry or the local economy.  The management team is considered capable and stable.  Individuals have reliable cash flow and alternate sources of repayment which may require the sale of assets.  Financial position has been leveraged to a modest degree. However, the individual has a relatively strong net worth considering income and debt.

Grade 4:  Below average quality.  Loan conditions require more frequent monitoring.  Stability is lacking in the primary repayment source, cash flow, credit history or liquidity; however, the instability is manageable and considered temporary.  Overall trends are not yet adverse.  Loans exhibiting Grade 3 financial characteristics but lacking proper and complete documentation.  Individuals whose sources of income or cash flow have become unstable or may possibly decline given current business or economic conditions.  An individual with highly leveraged financial position or limited capital.  Speculative construction loans originated by third parties.

12

Note 3 – Loans (continued)

Grade 5:  Other Assets Especially Mentioned.  These loans have potential weaknesses which may inadequately protect the Bank’s position at some future date.  Unlike a Grade 4 credit, adverse trends in the obligor’s operations and/or financial position are evident, but have not yet developed into well-defined credit weaknesses.  Specific negative events within the obligor or the industry have occurred, which may jeopardize cash flow.  Borrower’s operations are highly cyclical or vulnerable to economic or market conditions.  Management has potential weaknesses and backup depth is lacking.  Borrower is taking positive steps to alleviate potential weaknesses and has the potential for improvement and upgrade.  Corrective strategy to protect the Bank may be required and active management attention is warranted.  Some minor delinquencies may exist from time to time.  Individuals exhibit some degree of weakness in financial condition.  This may manifest itself in a reduction of net worth and liquidity.  Infrequent delinquencies may occur.

Grade 6:  Substandard.  A substandard loan has a well-defined weakness or weaknesses in the primary repayment source and undue reliance is placed on secondary repayment sources (collateral or guarantors).  No loss is presently expected beyond the Bank’s recorded basis based on a current assessment of collateral values and guarantor cash flow.  However, there is the distinct possibility that the Bank will sustain some future loss if the credit weaknesses are not corrected.  Management is inadequate to the extent that the business’ ability to continue operations is in question.  Intensive effort to correct the weaknesses and ensure protection against loss of principal (i.e. additional collateral) is mandatory.  Delinquency of principal or interest may exist.  Net worth, repayment ability, management and collateral protection, all exhibit weakness. In the case of consumer credit, closed end consumer installment loans delinquent between 90 and 119 days (4 monthly payments) will be minimally classified Substandard.   Open end consumer credit will be minimally classified Substandard if delinquent 90 to 179 days (4 to 6 billing cycles).

Grade 7: Doubtful.  A doubtful loan has well-defined weaknesses as in Grade 6 with the added characteristic that collection or liquidation in full, on the basis of currently existing facts, conditions and values, is highly questionable and improbable.  The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors which may work to strengthen the credit, its classification as a loss is deferred until a more exact status can be determined.  Pending factors include proposed merger, acquisition, liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans.  Borrower is facing extreme financial distress, bankruptcy or liquidation, and prospects for recovery are limited.  Loans are seriously in default and should be on non-accrual status.  Collateral and guarantor protection are insufficient.  Efforts are directed solely at retirement of debt, e.g., asset liquidation.  Due to their highly questionable collectability, assets rated doubtful should not remain in this category for an extended period of time.

Grade 8:  Loss.  Loans classified loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off the asset while pursuing recovery.  The Bank should not attempt long-term recoveries while the asset remains on the active loan system.  In the case of consumer credit, closed end consumer installment loans delinquent 120 days or more (5 monthly payments) will be classified Loss.  Open end consumer credit will be classified Loss if delinquent 180 days or more (7 or more billing cycles).

As of September 30, 2012 and December 31, 2011, the Bank had no loans classified as Grade 7 or 8.  It is the Bank’s practice, in most cases, to take a charge-off when a loan or portion of a loan is deemed doubtful or loss.  Consequently, the remaining principal balance, if applicable, which has been evaluated as collectible, is graded accordingly.

13

Note 3 – Loans (continued)

As of September 30, 2012 and December 31, 2011, the risk grades of loans by loan class, including deferred loan fees, were as follows:

Credit Risk Profile by Risk Grade Category:

	As of September 30, 2012 (in thousands)
	Grades 1-4			Grade 5		Grade 6		Total
Commercial and industrial	$	17,154		$	5	$	442	$	17,601
Real estate – construction, land and land development
Acquisition, development, & construction		13,895			632		73		14,600
Other real estate - construction		45,361			785		717		46,863
Real estate – residential
Home equity lines		20,175			108		38		20,321
Other real estate – residential		31,823			824		1,243		33,890
Real estate – commercial
Owner occupied		50,772			1,266		5,742		57,780
Non-owner occupied		74,498			2,974		-		77,472
Consumer		3,975			25		44		4,044
Loans in process and fees		(65	)		-		-		(65	)
Total loans receivable	$	257,588		$	6,619	$	8,299	$	272,506

The credit risk profile by risk grade category excludes accrued interest receivable which totaled $1,170,000 at period end.

	As of December 31, 2011 (in thousands)
	Grades 1-4		Grade 5		Grade 6		Total
Commercial and industrial	$	18,118	$	-	$	751	$	18,869
Real estate – construction, land and land development
Acquisition, development, & construction		18,469		1,497		1,366		21,332
Other real estate - construction		46,685		1,077		4,699		52,461
Real estate – residential
Home equity lines		22,104		392		9		22,505
Other real estate – residential		31,742		365		1,952		34,059
Real estate – commercial
Owner occupied		47,336		227		5,956		53,519
Non-owner occupied		76,385		593		1,202		78,180
Consumer		4,501		-		79		4,580
Loans in process and fees		109		-		-		109
Total loans receivable	$	265,449	$	4,151	$	16,014	$	285,614

The credit risk profile by risk grade category excludes accrued interest receivable which totaled $1,174,000 at period end.

14

Note 3 – Loans (continued)

During the second quarter of 2011, the Bank experienced a significant increase in loans classified as Grade 6 or Substandard, mostly due to the downgrade of a large relationship consisting of 10 loans totaling $8.8 million.  The relationship was made up of $90,000 real estate - residential, $4.3 million real estate – construction, land and land development, and $4.4 million real estate – commercial.  As of September 30, 2012, the Bank had transferred all of the relationship to other real estate owned.

The following table presents the activity in the allowance for loan losses by loan type for the three and nine months ended September 30, 2012 and 2011:

Allowance for Loan Losses Activity

For the Three and Nine Months Ended September 30, 2012 and 2011

(in thousands)

	Commercial and industrial			Real estate – construction, land and land development			Real estate – residential			Real estate – commercial			Consumer			Unallocated			Total
Three Months Ended September 30, 2012:
Beginning balance	$	236		$	3,368		$	767		$	1,934		$	89		$	460		$	6,854
Charge-offs		(10	)		(41	)		-			-			(12	)		-			(63	)
Recoveries		4			460			5			-			26			-			495
Provisions		141			(476	)		2			(51	)		(9	)		(336	)		(729	)
Ending Balance	$	371		$	3,311		$	774		$	1,883		$	94		$	124		$	6,557
Three Months Ended September 30, 2011:
Beginning balance	$	92		$	3,656		$	1,027		$	1,845		$	168		$	970		$	7,758
Charge-offs		-			(591	)		(94	)		(124	)		(25	)		-			(834	)
Recoveries		4			20			2			70			7			-			103
Provisions		59			270			213			655			(30	)		(511	)		656
Ending Balance	$	155		$	3,355		$	1,148		$	2,446		$	120		$	459		$	7,683
Nine Months Ended September 30, 2012:
Beginning balance	$	185		$	3,219		$	1,141		$	1,706		$	108		$	445		$	6,804
Charge-offs		(10	)		(655	)		(227	)		-			(82	)		-			(974	)
Recoveries		228			709			38			-			51			-			1,026
Provisions		(32	)		38			(178	)		177			17			(321	)		(299	)
Ending Balance	$	371		$	3,311		$	774		$	1,883		$	94		$	124		$	6,557
Nine Months Ended September 30, 2011:
Beginning balance	$	227		$	3,908		$	1,070		$	1,617		$	251		$	793		$	7,866
Charge-offs		(30	)		(910	)		(503	)		(240	)		(58	)		-			(1,741	)
Recoveries		58			20			138			99			36			-			351
Provisions		(100	)		337			443			970			(109	)		(334	)		1,207
Ending Balance	$	155		$	3,355		$	1,148		$	2,446		$	120		$	459		$	7,683

15

Note 3 – Loans (continued)

The following table presents the ending balances of allowance for loan losses by loan type as of September 30, 2012 and December 31, 2011:

Ending Balances of Allowance for Loan Losses

As of September 30, 2012 and December 31, 2011

(in thousands)

	Commercial and industrial		Real estate – construction, land and land development		Real estate – residential		Real estate – commercial		Consumer		Unallocated		Total
September 30, 2012:
Individually evaluated for impairment	$	199	$	-	$	53	$	132	$	14	$	-	$	398
Collectively evaluated for impairment	$	172	$	3,311	$	721	$	1,751	$	80	$	124	$	6,159
December 31, 2011:
Individually evaluated for impairment	$	51	$	-	$	208	$	100	$	36	$	-	$	395
Collectively evaluated for impairment	$	134	$	3,219	$	933	$	1,606	$	72	$	445	$	6,409

16

Note 3 – Loans (continued)

The following table presents the recorded investment in loans receivable by loan segment and based on impairment method as of September 30, 2012 and December 31, 2011:

Recorded Investment in Loans Receivable

As of September 30, 2012 and December 31, 2011

(in thousands)

	Commercial and industrial		Real Estate – construction, land and land development		Real estate – residential		Real estate – commercial		Consumer		Total
September 30, 2012:
Total	$	17,681	$	61,750	$	54,537	$	135,702	$	4,071	$	273,741
Individually evaluated for impairment	$	444	$	1,388	$	1,607	$	6,575	$	44	$	10,058
Collectively evaluated for impairment	$	17,237	$	60,362	$	52,930	$	129,127	$	4,027	$	263,683
December 31, 2011:
Total	$	19,003	$	74,173	$	56,807	$	132,151	$	4,740	$	286,874
Individually evaluated for impairment	$	950	$	5,925	$	1,591	$	9,415	$	80	$	17,961
Collectively evaluated for impairment	$	18,053	$	68,248	$	55,216	$	122,736	$	4,660	$	268,913

The recorded investment in loans receivable includes accrued interest receivable and deferred loan fees, net.

17

Note 3 – Loans (continued)

Impaired loans

Loans for which it is probable that the payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired, and are individually evaluated for impairment.  The following tables present loans individually evaluated for impairment and related allowance by loan class as of and for the periods ended September 30, 2012 and December 31, 2011:

Impaired Loans

As of September 30, 2012

(in thousands)

	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:
Commercial and industrial	$	35	$	35	$	-
Real estate – construction, land and land development
Acquisition, development, & construction		73		1,988		-
Other real estate - construction		1,315		1,611		-
Real estate – residential
Home equity lines		104		104		-
Other real estate - residential		1,397		1,560		-
Real estate – commercial
Owner occupied		5,779		5,806		-
Non-owner occupied		-		-		-
Consumer		31		41		-
Total	$	8,734	$	11,145	$	-
With an allowance recorded:
Commercial and industrial	$	409	$	407	$	199
Real estate – construction, land and land development
Acquisition, development, & construction		-		-		-
Other real estate - construction		-		-		-
Real estate – residential
Home equity lines		-		-		-
Other real estate - residential		106		106		53
Real estate – commercial
Owner occupied		222		222		32
Non-owner occupied		574		574		100
Consumer		13		14		14
Total	$	1,324	$	1,322	$	398
Commercial and industrial	$	444	$	442	$	199
Real estate – construction, land and land development
Acquisition, development, & construction		73		1,988		-
Other real estate - construction		1,315		1,611		-
Real estate – residential
Home equity lines		104		104		-
Other real estate - residential		1,503		1,666		53
Real estate – commercial
Owner occupied		6,001		6,028		32
Non-owner occupied		574		574		100
Consumer		44		54		14
Total	$	10,058	$	12,467	$	398

For purposes of this disclosure, the unpaid principal balance is not reduced for net charge-offs.

18

Note 3 – Loans (continued)

Impaired Loans

As of December 31, 2011

(in thousands)

	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:
Commercial and industrial	$	887	$	884	$	-
Real estate – construction, land and land development
Acquisition, development, & construction		1,101		3,663		-
Other real estate - construction		4,824		6,558		-
Real estate – residential
Home equity lines		58		58		-
Other real estate - residential		1,275		1,368		-
Real estate – commercial
Owner occupied		6,729		6,730		-
Non-owner occupied		2,091		4,037		-
Consumer		36		45		-
Total	$	17,001	$	23,343	$	-
With an allowance recorded:
Commercial and industrial	$	63	$	62	$	51
Real estate – construction, land and land development
Acquisition, development, & construction		-