10-Q 1 gcbi_10q-093012.htm FORM 10Q gcbi_10q-093012.htm
 
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
    -       -       -