10-Q 1 gcbi_10q-033113.htm FORM 10-Q gcbi_10q-033113.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2013
- or -
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
 
(I.R.S. Employer Identification Number)
 
Incorporation or Organization)
     

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 May 6, 2013
 
Common Stock, $.001 Par Value   
 
3,556,648 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 March 31, 2013 and December 31, 2012
3
 
 
Consolidated Statements of Income for the Three Months Ended March 31, 2013 and 2012
4
     
 
Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2013 and 2012
5
 
 
 
 
Consolidated Statements of Shareholders’ Equity for the Three Months Ended March 31, 2013 and 2012
6
 
 
 
 
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2013 and 2012
7
 
 
 
 
Notes to Consolidated Financial Statements
9
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
34
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
41
   
Item 4.
Controls and Procedures
41
     
PART II.
OTHER INFORMATION
 
     
Item 6.
Exhibits
42
     
 
SIGNATURES
43
     
 
EXHIBIT INDEX
44
 
 
 

 
 
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, 2012.  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.
 
 
 

 
 

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)

   
March 31,
2013
   
December 31,
2012
 
   
(Unaudited)
       
Assets  
Cash and due from banks
  $ 21,524     $ 30,279  
Securities available-for-sale
    138,302       132,760  
                 
Loans     266,430       265,831  
Allowance for loan losses
    (5,490 )     (5,954 )
Loans, net
    260,940       259,877  
                 
Loans held for sale at fair value
    34,295       48,432  
Bank-owned life insurance
    10,085       10,001  
Bank premises and equipment, net
    9,119       8,790  
Accrued interest receivable
    1,754       1,772  
Other real estate owned, net
    5,235       5,876  
Federal Home Loan Bank stock
    697       1,865  
Other assets
    7,758       6,523  
Total assets
  $ 489,709     $ 506,175  
                 
Liabilities and Shareholders’ Equity
 
Liabilites                
Deposits                
Non-interest bearing
  $ 71,995     $ 70,880  
Interest-bearing:
               
NOW accounts
    55,326       57,482  
Savings
    63,594       64,236  
Money market accounts
    67,875       54,982  
Time deposits of $100,000 or more
    107,407       111,537  
Other time deposits
    57,385       57,839  
Total deposits
    423,582       416,956  
                 
Short-term debt
    -       25,028  
Repurchase agreements
    2,959       3,333  
Other liabilities
    4,862       4,533  
Total liabilities
    431,403       449,850  
                 
Shareholders’ equity
               
Preferred stock, par value $.001; 1,000,000 shares authorized; none issued
    -       -  
Common stock, par value $.001; 9,000,000 shares authorized; 3,555,283 and 3,528,296 shares issued and outstanding, respectively
    4       4  
Additional paid-in capital
    15,777       15,687  
Retained earnings
    41,342       39,177  
Accumulated other comprehensive income
    1,183       1,457  
Total shareholders’ equity
    58,306       56,325  
                 
Total liabilities and shareholders’ equity
  $ 489,709     $ 506,175  
 
See notes to the consolidated financial statements.
 
 
3

 

GEORGIA-CAROLINA BANCSHARES, INC.
Consolidated Statements of Income
(Unaudited)
(dollars in thousands, except share and per share data)
 
   
Three Months Ended March 31,
 
   
2013
   
2012
 
Interest income
           
Interest and fees on loans
  $ 3,884     $ 4,611  
Interest on taxable securities
    514       514  
Interest on nontaxable securities
    116       111  
Other interest income
    6       20  
Total interest income
    4,520       5,256  
                 
Interest expense
               
Interest on time deposits of $100,000 or more
    282       470  
Interest on other deposits
    281       377  
Interest on funds purchased and other borrowings
    6       225  
Total interest expense
    569       1,072  
                 
Net interest income
    3,951       4,184  
                 
Provision for loan losses
    (602 )     305  
                 
Net interest income after provision for loan losses
    4,553       3,879  
                 
Non-interest income
               
Service charges on deposits
    370       356  
Mortgage banking activities
    2,004       2,108  
Net gains on sales of other real estate
    145       26  
Gain on sale of securities
    13       -  
Other      1,257       431  
Total non-interest income
    3,789       2,921  
                 
Non-interest expense
               
Salaries and employee benefits
    3,074       2,942  
Occupancy expenses
    368       397  
Other real estate owned expenses
    159       212  
Other      1,612       1,415  
Total non-interest expense
    5,213       4,966  
                 
Income before income taxes
    3,129       1,834  
                 
Income tax expense
    822       550  
                 
Net income
  $ 2,307     $ 1,284  
                 
Earnings per common share
               
Basic   $ 0.65     $ 0.36  
Diluted
  $ 0.65     $ 0.36  
                 
Dividends per common share
  $ 0.04     $ 0.00  
 
See notes to the consolidated financial statements.
 
 
4

 

GEORGIA-CAROLINA BANCSHARES, INC.
Consolidated Statements of Comprehensive Income
(Unaudited
(dollars in thousands)
 
   
Three Months Ended March 31,
 
   
2013
   
2012
 
             
Net income
  $ 2,307     $ 1,284  
                 
Other comprehensive income (loss):
               
                 
Unrealized holding loss arising during the period
    (502 )     (75 )
Tax effect of unrealized holding loss
    237       20  
Reclassification for gain included in net income
    (13 )     -  
Tax effect of gain included in net income
    4       -  
                 
Total other comprehensive income (loss)
    (274 )     (55 )
                 
Comprehensive income
  $ 2,033     $ 1,229  

See notes to the consolidated financial statements.
 
 
5

 
 
GEORGIA-CAROLINA BANCSHARES, INC.
Consolidated Statements of Shareholders' Equity
(Unaudited)
(dollars in thousands except share adnd per share data)
 
 
   
Common
Stock Shares
   
Common Stock Par Value
   
Additional Paid-in-Capital
   
Retained Earnings
   
Accumulated Other Comprehensive Income (Loss)
   
Total Shareholders' Equity
 
Balance at January 1, 2012
    3,592,140     $ 4     $ 16,301     $ 32,988     $ 1,152     $ 50,445  
Net income
    -       -       -       1,284       -       1,284  
Other comprehensive income (loss)
    -       -       -       -       (55 )     (55 )
Proceeds from exercise of stock options
    26,051       -       119       -       -       119  
Stock-based compensation expense
    -       -       27       -       -       27  
Issuance of restricted stock for compensation
    8,488               3                       3  
Issuance of stock for directors' fees
    7,187       -       54       -       -       54  
Balance at March 31, 2012
    3,633,866     $ 4     $ 16,504     $ 34,272     $ 1,097     $ 51,877  
                                                 
                                                 
Balance at January 1, 2013
    3,528,296     $ 4     $ 15,687     $ 39,177     $ 1,457     $ 56,325  
Net income
    -       -       -       2,307       -       2,307  
Other comprehensive income (loss)
    -       -       -       -       (274 )     (274 )
Stock-based compensation expense
    -       -       24       -       -       24  
Issuance of restricted stock for compensation
    24,006       -       27       -       -       27  
Issuance of stock for directors' fees
    2,981       -       39       -       -       39  
Dividends
    -       -       -       (142 )     -       (142 )
Balance at March 31, 2013
    3,555,283     $ 4     $ 15,777     $ 41,342     $ 1,183     $ 58,306  
 
See notes to the consolidated financial statements.
 
 
6

 
 
GEORGIA-CAROLINA BANCSHARES, INC.
Consolidated Statements of Cash Flows
(Unaudited)
(dollars in thousands)
 
   
Three Months Ended March 31,
 
   
2013
   
2012
 
Cash flows from operating activities
           
Net income   $ 2,307     $ 1,284  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    145       163  
Provision for loan losses
    (602 )     305  
Write-downs of other real estate owned
    -       15  
Gain on sale of other real estate owned
    (145 )     (26 )
(Gain) loss on sale of equipment
    1       -  
(Gain) loss on sale of securities
    (13 )     -  
Mortgage banking activities
    (2,004 )     (2,108 )
Proceeds from sale of loans held for sale
    107,648       106,867  
Originations of loans held for sale
    (91,507 )     (93,461 )
Increase in cash value of bank-owned life insurance
    (84 )     (83 )
Stock-based compensation expense
    51       30  
Stock issued for directors' fees
    39       54  
Deferred income tax (benefit) expense
    31       (300 )
(Increase) decrease in accrued interest receivable
    18       (84 )
(Increase) decrease in other assets
    (1,051 )     670  
Increase (decrease) in accrued interest payable
    5       (3 )
Increase in other liabilities
    325       488  
Net cash provided by operating activities
    15,164       13,811  
                 
Cash flows from investing activities
               
Loan originations and collections, net
    (604 )     5,578  
Purchases of available-for-sale securities
    (20,146 )     (10,807 )
Proceeds from maturities and calls of available-for-sale securities
    8,195       6,112  
Proceeds from sales of available-for-sale securities
    5,906       -  
Proceeds from redemption of FHLB stock
    1,168       -  
Proceeds from sale of other real estate owned
    929       1,213  
Net additions to bank premises and equipment
    (449 )     (104 )
Net cash provided by (used in) investing activities
    (5,001 )     1,992  
                 
Cash flows from financing activities
               
Net increase in deposits
    6,626       2,736  
Net repayments of short-term borrowings
    (25,028 )     -  
Decrease in repurchase agreements
    (374 )     (400 )
Proceeds from stock options exercised
    -       119  
Cash dividends paid
    (142 )     -  
Net cash provided by (used in) financing activities
    (18,918 )     2,455  
                 
Net increase (decrease) in cash and due from banks
    (8,755 )     18,258  
                 
Cash and due from banks at beginning of the year
    30,279       34,902  
Cash and due from banks at end of the year
  $ 21,524     $ 53,160  
 
See notes to the consolidated financial statements.
 
 
7

 
 
Supplemental Consolidated Cash Flow Information

The Bank had the following significant non-cash transactions during the three months ended March 31, 2013 and 2012.
 
   
Three Months Ended March 31,
 
      2013       2012  
   
(dollars in thousands)
 
Supplemental cash flow information:
               
Interest received
  $ 4,538     $ 5,172  
Interest paid
    564       1,075  
Income taxes paid
    -       -  
                 
Supplemental noncash information:
               
Transfers from loans to other real estate owned
    143       754  
Unrealized loss on securities, net of tax
  $ (274 )   $ (55 )
 
See notes to the consolidated financial statements.
 
 
8

 
 
GEORGIA-CAROLINA BANCSHARES, INC.

Notes to Consolidated Financial Statements
March 31, 2013
(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 consolidated financial statements as of March 31, 2013 and for the three months ended March 31, 2013 and 2012 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, 2012.

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 March 31, 2013 and December 31, 2012 are shown below:

   
March 31, 2013
 
   
Amortized
Cost
   
Gross
Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
   
(dollars in thousands)
 
Securities available-for-sale:
                       
U.S. Government and agency
  $ 60,713     $ 341     $ (265 )   $ 60,789  
Mortgage-backed
    47,205       1,155       (146 )     48,214  
State and municipal
    24,857       780       (193 )     25,444  
Corporate bonds
    3,787       68       -       3,855  
                                 
Total
  $ 136,562     $ 2,344     $ (604 )   $ 138,302  
 
 
9

 
 
Note 2 – Investment Securities (continued)
 
   
December 31, 2012
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair Value
 
   
(dollars in thousands)
 
Securities available-for-sale:
                       
U.S. Government and agency
  $ 55,404     $ 260     $ (99 )   $ 55,565  
Mortgage-backed
    50,074       1,313       (92 )     51,295  
State and municipal
    21,974       852       (38 )     22,788  
Corporate bonds
    3,052       68       (8 )     3,112  
                                 
Total
  $ 130,504     $ 2,493     $ (237 )   $ 132,760  
 
The amortized cost and fair value of securities as of March 31, 2013 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
 
   
(dollars in thousands)
 
             
Less than one year
  $ 14,195     $ 14,088  
One to five years
    26,437       26,748  
Five to ten years
    30,214       30,639  
Over ten years
    18,511       18,613  
Mortgage-backed securities
    47,205       48,214  
Total
  $ 136,562     $ 138,302  
 
Securities with a carrying amount of approximately $58.8 million and $53.7 million were pledged to secure public deposits and for other purposes at March 31, 2013 and December 31, 2012, respectively.

During the three months ended March 31, 2013, the Bank sold $5.9 million in securities available-for-sale, realizing gains of $71,600 and losses of $58,500 for a net gain of $13,100.  During the three months ended March 31, 2012, there were no sales of securities available-for-sale.

For the three months ended March 31, 2013, the Bank reclassified $13,000 in gains from accumulated other comprehensive income to gain on sale of securities.  The tax effect of $4,000 was included in income tax expense.

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.
 
 
10

 

Note 2 – Investment Securities (continued)

Information pertaining to securities with gross unrealized losses at March 31, 2013 and December 31, 2012, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
 
   
March 31, 2013
 
   
Less than Twelve Months
   
Over Twelve Months
 
   
Number of Securities
   
Fair Value
   
Gross Unrealized Losses
   
Number of Securities
   
Fair Value
   
Gross Unrealized Losses
 
   
(dollars in thousands)
 
Securities available-for-sale:
                                   
U.S. Government and agency
    14     $ 23,234     $ (265 )     1     $ 1,254       *  
Mortgage-backed
    8       14,986       (146 )     -       -       -  
State and municipal
    15       6,176       (193 )     -       -       -  
Corporate bonds
    2       1,746       *       -       -       -  
                                                 
Total
    39     $ 46,142     $ (604 )     1     $ 1,254       *  
*  Gross unrealized loss is less than $1,000.
 
   
December 31, 2012
 
   
Less than Twelve Months
   
Over Twelve Months
 
   
Number of Securities
   
Fair Value
   
Gross Unrealized Losses
   
Number of Securities
   
Fair Value
   
Gross Unrealized Losses
 
   
(dollars in thousands)
 
Securities available-for-sale:
                                   
U.S. Government and agency
    7     $ 13,757     $ (99 )     1     $ 1,365       *  
Mortgage-backed
    2       4,794       (92 )     -       -       -  
State and municipal
    5       2,035       (38 )     -       -       -  
Corporate bonds
    1       992       (8 )     -       -       -  
                                                 
Total
    15     $ 21,578     $ (237 )     1     $ 1,365       *  
*  Gross unrealized loss is less than $1,000.
 
At March 31, 2013, the gross unrealized losses in securities available-for-sale are primarily the result of changes in market interest rates and are not related to the credit quality of the underlying issuer.  The Bank has determined that no declines in market value are deemed to be other than temporary at March 31, 2013.

Included in “Other assets” is an investment of approximately $262,500, 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.
 
 
11

 
 
Note 3 – Loans

The Bank engages in a full complement of lending activities, including commercial, consumer and real estate loans.  The composition of loans at March 31, 2013 and December 31, 2012 is summarized as follows:
 
 
   
March 31,
2013
   
December 31,
2012
 
   
(dollars in thousands)
 
             
Commercial and industrial
  $ 20,177     $ 19,816  
Real estate - construction, land and land development
    57,586       55,926  
Real estate - residential
    53,073       55,495  
Real estate - commercial
    131,919       130,729  
Consumer
    3,726       3,921  
Total loans
    266,481       265,887  
Deferred loan fees
    (51 )     (56 )
Total loans
    266,430       265,831  
Allowance for loan losses
    (5,490 )     (5,954 )
                 
Loans, net of allowance for loan losses
  $ 260,940     $ 259,877  

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 in 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.  These loans include certain real estate – construction loans classified as acquisition, development & construction.  The loans 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.
 
 
12

 
 
Note 3 – Loans (continued)

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.

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.  These are 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.  The companies are market leaders within the industry and the industry performance is excellent. This grade includes loans which are fully secured by cash or equivalents.  This grade includes loans secured by marketable securities with no less than 25% margin. Borrowers are 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 - There is minimal risk.  Borrowers have strong, stable financial trends.  There is 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.  Borrower has 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.  This grade includes loans secured by marketable securities with a margin less than 25%, and includes individuals who have stable and reliable cash flow and above average liquidity and cash flow.  There is 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 there is a stable industry outlook, although there may be some cyclical characteristics.  Borrowers are of average position in the industry or the local economy.  The management team is considered capable and stable.  This grade includes individuals with 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.  These loans exhibit Grade 3 financial characteristics but lack proper and complete documentation.  The individuals’ sources of income or cash flow have become unstable or may possibly decline given current business or economic conditions.  The individual has a highly leveraged financial position or limited capital.  Speculative construction loans originated by third parties are included in this grade.
 
 
13

 

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 beyond the specific reserves of the allowance for loan losses allocated to these loans is presently expected 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’s 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 credits 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 very 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, loans 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 in 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 credits will be classified Loss if delinquent 180 days or more (7 or more billing cycles).

As of March 31, 2013 and December 31, 2012, 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.
 
 
14

 
 
Note 3 – Loans (continued)

As of March 31, 2013 and December 31, 2012, the principal balance of risk grades of loans by loan class, were as follows:
 
 
Credit Risk Profile by Risk Grade Category:
   
March 31, 2013
 
   
(dollars in thousands)
 
   
Grades 1 - 4
   
Grade 5
   
Grade 6
   
Total
 
Commercial and industrial
  $ 20,105     $ -     $ 72     $ 20,177  
Real estate - construction, land and land development
                               
Acquistion, development, & construction
    12,533       516       -       13,049  
Other real estate - construction
    42,370       802       1,365       44,537  
Real estate - residential
                               
Home equity lines
    19,509       101       -       19,610  
Other real estate - residential
    31,288       771       1,404       33,463  
Real estate - commercial
                               
Owner occupied
    49,849       5,889       789       56,527  
Non-owner occupied
    72,463       2,749       180       75,392  
Consumer
    3,677       21       28       3,726  
Total loans receivable
  $ 251,794     $ 10,849     $ 3,838     $ 266,481  
 
   
December 31, 2012
 
   
(dollars in thousands)
 
   
Grades 1 - 4
   
Grade 5
   
Grade 6
   
Total
 
Commercial and industrial
  $ 19,723     $ 32     $ 61     $ 19,816  
Real estate - construction, land and land development
                               
Acquistion, development, & construction
    13,498       774       -       14,272  
Other real estate - construction
    41,344       192       118       41,654  
Real estate - residential
                               
Home equity lines
    19,829       104       4       19,937  
Other real estate - residential
    33,446       81       2,031       35,558  
Real estate - commercial
                               
Owner occupied
    47,833       5,191       1,804       54,828  
Non-owner occupied
    72,603       3,103       195       75,901  
Consumer
    3,872       22       27       3,921  
Total loans receivable
  $ 252,148     $ 9,499     $ 4,240     $ 265,887  
 
The credit risk profile by risk grade category excludes accrued interest receivables of approximately $931,000 and $1,057,000 as of March 31, 2013 and December 31, 2012, respectively.
 
 
15

 
 
Note 3 – Loans (continued)

The following table presents the activity in the allowance for loan losses by loan segment and the allowance by impairment method as of and for the three months ended March 31, 2013 and 2012:
 

Allowance for Loan Losses Activity and Allowance by Impairment Method
For the Three Months Ended March 31, 2013
(dollars in thousands)
 
   
Commercial and industrial
   
Real estate - construction, land and land development
   
Real estate - residential
   
Real estate - commercial
   
Consumer
   
Unallocated
   
Total
 
                                           
Beginning balance
  $ 225     $ 2,870     $ 794     $ 1,872     $ 77     $ 116     $ 5,954  
Charge offs
    -       -       (49 )     (54 )     (13 )     -       (116 )
Recoveries
    1       229       3       11       10       -       254  
Provisions
    51       (751 )     (34 )     65       112       (45 )     (602 )
Ending balance
  $ 277     $ 2,348     $ 714     $ 1,894     $ 186     $ 71     $ 5,490  
                                                         
Ending balances:
                                                       
Individually evaluated for impairment
  $ 26     $ 56     $ 76     $ 176     $ -     $ -     $ 334  
Collectively evaluated for impairment
  $ 251     $ 2,292     $ 638     $ 1,718     $ 186     $ 71     $ 5,156  
 
Allowance for Loan Losses Activity and Allowance by Impairment Method
For the Three Months Ended March 31, 2012
(dollars in thousands)
 
   
Commercial and industrial
   
Real estate - construction, land and land development
   
Real estate - residential
   
Real estate - commercial
   
Consumer
   
Unallocated
   
Total
 
                                           
Beginning balance
  $ 185     $ 3,219     $ 1,141     $ 1,706     $ 108     $ 445     $ 6,804  
Charge offs
    -       (481 )     (162 )     -       (37 )     -       (680 )
Recoveries
    218       202       31       -       18       -       469  
Provisions
    (227 )     302       110       103       3       14       305  
Ending balance
  $ 176     $ 3,242     $ 1,120     $ 1,809     $ 92     $ 459     $ 6,898  
                                                         
Ending balances:
                                                       
Individually evaluated for impairment
  $ 49     $ -     $ 280     $ 354     $ 16     $ -     $ 699  
Collectively evaluated for impairment
  $ 127     $ 3,242     $ 840     $ 1,455     $ 76     $ 459     $ 6,199  
 
 
16

 
 
Note 3 – Loans (continued)

The following table presents the allowance by impairment method as of December 31, 2012:
 
Allowance by Impairment Method
December 31, 2012
(dollars in thousands)

 
   
Commercial and industrial
   
Real estate - construction, land and land development
   
Real estate - residential
   
Real estate - commercial
   
Consumer
   
Unallocated
   
Total
 
Individually evaluated for impairment
  $ 28     $ -     $ 59     $ 185     $ -     $ -     $ 272  
Collectively evaluated for impairment
  $ 197     $ 2,870     $ 735     $ 1,687     $ 77     $ 116     $ 5,682  
Ending balances:
  $ 225     $ 2,870     $ 794     $ 1,872     $ 77     $ 116     $ 5,954  
 
The following table presents the recorded investment in loans receivable, including accrued interest and excluding deferred loan fees, by loan segment based on impairment method as of March 31, 2013 and December 31, 2012:
 
Recorded Investment in Loans Receivable
As of March 31, 2013
(dollars in thousands)
 
   
Commercial and industrial
   
Real estate - construction, land and land development
   
Real estate - residential
   
Real estate - commercial
   
Consumer
   
Total
 
                                     
Individually evaluated for impairment
  $ 72     $ 1,520     $ 2,192     $ 6,092     $ 28     $ 9,904  
Collectively evaluated for impairment
  $ 20,176     $ 56,330     $ 51,095     $ 126,190     $ 3,717     $ 257,508  
                                                 
Ending balance total
  $ 20,248     $ 57,850     $ 53,287     $ 132,282     $ 3,745     $ 267,412  
 
Recorded Investment in Loans Receivable
As of December 31, 2012
(dollars in thousands)
 
   
Commercial and industrial
   
Real estate - construction, land and land development
   
Real estate - residential
   
Real estate - commercial
   
Consumer
   
Total
 
                                     
Individually evaluated for impairment
  $ 90     $ 566     $ 2,376     $ 6,770     $ 27     $ 9,829  
Collectively evaluated for impairment
  $ 19,798     $ 55,657     $ 53,413     $ 124,420     $ 3,914     $ 257,202  
                                                 
Ending balance total
  $ 19,888     $ 56,223     $ 55,789     $ 131,190     $ 3,941     $ 267,031  
 
 
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 the related allowance by loan segment as of and for the periods ended March 31, 2013 and December 31, 2012:
 
Impaired Loans
As of and for the Three Months Ended March 31, 2013
(dollars in thousands)
 
   
Unpaid Principal Balance
   
Recorded Investment
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With no related allowance recorded:
                             
Commercial and industrial
  $ 46     $ 46     $ -     $ 54     $ -  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    415       310       -       310       1  
Other real estate - construction
    856       667       -       684       3  
Real estate - residential
                                       
Home equity lines
    67       67       -       66       1  
Other real estate - residential
    1,907       1,831       -       1,831       10  
Real estate - comercial
                                       
Owner occupied
    4,971       4,937       -       4,937       47  
Non-owner occupied
    -       -       -       -       -  
Consumer
    39       28       -       28       -  
Total   $ 8,301     $ 7,886     $ -     $ 7,910     $ 62  
                                         
With an allowance recorded:
                                       
Commercial and industrial
  $ 26     $ 26     $ 26     $ 26     $ -  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    -       -       -       -       -  
Other real estate - construction
    543       543       56       543       -  
Real estate - residential
                                       
Home equity lines
    -       -       -       -       -  
Other real estate - residential
    294       294       76       294       1  
Real estate - comercial
                                       
Owner occupied
    418       418       56       418       4  
Non-owner occupied
    752       737       120       740       9  
Consumer
    -       -       -       -       -  
Total   $ 2,033     $ 2,018     $ 334     $ 2,021     $ 14  
                                         
Total impaired loans
                                       
Commercial and industrial
  $ 72     $ 72     $ 26     $ 80     $ -  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    415       310       -       310       1  
Other real estate - construction
    1,399       1,210       56       1,227       3  
Real estate - residential
                                       
Home equity lines
    67       67       -       66       1  
Other real estate - residential
    2,201       2,125       76       2,125       11  
Real estate - comercial
                                       
Owner occupied
    5,389       5,355       56       5,355       51  
Non-owner occupied
    752       737       120       740       9  
Consumer
    39       28       -       28       -  
Total   $ 10,334     $ 9,904     $ 334     $ 9,931     $ 76  
 
 
18

 
 
Note 3 – Loans (continued)
 
Impaired Loans
As of and for the Year Ended December 31, 2012
(dollars in thousands)
 
   
Unpaid Principal Balance
   
Recorded Investment
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With no related allowance recorded:
                             
Commercial and industrial
  $ 60     $ 61     $ -     $ 454     $ 25  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    2,457       447       -       2,429       21  
Other real estate - construction
    197       119       -       206       5  
Real estate - residential
                                       
Home equity lines
    70       70       -       74       -  
Other real estate - residential
    2,129       1,964       -       2,283       96  
Real estate - comercial
                                       
Owner occupied
    6,053       5,866       -       6,168       258  
Non-owner occupied
    -       -       -       -       -  
Consumer
    37       27       -       41       -  
Total
  $ 11,003     $ 8,554     $ -     $ 11,655     $ 405  
                                         
With an allowance recorded:
                                       
Commercial and industrial
  $ 29     $ 29     $ 29     $ 32     $ 2  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    -       -       -       -       -  
Other real estate - construction
    -       -       -       -       -  
Real estate - residential
                                       
Home equity lines
    -       -       -       -       -  
Other real estate - residential
    342       342       60       346       23  
Real estate - comercial
                                       
Owner occupied
    143       143       23       149       8  
Non-owner occupied
    760       761       160       780       50  
Consumer
    -       -       -       -       -  
Total
  $ 1,274     $ 1,275     $ 272     $ 1,307     $ 83  
                                         
Total impaired loans
                                       
Commercial and industrial
  $ 89     $ 90     $ 29     $ 486     $ 27  
Real estate - construction, land and land development
                                       
Acquistion, development, & construction
    2,457       447       -       2,429       21  
Other real estate - construction
    197       119       -       206       5  
Real estate - residential
                                       
Home equity lines
    70       70       -       74       -  
Other real estate - residential
    2,471       2,306       60       2,629       119  
Real estate - comercial
                                       
Owner occupied
    6,196       6,009       23       6,317       266  
Non-owner occupied
    760       761       160       780       50  
Consumer
    37       27       -       41       -  
Total
  $ 12,277     $ 9,829     $ 272     $ 12,962     $ 488  
 
For purposes of this disclosure, the unpaid principal balance is not reduced for net charge-offs.
 
 
19

 
 
Note 3 – Loans (continued)

The following tables present a summary of current, past due and nonaccrual loans as of March 31, 2013 and December 31, 2012 by loan class:
 
Analysis of Current, Past Due and Nonaccrual Loans
As of March 31, 2013
(dollars in thousands)
 
   
Accruing
                         
   
30-89 Days
 Past Due
   
90 Days or
more Past Due
   
Nonaccrual
   
Total Past Due and Nonaccrual
   
Current and not Past Due or Nonaccrual
   
Total Loans Receivable
 
Commercial and industrial
  $ 720     $ -     $ 46     $ 766     $ 19,411     $ 20,177  
Real estate - construction, land and land development
                                               
Acquistion, development, & construction
    -       -       -       -       13,049       13,049  
Other real estate - construction
    187       -       1,316       1,503       43,034       44,537  
Real estate - residential
                                               
Home equity lines
    70       17       101       188       19,422       19,610  
Other real estate - residential
    1,582       -       1,348       2,930       30,533       33,463  
Real estate - comercial
                                               
Owner occupied
    233       -       513       746       55,781       56,527  
Non-owner occupied
    -       -       180       180       75,212       75,392  
Consumer
    6       -       27       33       3,693       3,726  
Total
  $ 2,798     $ 17     $ 3,531     $ 6,346     $ 260,135     $ 266,481  
 
Analysis of Current, Past Due and Nonaccrual Loans
As of December 31, 2012
(dollars in thousands)
 
   
Accruing
                         
   
30-89 Days Past Due
   
90 Days or more Past Due
   
Nonaccrual
   
Total Past Due and Nonaccrual
   
Current and not Past Due or Nonaccrual
   
Total Loans Receivable
 
Commercial and industrial
  $ 134     $ -     $ 61     $ 195     $ 19,621     $ 19,816  
Real estate - construction, land and land development
                                               
Acquistion, development, & construction
    -       -       134       134       14,138       14,272  
Other real estate - construction
    1,318       -       68       1,386       40,268       41,654  
Real estate - residential
                                               
Home equity lines
    211       -       108       319       19,618       19,937  
Other real estate - residential
    1,322       -       1,776       3,098       32,460       35,558  
Real estate - comercial
                                               
Owner occupied
    941       -       1,527       2,468       52,360       54,828  
Non-owner occupied
    772       -       195       967       74,934       75,901  
Consumer
    27       -       27       54       3,867       3,921  
Total
  $ 4,725     $ -     $ 3,896     $ 8,621     $ 257,266     $ 265,887  
 
 
20

 
 
Note 3 – Loans (continued)

The Bank’s policy is that loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current and the prospect for future payments in accordance with the loan agreement appear relatively certain.  The Bank’s policy generally refers to six months of payment performance as sufficient to warrant a return to accrual status.

Troubled debt restructurings

Troubled debt restructurings are defined as debt modifications, for economic or legal reasons related to the borrower’s financial difficulties, in which the Bank grants a concession that it would not otherwise consider.  Such a concession may stem from an agreement between the Bank and the borrower, or may be imposed by law or a court.  Some examples of modifications are as follows:

Rate Modification - A modification in which the interest rate is changed below current market rate.

Term Modification - A modification in which the maturity date, timing of payments, or frequency of payments is changed.

Interest Only Modification – A modification in which the loan is converted to interest only payments for a period of time.

Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Transfer of Assets Modification – A modification in which a transfer of assets has occurred to partially satisfy debt, including foreclosure and repossession.

Combination Modification – Any other type of modification, including the use of multiple categories above.

The following tables present the Bank’s loans classified as troubled debt restructurings by loan class as of March 31, 2013 and December 31, 2012:
 
As of March 31, 2013
(dollars in thousands)
 
   
Number of
Contracts
   
Accrual
   
Nonaccrual
   
Total
Restructurings
 
Commercial and industrial
    1     $ -     $ 23     $ 23  
Real estate - construction, land and land development
                               
Acquistion, development, & construction
    2       155       310       465  
Other real estate - construction
    -       -       -       -  
Real estate - residential
                               
Home equity lines
    1       66       -       66  
Other real estate - residential
    10       706       251       957  
Real estate - comercial
                               
Owner occupied
    10       4,506       707       5,213  
Non-owner occupied
    -       -       -       -  
Consumer
    -       -       -       -  
Total
    24     $ 5,433     $ 1,291     $ 6,724  
 
 
21

 
 
Note 3 – Loans (continued)
 
As of December 31, 2012
(dollars in thousands)
 
   
Number of
Contracts
   
Accrual
   
Nonaccrual
   
Total
Restructurings
 
Commercial and industrial
    1     $ -     $ 34     $ 34  
Real estate - construction, land and land development
                               
Acquistion, development, & construction
    2       310       134       444  
Other real estate - construction
    -       -       -       -  
Real estate - residential
                               
Home equity lines
    1       66       -       66  
Other real estate - residential
    10       583       243       826  
Real estate - comercial
                               
Owner occupied
    9       4,187       1,177       5,364  
Non-owner occupied
    -       -       -       -  
Consumer
    -       -       -       -  
Total
    23     $ 5,146     $ 1,588     $ 6,734  

At March 31, 2013 and December 31, 2012, there were no outstanding commitments to advance additional funds on troubled debt restructurings.

For the three months ended March 31, 2013, there were four newly restructured loans that occurred which totaled $808,000 compared to one newly restructured loan which totaled $66,000 for the three months ended March 31, 2012.  The impact of these modifications were not material to the consolidated financial statements for the three months ended March 31, 2013 and 2012.

Loans receivable modified as troubled debt restructurings and with a payment default, with the payment default occurring within 12 months of the restructure date, for the three months ended March 31, 2013 and 2012, were $435,000 and $180,000, respectively.

Note 4 – Stock-Based Compensation

During the three months ended March 31, 2013 and 2012, the Company recorded stock option expense of $24,333 and $26,911, respectively.  The Company did not issue any stock options during the three months ended March 31, 2013 and 2012.  Future levels of compensation cost recognized related to share-based compensation awards may be impacted by new awards and/or modifications, repurchases and cancellations of existing awards.

During the three months ended March 31, 2013 and 2012, the Company made restricted stock awards totaling 24,006 and 8,488, respectively.  The awards granted in 2012 vest fully at the end of three years.  The awards granted in 2013 which vest fully at the end of three years totaled 16,406.  The awards granted in 2013 which vest fully at the end of five years totaled 7,600.  The Company recorded restricted stock expense of $27,086 and $3,006 during the three months ended March 31, 2013 and 2012, respectively.
 
 
22

 
 
Note 5 – Earnings Per Share

Earnings per common share are calculated on the basis of the weighted average number of common shares outstanding.  Related to the Company’s granting of stock options to certain officers and other employees of the Company, diluted earnings per share are presented in the Consolidated Statements of Income.

The following table is a reconciliation of the income amounts and common stock amounts utilized in computing the Company’s earnings per share for the periods then ended:

   
March 31, 2013
 
   
Income
(Numerator)
   
Shares
 (Denominator)
   
Per Share
 
   
(dollars in thousands, except per share data)
 
Basic EPS
                 
Net income available to common shareholder
  $ 2,307       3,546,895     $ 0.65  
Effect of stock options outstanding
    -       22,889       -  
Diluted EPS
                       
Net income available to common shareholder
  $ 2,307       3,569,784     $ 0.65  
 
   
March 31, 2012
 
   
Income
(Numerator)
   
Shares
 (Denominator)
   
Per Share
 
   
(dollars in thousands, except per share data)
 
Basic EPS
                       
Net income available to common shareholder
  $ 1,284       3,609,991     $ 0.36  
Effect of stock options outstanding
    -       -       -  
Diluted EPS
                       
Net income available to common shareholder
  $ 1,284       3,609,991     $ 0.36  
 
For the three months ended March 31, 2013 and 2012, there were 106,483 and 175,182 outstanding stock options, respectively, that were antidilutive since the exercise price exceeded the average market price.
 
Note 6 – Fair Value Measurement

The Company utilizes fair value measurement to record fair value adjustments to certain assets and liabilities and to determine fair value measurements where required.  For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are as follows:

 
23

 

Note 6 – Fair Value Measurement (continued)

Level 1 – Valuations are readily obtainable because the assets and liabilities are traded in active exchange markets, such as the New York Stock Exchange.  At March 31, 2013, the Company had no Level 1 assets.
 
Level 2 – Valuations are obtained from readily available pricing sources via independent providers for market transactions involving similar assets or liabilities.  The Company’s principal market for these securities is the secondary institutional markets and valuations are based on observable market data in
those markets.  At March 31, 2013, the Company’s Level 2 assets included U.S. Government agency obligations, state and municipal bonds, mortgage-backed securities, and mortgage loans held for sale.

Level 3 – Valuations are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and are not based on market exchange, dealer, or broker traded transactions.  Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.  Level 3 assets include impaired loans and other real estate owned as discussed below.

Following is a description of valuation methodologies used for determining fair value for assets and liabilities:

Investment Securities Available-for-Sale
Investment securities available-for-sale are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the securities’ credit rating, prepayment assumptions, and other factors such as credit loss assumptions.  Periodically, management compares the fair values obtained through its pricing provider with another independent party to determine reliability.  Management completed such a comparison during the second quarter of 2012 and noted differences were clearly immaterial.  The Company classified $138.3 million and $132.8 million of investment securities available-for-sale subject to recurring fair value adjustments as Level 2 at March 31, 2013 and December 31, 2012, respectively.

Loans
The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once an individual loan is identified as impaired, management measures the impairment.   The fair value of impaired loans is estimated primarily using the collateral value.  However, in some cases other methods are used, such as market value of similar debt, enterprise value, liquidation value, and discounted cash flows.  Those impaired loans not requiring an allowance represent loans with respect to which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At March 31, 2013, substantially all of the impaired loans were evaluated based on the fair value of the collateral less estimated selling costs.  Impaired loans where an allowance is established based on the fair value of collateral, or those that have been charged down to the fair value of collateral, require classification in the fair value hierarchy.  The fair value of the collateral is generally based on recent third party appraisals, tax valuations, or broker price opinions. The appraisals may include adjustments by the appraisers for differences between approaches such as the comparable sales approach and the income approach.

As such, the Company records these collateral dependent impaired loans at fair value as nonrecurring Level 3.  Collateral dependent impaired loans recorded at fair value totaled $2.7 million and $2.9 million at March 31, 2013 and December 31, 2012, respectively.  Specific loan loss allowances for these impaired loans totaled $334,000 and $272,000 at March 31, 2013 and December 31, 2012, respectively.
 
 
24

 
 
Note 6 – Fair Value Measurement (continued)

Loans Held for Sale
Loans held for sale are carried at fair value on a recurring basis, as determined by outstanding commitments from third party investors (Level 2).  The Company elected the fair value option for loans held for sale on July 1, 2012.  These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans.  Interest income is recorded based on the contractual terms of the loan and in accordance with the Company’s policy on loans held for investment.  None of these loans are 90 days or more past due, nor on non-accrual as of March 31, 2013 and December 31, 2012.  As of March 31, 2013 and December 31, 2012, the aggregate fair value was $34.3 million and $48.4 million, respectively; the contractual balance including accrued interest was $34.3 million and $48.3 million, respectively.

Interest Rate Lock Commitments
Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives.  Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked.  Changes in the fair values of these derivatives are included in mortgage banking activities.  At March 31, 2013 and December 31, 2012, the interest rate lock commitments with a positive fair value totaled $112,000 and $97,000, respectively, and were recorded in other assets. The interest rate lock commitments with a negative fair value at March 31, 2013 and December 31, 2012 totaled $126,000 and $49,000, respectively, and were recorded in other liabilities.

The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge against the change in interest rates resulting from its commitments to fund loans.  Changes in the fair values of these derivatives are included in net gains on sales of loans.  At March 31, 2013 and December 31, 2012, the interest rate lock commitments with a positive fair value totaled $126,000 and $49,000, respectively, and were recorded in other assets.  The interest rate lock commitments with a negative fair value at March 31, 2013 and December 31, 2012 totaled $112,000 and $97,000, respectively, and were recorded in other liabilities.  At March 31, 2013 and December 31, 2012, the forward commitments for loans held for sale with a positive fair value totaled $181,000 and $83,000, respectively, and were recorded in other assets.  The forward commitments for loans held for sale with a negative fair value at March 31, 2013 and December 31, 2012 totaled $151,000 and $263,000, respectively, and were recorded in other liabilities.

Other Real Estate Owned
Foreclosed assets are adjusted to fair value less estimated selling costs upon transfer of the loans to other real estate owned establishing a new cost basis.  Subsequently, other real estate owned is carried at the lower of carrying value or fair value less estimated selling costs.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  Most fair values of the collateral are based on an observable market price or a current appraised value; however, in some cases an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price.  Management may apply discount adjustments to the appraised value for estimated selling costs, information from comparable sales, and marketability of the property.  As such, the Company records other real estate owned with subsequent write downs after transfer as nonrecurring Level 3.  Other real estate owned that has had subsequent write-downs after transfer from loans to other real estate totaled $599,000 and $1.2 million at March 31, 2013 and December 31, 2012, respectively.
 
 
25

 
 
Note 6 – Fair Value Measurement (continued)

The tables below present information as of March 31, 2013 and December 31, 2012 about assets and liabilities which are measured at fair value on a recurring basis:

   
Fair Value Measurements at
March 31, 2013, Using,
 
   
Quoted Prices in Active Markets for Identical Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Other Unobservable Inputs
(Level 3)
   
Total
 
   
(dollars in thousands)
 
U.S. Government and agency
  $ -     $ 60,789     $ -     $ 60,789  
Mortgage-backed - residential GSEs